This puts significant pressure on plan sponsors and plan participants. By 2015, those ages 50 and older will represent 45% of the U.S. population (AARP), and the ever increasing challenges for plan participants are learning how to invest, figuring out how much to save, and recognizing what their plans offer so retirement will be an enjoyable adventure. Getting employees to participate in the plan, having them contribute at high enough levels to be meaningful, and giving them the tools to make sensible investment decisions are the core challenges many plan sponsors face today.
Aging workforce effects corporate profitability
There are significant consequences for the company sponsoring these plans over the long run. An aging workforce may dampen overall productivity while generating significantly higher employee benefit plan costs. For example, the average annual cost of health and disability insurance for a 30-year-old employee is $2,592. For employees ages 60 and older, the average cost increases 277%, to $9,762 a year. Now cascade this thinking to three, 1,000-life companies that are exactly the same, other than the demographics of the workforce.
In the first company, 30% of the workers are 60+ in age, 45% are between 40 and 60 and the remaining 25% are younger than 40. Employer premium costs combined for disability insurance (DI) and health care would be right around $6.1 million dollars. In the second company, 20% of the workers are 60+ in age, 40% are between 40 and 60 and the remaining 40% are younger than 40. Employer premium costs combined for DI and health care would be right around $5.3 million dollars. This is an $800k cost difference with just a 10% change in the number of workers older than 60. In the third company, just 10% of the workers are 60+ in age, 35% are between 40 and 60 and the remaining 55% are younger than 40. Employer premium costs combined for DI and health care would be right around $4.4 million dollars. The cost difference between company 1 and company 3 is $1.7 million a year!
Plan sponsors can make a difference
A key challenge for plan sponsors and providers is to facilitate retirement readiness among employees, so current and future plan participants can retire on their terms.
Retirement plan consultants and advisers can be a resource for plan sponsors to design effective solutions to better meet the retirement readiness needs of their participants. For example, at Morgan Stanley we help employees achieve retirement readiness by helping plan sponsors:
• Recognize the extent of their plan’s ability to replace income;
• Customize effective education programs;
• Guide participants and employees to income replacement; and
• Design effective plan features and incentives.
Knowing the plans income replacement the first step
Any company that sponsors a defined benefit plan knows what a funding ratio is and if they are underfunded, by how much. With the adoption of 401(k) plans as the sole retirement benefit offered, very few companies know if their employees will have enough to retire. Conducting an income replacement analysis on a 401(k) plan will provide:
• An overall average income replacement ratio of all plan participants;
• An overall percentage of participants on track and not on track for retirement;
• Further breakdown of participants within each income replacement ratio range; and
• Percentage of participants on track and not on track by salary and age.
Our experience shows that conducting an income replacement analysis for the 401(k) plan, in a sense finding the funding ratio of their plan, provides an insight into where to target solutions.
Meetings, education help if structured properly
While there is no doubt that employee education is important, the industry has spent literally millions of dollars on education and the results have been less than optimal. A recent report on financial behaviors, consisting of 168 research papers covering 201 prior studies, confirms financial education is basically ineffective if it is not elaborated or acted upon soon afterward.
We have found the most effective method for helping employees is achieved through individual counseling sessions. These meetings provide employees the opportunity to meet with a retirement planning professional and learn about implementing an action-oriented retirement plan.
Recently, we spent three days at a Chicago-based manufacturing company, meeting individually with employees about their retirement goals and their 401(k) plan. Among those who participated in the one-on-one sessions, more than 80% took action by either increasing their contribution or enrolling in the plan. These steps encourage participants to construct a retirement plan designed to achieve long-term success.
Focus on income replacement, not account balances
A larger educational issue involves shifting employees’ focus from account balances to income replacement. For years, many providers have focused on building employees’ 401(k) account balances. That’s focusing on the wrong target.
Instead, participants need to focus on replacing income through their 401(k) plans. Based on age, asset allocation, risk tolerance, and the employee’s deferral rate, we must help participants craft a plan to replace at least 75% of their working income in retirement. We also need to show them alternatives, such as what a small deferral increase or a shift in the asset mix, may do to change their estimated future income. An effective counseling session, that helps re-focus this employee on replacement income, will bring clarity to the employee on the steps needed to bridge this gap.
Design a plan with auto enrollment
Although participant education is important, nothing may be as crucial as plan design. And in terms of plan design, nothing may be as important as implementing an automatic enrollment feature. Only 38% of plan sponsors use this feature, and among those that do, the vast majority only auto enroll new hires, excluding their long-term employees.
Furthermore, most plans have a default deferral rate of 3%, meaning most plan sponsors are effectively endorsing a savings rate that cannot generate a successful retirement nest egg. And because most plan sponsors don’t auto-escalate savings, their participants may face a significant retirement shortfall.
The right matching formula can help drive results
Including an employer match in the plan is generally a powerful motivator in boosting participant contributions. With an employer match, we have found:
• Participants contribute more when employers “stretch the target” through matching contributions—that is, they present the matching formula in formats that encourage greater employee savings. For example, offering a 25% match on up to 8% of pay can result in greater employee participation rates and the same employer costs as offering a 100% match on 2% of pay. The accompanying chart illustrates this.
Today, retirement can represent a meaningful new stage of life. Americans tend to live 25, 30, even 35 years in retirement. Their health is better, and they are able to stay active longer. Few C-Suite executives, plan sponsors, fiduciaries, and those charged with making decisions about their company’s retirement plan would argue that helping employees become better prepared for retirement is the not the right thing to do. By working with an experienced, proactive 401(k) adviser, plan sponsors can help their employees meet the challenges of retirement planning and ultimately enjoy a comfortable retirement lifestyle.
Sam Valeo is 401(k) Plan Consulting Director for Morgan Stanley in Oak Brook, Illinois. He can be reached via email at Sam.Valeo@morganstanley.com and by phone at (630) 203-6184.
Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC (“Morgan Stanley”) , its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors do not provide tax or legal advice and are not “fiduciaries” (under ERISA, the Internal Revenue Code or otherwise) with respect to the services or activities described herein except as otherwise agreed to in writing by Morgan Stanley. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are encouraged to consult their tax and legal advisors (a) before establishing a retirement plan or account, and (b) regarding any potential tax, ERISA and related consequences of any investments made under such plan or account.