Some Plan Design Choices Could Undermine Participant Outcomes

Setting defaults too low, choosing the wrong default investment and offering company stock as an investment option could result in unintended consequences, BlackRock found.

BlackRock took a look at various cases where a plan sponsor made changes to plan design to see what the outcomes were and found some unintended consequences.

Setting defaults too low

In the first case study, a large consumer staples company with more than 100,000 participants and $5 billion in assets added auto-escalation as an opt-out for all new participants in annual increments of 1% up to a 6% cap. A look at the active participants, those who made proactive changes to their savings amounts, found that 43% were saving more than 6%. Thirty-three percent were saving between 4% and 6%, and 24% less than 6%.

BlackRock then looked at passive participants, those who merely accepted the defaults their employer set them into, and found that only 19% were saving more than 6%. Twenty-one percent were saving less than 6%, and 60% were saving between 4% and 6%.

In total, active participants’ deferral rates averaged 6.8%, and passive participants’ deferral rates averaged 4.9%.

“Passive participants will typically remain at the plan sponsor’s default,” BlackRock says. “This tendency can be used to their advantage by setting defaults higher and increasing auto-escalation caps considerably—or even allowing them to reach IRS contribution caps. The example of the active group with their increased appetite for savings may also be considered an argument in favor of higher caps.”

BlackRock then looked at how saving 2% more a year over a 40-year career starting at age 25 would have on plan balances. For those saving 9%, the projected end balance would be $1,039,000. Those saving 11% would end up with $1,270,000, 22% more than the other group.

BlackRock concludes that setting defaults and auto-escalations too low may undermine the power of these plan design features.

Investing in a TDF

In the second case study, a U.S. technology company decided 10 years ago to use a target-date fund (TDF) as the qualified default investment alternative for new hires, but not for legacy employees, who had been automatically enrolled into a stable value fund. Two years ago, the company added 10,000 employees through an acquisition, all of whom were reenrolled into a TDF. The result was that the company now had two very different participant populations with very different return profiles.

After 10 years, 42% of the legacy company employees were invested in a TDF, 25% in the stable value fund, and 32% in another fund. Sixty-one percent of the newly acquired employees were invested in a TDF, 10% in the stable value fund, and 29% in another fund.

Again, BlackRock projected the ending balance over a 40-year career starting at age 25 if a participant were invested in the stable value fund versus a TDF. The balance for the first choice would be $875,000—and $1,388,000 for the second, a 59% increase.

“The opportunity for the legacy company’s longest tenured employees may be significant,” BlackRock says. “Higher returns from a TDF compared to a stable value fund compounded over a career can result in a nest egg that’s 59% larger, or would potentially require a participant to save 7% more to make up the difference.”

Offering company stock as an investment

In the third case study, a large U.S. health care company gave employees company stock as the company match and also offered company stock on the investment lineup. Senior managers and executives were required to hold a percentage of their assets in company stock.

BlackRock was surprised to find that those in the lowest quartile has 33% of their assets in company stock, whereas those in the highest quartile had only 15% in company stock.

“Non-investment savvy participants may tend to equate risk with the unknown and may, therefore, think that shares in the company they know firsthand are safer than an S&P 100 index fund filled with many companies they know little or nothing about,” BlackRock says. “Employees underestimate the risk of owning company stock.”

Using the S&P 500 Health Care Net Index as a proxy for the company stock, BlackRock found that in the event of a global stock market drop, the index would decline by 22.9%, whereas a TDF strategy would lose only 11.7% of its value.

BlackRock concludes that the three cases are an “argument for better data and deeper analysis.” The company recommends that retirement plan advisers and sponsors “review plan objectives. Conduct plan and participant analysis, and test plan changes.”

BlackRock’s white paper, “Best Intentions: The Unintended Consequences of Plan Design,” can be downloaded here.