According to a study from the Employee Benefits Research Institute:
Among employees earning between $30,000 and $50,000, and without access to a retirement plan at work, only 5% make IRA contributions.
Now some may argue that workers earning $30K-$50K don't contribute to IRA's simply because they can't afford to do without the money. But that same study found that 72% of workers in the same income group participate in their 401(k) plan if they have access to one. Given that the tax benefits of deductible IRA contributions are identical to those of 401(k) contributions, what explains this difference in participation rates?
The existence of employer matches to 401(k) contributions surely accounts for some of this disparity. (Although, amazingly, almost a third of 401(k) plan participants contribute less than necessary to receive their full employer match, in essence saying "no thanks" to free money).
It also seems very likely, however, that a big part of the answer to the question above lies in the increasingly paternalistic nature of 401(k) plans. In 2006, the Pension Protection Act allowed employers more latitude in choosing how a worker's 401(k) account is to be invested if he or she doesn't proactively make that decision. These default investment options now used by many 401(k) sponsors come in the form of a series of target-date mutual funds. Employers then simply invest a given worker's 401(k) balance in the target-date fund that corresponds with his or her projected retirement age.
This example of a more paternalistic approach to the regulation of retirement plans has been a step forward. It used to be the case that companies, fearing potential lawsuits from employees whose account values had fallen, would as a default option invest in money market or stable value funds. In this prolonged period of near-zero interest rates, these workers' accounts were bound to lose purchasing power to inflation over time. While target-date funds are certainly not a panacea, they do provide simple, diversified exposure to the markets and should outpace inflation over the long-term.
The Pension Protection Act also permitted employers:
· to automatically enroll their workers in the company's 401(k) plan, unless a worker specifically opts out,
· to set these participants' initial contributions at a minimum of 3% of their pay, and
· to boost these contribution rates by 1% a year (up to 6%).
In other words, employees often participate in retirement plans at work now because they must make a conscious decision, a proactive effort, to do otherwise. This new legislation takes advantage of our natural tendency towards retirement inertia. And that's good. In this case, the end justifies the means. Lawmakers are nudging workers towards making better decisions about saving for retirement and investing appropriately.
In an effort to defuse our "retirement crisis", politicians at both the state and federal levels have become much more paternalistic in how they're treating the nation's employers and employees. As a further example, several states have now made it mandatory for private sector employers to offer retirement plans to their workers. And many other states are considering similar measures.
Why Retirement Savers Need This Guiding Hand
These new 401k plan design features (auto-enrollment, auto-escalation, and riskier default investment options) are based on the knowledge that, in general, investors and retirement savers do not make very good financial decisions. Reams of academic research support this conclusion.
In fact, "behavioral economics", a relatively new field of study, for which Nobel Prizes have been awarded, centers around how and why we make irrational financial decisions. And educational material provided to retirement plan participants has done nothing to change this poor decision-making. To quote retirement plan expert Warren Cormier:
"If we look at forces working on participants as they make decisions, we see that education is a minor weapon against irrational choices."
"...powerful forces such as loss aversion, regret aversion, hindsight bias, illusion of control, overconfidence, the Endowment Effect and hedonics neutralize the impact of great education."
Even worse, irrational overconfidence seems to manifest itself beyond just retirement plans, to all types of retirement-related decisions. Recently the American College quizzed over a thousand people at retirement age with more than $100,000 in investible assets on a variety of retirement- and investment-related topics. More than 90% of the test-takers were at least moderately confident in their ability to achieve a secure retirement. Only 21% passed the test.
Test your own retirement literacy by clicking on the Center for Retirement Income's Retirement Income Quiz and taking the multiple choice test.
About the Author
Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses. To contact Paul, please click here.