Are your participants sabotaging their retirement security?

Most plan sponsors are all too familiar with issues that make it more difficult for participants to achieve retirement security—low contribution levels, inappropriate investment choices, and reducing or stopping contributions are prime examples. However, a concept that plan sponsors tend to be less familiar with is that certain behavioral biases can influence participant decision-making about saving and investing for retirement.

Common behavioral biases

In a recent book published by the CFA Institute Research Foundation,1 the authors Jeffrey Bailey and Kurt Winkelmann identified five primary biases that are common among plan participants.

  1. Overconfidence bias. This occurs when participants overestimate their investment skills. They may, for example, select from among a plan’s individual investment options even though a diversified strategy obtained using a target-date fund or through a managed account may be a better choice.
  2. Confirmation bias. Participants may rationalize their decisions to hold a large percentage of their plan assets in their employer’s stock or in the stocks of the industry they work in since they believe that they can.
  3. Loss aversion bias. Some plan participants are very sensitive to short-term losses, so much so that they hold excessive amounts of low-risk investments in their retirement plan portfolios. Often, the returns of portfolios that are heavily allocated in low-risk investments fail to produce adequate long-term returns.
  4. Recency bias. Some plan participants may have the tendency to make asset allocation decisions based on the recent performance of various investments. However, past performance is no guarantee of future results.
  5. Anchoring bias. Participants may contribute just enough to their plan to receive their employer’s matching contributions rather than contribute at a level that will put them on a path to retirement security.

What sponsors can do

Both financial education and plan design can be helpful in overcoming the behavioral biases that prevent participants from using their plans effectively. Education should focus on providing digestible retirement planning information that avoids jargon and stresses the importance of participants taking a long-range perspective when it comes to preparing for retirement. Plan sponsors should consider leveraging different forms of media to deliver these messages.

In their book, Bailey and Winkelmann identified several best practices in financial education that can steer participants toward making better choices about their retirement planning, including:

  • Customizing participant messaging based on demographics
  • Making use of widely read communications, such as plan statements
  • Translating account balances into lifetime income projections
  • Integrating retirement savings with other financial goals
  • Emphasizing sound behaviors, such as cautioning participants against taking frequent plan loans or making withdrawals
  • Simplifying messages and producing education modules that participants can consume in five-to 10-minute increments

Along with education efforts, plan sponsors may want to identify ways to offset the negative impact of behavioral bias with plan features that are designed around participant tendencies. The plan’s default settings are particularly important. For example, automatic contribution escalation can get around a participant’s inertia and tendency toward anchoring bias. And an automatic rebalancing feature can be helpful in countering recency bias.

Promoting successful outcomes

Participation in an employer-sponsored retirement plan can be an essential component of an employee’s journey to retirement security. As a plan sponsor, your actions can influence how effective your plan is in helping employees prepare for retirement. Having clearly defined metrics and regularly monitoring them will allow you to focus on measures that are likely to have an impact on retirement readiness.

Engage your retirement plan consultant regarding their ability to deliver participant education around financial wellness and optimizing decision-making in order to minimize the effect of negative behavioral biases among participants.

DOL speaks out on push to include cryptocurrencies as investment options for 401(k) plans

The US Department of Labor (DOL) recently issued a Compliance Assistance Release2 that addresses some of its concerns with offering cryptocurrencies as an investment option within 401(k) plans. It did so in response to what appears to be growing pressure on plan sponsors and regulators to consider offering this investment option to retirement plan investors.

Plan sponsors, especially those who have had participants asking about including a cryptocurrency option in the plan’s investment lineup, may find the DOL’s thinking on the issue to be helpful and clarifying. In particular, sponsors should pay close attention to the DOL’s emphasis on the role of the plan fiduciary.

The big picture

The release immediately states the DOL’s position when it declares in the first paragraph: “The Department cautions plan fiduciaries to exercise extreme care before they consider adding a cryptocurrency option to a 401(k) plan’s investment menu for plan participants.”

The release notes that in a 401(k) or other defined contribution plan, a plan participant’s account value depends on the investment performance of the employee’s and employer’s contributions. When a plan offers its participants a menu of investment options, the responsible fiduciaries have an obligation to ensure the prudence of the options on an ongoing basis.

The release cites a recent Supreme Court decision in which the court explained that “even in a defined-contribution plan where participants choose their investments, plan fiduciaries are required to conduct their own independent evaluation to determine which investments may be prudently included in the plan’s menu of options.” The DOL notes that the failure to remove imprudent investment options is a breach of fiduciary duty.

