One drawback of defined contribution (DC) retirement plans is that they place the burden of making financial decisions on participants who are often ill equipped for the task. This has contributed to widespread concerns about retirement security. Will people have enough savings when they leave the workforce to afford a comfortable retirement? Will they then draw on their nest eggs efficiently while in retirement, enabling them to avoid financial ruin over an uncertain lifetime?
The field of behavioral economics has been instrumental in understanding how to deal with such issues. One significant contribution has led to the establishment of default features that automatically enroll new employees into DC plans using a sensible contribution rate schedule and investment strategy. These help address peoples’ tendencies to postpone enrollment and to make poor decisions later when they finally do enroll (e.g., select inappropriate or under diversified asset allocations, chase performance, panic sell).
An early criticism of default features focused on their one-size-fits-all nature. Nevertheless, one size can fit most people well enough; so on the whole, sensible defaults can lead to significantly better outcomes than the alternative of leaving ill-equipped participants on their own with no defaults at all. Moreover, prudently selected and well-communicated defaults seem relatively harmless, given that participants can always elect to opt out or otherwise deviate from them if they wish. Thus, default features appear to be a step in the right direction in improving retirement security.
The Weak Link: DC plan default features have mainly focused on the retirement accumulation task, but there has been little innovation on the payout side. That is, when participants reach retirement, they are typically left on their own to untangle the dissaving challenge. This is complex since managing retirement payouts involves a complex calculus of mortality rates, lifespan probabilities, and sustainable spending when drawing from accumulated savings. And while the saving decision can accommodate a “set it and forget it” approach, the task of dissaving requires ongoing attention.
The reality of declining cognitive ability in old age deepens this challenge. Unfortunately, most DC plans typically pay out a lump sum that the participant must then figure out how to manage. This highlights a crucial weak link in the retirement security challenge because, as Professors Annamaria Lusardi and Olivia S Mitchell recently noted, many people lack the level of financial literacy that could better protect themselves against longevity risk in retirement.
One way to address this weak link is to allow plans to adopt automatic default provisions, so that participants could draw down their account balances smoothly during retirement. For instance, at retirement people could be automatically enrolled in a default withdrawal approach that paid out benefits according to sound economic principles and actuarial expectations based on the participant’s age. People could initiate their withdrawals at the dates best suiting them, recognizing that different people will elect to retire at different ages.
Nothing about this idea would limit participant choice: all it would do is provide a default payout structure that participants could alter at any time.
Practicalities: For a default payout distribution strategy to be practical, it must be consistent with the tax code, regulations governing qualified plans (including the Employee Retirement Income Security Act), and the variable way that participants time their retirements. These practicalities are the subject of my recent discussion paper that also considered how such a default option can produce sustainable lifetime income.
Moreover, default payout distributions could be guaranteed or non-guaranteed. Because the former tend to be more costly, complex, and prone to limitations on portability or revocability, the latter may be more easily accepted as a default option. In any event, plan sponsors could decide for themselves whether defaulting participants into a guaranteed payout arrangement would be appropriate for their particular plans.
Defaults in Perspective: My point is not to suggest that the retirement income challenge has a one-size-fits-all solution. Instead, I believe that a sensible default plan for lifetime retirement account decumulation might make a better starting place than the alternative of leaving DC participants (many of whom lack the necessary financial and actuarial expertise) with nothing but a lump sum, to do with as they wish. The challenge is perhaps especially acute for lower net worth participants and retirees, for whom access to a financial advisor can be limited or prohibitively expensive.
While default options alone will not solve the retirement security challenge, they can help. The time is right to reframe DC plans as income continuation plans, rather than solely as saving plans.
Richard Fullmer is an asset allocation portfolio strategist at T. Rowe Price, where he focuses on research and development of retirement investment strategies, spending strategies, and ways to mitigate longevity risk.
