Collaborating to a Default

May 4, 2020

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Leading retirement experts work closely with plan sponsors to create the right 401(k) for their own workplaces.

New Brain Inside

It's the essential paradox unearthed by decades of research in psychology, economics and behavioral finance: Every individual is unique in similar ways. "We're all prone to certain decision-making processes," says Dave Stinnett, head of strategic retirement consulting for Vanguard's Institutional Investor Group. "We often make emotion-driven decisions that don't suit us well."

Leading retirement providers are encouraging plan sponsors to minimize opportunities for employees to make counterproductive decisions. Automation—of enrollment, contribution increases and investment selection, typically into a target date fund (TDF) that automatically rebalances over time—has been the most powerful tool in this effort.

Yet, a cookie cutter approach isn't the answer, either. New artificial intelligence-powered tools are starting to personalize behavioral prompts to encourage employees to optimize their choices. And well before these advanced new tools are turned on, top retirement providers seek to build stronger, more effective plans by collaborating with plan sponsors to customize aspects of the 401(k) plan based on each firm's individual situation. Think of it as "Behavioral Finance, the Sponsor Level."

Assessing the current plan

The modern approach to 401(k) plans has dramatically increased their effectiveness. For example, plan sponsors that use auto-enrollment have average participation rates of 91%, while plans that take a more traditional approach—asking employees to opt in, then select a contribution rate and asset allocation—have participation rates of roughly 60%, according to Vanguard.

Still, no two employers are identical, so different plan sponsors may take distinct approaches to adopting and implementing aspects of the modern plan. That's why leading providers begin new relationships with plan sponsors with a deep-dive discovery session. That process focuses on understanding the firm's overall employee benefits strategy and the role the 401(k) plan plays in it: Is the company aiming to drive recruiting, support employee engagement, boost retirement readiness or reach another goal altogether?

Stinnett notes this discussion is often as revealing for the plan sponsor as it is for the provider, giving the sponsor an opportunity to step back from the day to day and think about the larger implications of its benefits package, in some cases for the first time. By the same token, the discovery session also gives the retirement provider the information it needs to start considering how to tweak standard approaches for the company and its employee base.

Next, the retirement provider analyzes the existing plan design. This analysis aims to understand how well the plan works currently, while identifying gaps and opportunities for improvement. Vanguard has developed a proprietary metric called the Vanguard Plan Effectiveness Index, which captures employees' participation rates, savings rates and investing mixes, to help guide this process and measure the results. Retirement providers may also assess retirement income replacement ratios to determine how well the plan is supporting participants' need for sufficient income in retirement.

Some retirement providers take their analysis a step further, presenting plan sponsors with a detailed cost analysis of the various measures they recommend. "It's very easy for us to say, Here are some opportunities for you to sweep more people into the plan or tune up the default contribution or auto-escalation levels.' But if the company is offering a match, that's going to cost them more money," Stinnett says. "When we can give plan sponsors a good idea of what those costs will be, we can then have a meaningful, smart debate about how to build the best plan."

Plan sponsors are people, too

Automation and diversified, age-appropriate default investments have become widely accepted as best practices for plan design. Yet they remain far from universal—for example, only 61% of plans have an auto-enrollment feature, according to the Plan Sponsor Council of America. What's preventing the rest from following suit?

In some cases, a plan sponsor may be perfectly happy with a more traditional approach to the 401(k) plan, or simply may not be able to afford the increased costs of a plan that serves more participants at higher contribution rates. In other cases, the answer may go back to an insight from behavioral finance. Decision-makers and plan sponsors are human, so they too are prone to inertia and inconsistencies: They may intend to make improvements to their plan, but delay getting around to it, especially when they come up against impediments like limited budgets or internal opposition—even if they long ago decided the advantages were worth it.

Regardless of the reasons a particular organization holds on to the old way of managing its 401(k) plan, Stinnett believes his team has a responsibility to put the modern approach to the 401(k) on the table. In either scenario, his group can then work with plan sponsors to customize their plan in a way that makes the most sense for their organization—perhaps tweaking the match formula, adjusting the TDF glide path or simply designing communications that resonate with their employees.

The end result: a workplace retirement plan that benefits not only from research-backed insights, but also from a deep understanding of the plan sponsor and its employees.

To learn more about the latest research from Vanguard's strategic retirement consulting group, please click here.

Developed in collaboration with The Wall Street Journal.

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  • All investing is subject to risk, including the possible loss of the money you invest.
  • Diversification does not ensure a profit or protect against a loss.
  • Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in target date funds is not guaranteed at any time, including on or after the target date.