Employees with 401(k) plans face big obstacles to successful retirements.
These include low contribution rates, investment choices that would challenge even a licensed broker and the temptation to cash out plans when they change jobs. People close to retirement age have average 401(k) balances insufficient to support even modest retirements. Yet, it turns out, these are the lucky ones.
Roughly half of all Americans have no employer-based retirement program. Gen Xers and millennials are at a particular disadvantage. Debates over minimal contribution requirements, employer matches and tax benefits sadly are irrelevant to half of all workers in the United States, according to the Employee Benefit Research Institute. Their retirement option is to somehow cobble together personal savings and perhaps Individual Retirement Accounts to build a retirement nest egg.
Small business employers are particularly challenged in providing helpful retirement savings and investing programs. The financial, administrative and regulatory burdens of sponsoring a 401(k) program are substantial. This is not a rant against big government. It's just a reality that small businesses often don't have the management time or skill to offer such a benefit. They also may not have the money. And while it's possible in theory to appreciate that good benefits help attract and keep productive employees, the reality is that this is often viewed as an unaffordable luxury.
The U.S. Senate Committee on Health, Education, Labor and Pensions has long recognized that there are big holes in the private retirement safety net. The committee regularly holds hearings and convenes experts to advise senators on ways to plug these holes. Until Congress can shift gears and re-engage with significant issues like retirement security, that's about all we will see.
Still, the discussions can help develop a needed foundation for later action. At one such hearing late last January, the committee sought advice from witnesses on how to improve the availability and use of private workplace retirement plans.
One of the witnesses was Harvard professor Brigitte Madrian. Over the past few months, students in her master level course, Behavioral Economics and Public Policy, have been wrestling with how to shore up small-employer retirement plans. Bright as they may be, a review of some of their ideas and interviews with some of the students illustrates how narrow and challenging the course is to achieve more successful retirement outcomes.
Facing large and seemingly permanent budget deficits, ideas that involve spending a lot of money face headwinds among leaders of both political parties. Plans that use tax breaks to appeal to employees and employers also face increasing scrutiny. Such tax expenditures used to be popular ways to get things done because they didn't involve direct government spending. Further, the tax hit tended to be modest in early years of a new program, which is the period of greatest budget scrutiny for a piece of proposed legislation. But these days, even this relatively invisible cost is likely to trigger a "Do Not Pass Go" response to a new idea.
Behavioral economics, however, may offer solutions that produce the desired employee and employer behaviors without raising costs. The most successful retirement-plan use of behavioral prods was the introduction a few years ago of a rule requiring employees to participate in available 401(k) plans – which remain voluntary – unless they consciously opted out of the plans. Prior participation rules had assumed employees would not be in the plans unless they opted in. Not surprisingly, the behavioral tendency of people to do nothing has resulted in much higher participation rates under the opt-in rules than the old opt-out standard.
"Simplicity is really important," says one of Madrian's students, 27-year-old Kate Glazebrook. She worked on government pension plans in her native Australia before enrolling in the master's program. She, as well as some other students, support a new retirement plan for small employers that would feature simple and standardized investment choices and program rules.
This would make it easier for employees to understand the program, and it would also hold down the financial and time commitment for participating employers. Such a program would also need to protect employers from any legal action if employee investment results fell short of expectations. From a behavioral standpoint, any program needs to stress positive benefits (the "carrots") and not its compliance requirements (the "stick").
Another one of Madrian's students is 60-year-old Bill Urban, who is close to retirement on multiple levels. Besides his age, Urban came to Harvard after a long career in investment planning and advice. He is a certified financial planner and chartered financial analyst. In addition to practical knowledge, Urban says behavioral tools can help achieve better retirement outcomes.
For example, he suggests a new program should provide employees upfront with the amount of money they would receive from their employer's matching contributions for an entire year. Knowing this larger number would be at risk if they did not participate in the program, Urban says, would take advantage of research showing that people are more sensitive to money they might lose than money they might make. "Avoiding a loss is more compelling to people," and can be a motivator, he says.
Urban also recommends more use of Roth IRAs, which tax contributions – unlike normal 401(k)s – but do not tax investment gains when funds are withdrawn for retirement spending (regular 401(k) distributions are taxed as ordinary income).
The benefits of tax-free withdrawals become progressively larger the longer the funds are held within a Roth. By emphasizing these positive gains to younger employees, Urban says, it would be possible to overcome the difficulty many younger savers have in appreciating the benefits of putting aside funds today for a benefit that is so far in the future.
Student James Carty recommended in a class assignment creating a new federally approved small-employer savings program that would use tax breaks for participating companies as well as individual employees. Some student plans would use the tax code to pay small employers to participate. Otherwise, it was feared, their current tendency not to offer such programs would remain unchanged.
Glazebrook says using the tools of behavioral economics could be viewed as manipulating people's behavior. But having accepted the need that people likely need encouragement to change, the prospect of getting behavioral "nudges" is less threatening. "The question then becomes who manipulates you and for what purpose," she says.