Areas of serious concern

In the Compliance Assistance release, the DOL wrote that it has “serious concerns” about the prudence of a fiduciary’s decision to expose plan participants to cryptocurrency investments, whether as direct investments or through products whose value is tied to cryptocurrencies. In the release, the DOL identifies the following as giving rise to concern:

  1. Speculative and volatile investments. Securities and Exchange Commission (SEC) staffers have previously cautioned that cryptocurrency investments are “highly speculative” and marked by extreme price volatility related to the “many uncertainties associated with valuing these assets, speculative conduct, the amount of fictitious trading reported, widely published incidents of theft and fraud, and other factors.” The DOL cautions that extreme volatility can have a devastating impact on retirement plan participants, especially those nearing retirement age.
  2. Participants’ difficulty in making informed investment decisions. According to the DOL release, inexperienced investors are attracted by promoters’ claims of cryptocurrency’s alleged potential for outsized profits. These investors have little appreciation of the risks these investments pose to their retirement accounts. Plan participants, the DOL notes, may lack “the technical expertise necessary to make informed decisions about investing in them,” adding that it can be “extraordinarily difficult, even for expert investors, to evaluate these assets and separate the facts from the hype.” In the DOL’s view, when plan fiduciaries include a cryptocurrency option in a 401(k) plan’s menu, the fiduciaries are effectively telling plan participants that knowledgeable investment experts have drawn the conclusion that the cryptocurrency option is a prudent option for plan participants, which easily can result in losses.
  3. Custodial and recordkeeping issues. The release notes that traditional plan assets held in trusts or custodial accounts can be readily valued and made available to pay benefits and plan expenses. Cryptocurrencies, as the DOL points out, generally exist as lines of computer code in a digital wallet and losing or forgetting a password can result in the loss of the asset forever. Other methods of holding cryptocurrencies can be vulnerable to hackers and theft.
  4. Valuation concerns. The DOL is also concerned about the reliability and accuracy of cryptocurrency valuations. According to the release, experts describe as complex and challenging the question of how to appropriately value cryptocurrencies, noting that none of the proposed models for valuing cryptocurrencies are as sound or as academically defensible as traditional discounted cash flow analysis for equities or interest and credit models for debt. Moreover, says the DOL, “cryptocurrency market intermediaries may not adopt consistent accounting treatment and may not be subject to the same reporting and data integrity requirements with respect to pricing as other intermediaries working with more traditional investment products.”
  5. Evolving regulatory environment. The release cautions that some cryptocurrency market participants may be operating outside of existing regulatory frameworks or not complying with them. According to the DOL, if fiduciaries plan to consider cryptocurrency as an investment option, they will have to consider in their analysis how regulatory requirements may apply to issuance, investments, trading or other activities and how the requirements might affect investments by 401(k) plan participants.

The DOL concludes by saying that the Employee Benefits Security Administration expects to conduct an investigative program aimed at plans that offer participant investments in cryptocurrencies and related products. It is evident from the content and the tone of this compliance release that the DOL has serious concerns about the push toward including cryptocurrencies as an investment option for defined contribution plan accounts.

What’s next for SECURE 2.0?

New legislation known as SECURE 2.0 that would build on the SECURE Act retirement reform package is making its way through Congress and a final version could become law as early as the end of this year. The House of Representatives passed the Securing a Strong Retirement Act of 20223 in March. In June, the Senate Health, Education, Labor and Pensions Committee and the Senate Finance Committee approved their own versions of the bill—the Retirement Improvement and Savings Enhancement to Supplement Healthy Investments for the Nest Egg (RISE & SHINE) Act and Enhancing American Retirement Now (EARN) Act.4 If enacted, the changes that are under consideration would have a significant impact on plan sponsors and participants. Here are some highlights of the proposed legislation.

Securing a Strong Retirement Act of 2022

The House bill contains a variety of provisions to encourage adequate retirement savings and the creation of new plans.

  • Expanding auto enrollment. The legislation would require all new 401(k) and 403(b) plans to automatically enroll employees (with an opt-out provision).5 Deferrals would start at a minimum of 3% of pay, but no more than 10%, with mandatory 1% annual increases until total deferrals reach 10% of pay. Certain classes of employers would be excluded from this requirement:
    • New employers that have been in business fewer than three years
    • Church plans
    • Governmental plans
    • Employers with 10 or fewer employees
  • Small business incentives. The legislation would expand the three-year, new retirement plan start-up credit for employers with up to 50 employees by increasing the credit percentage from 50% to 100% of costs. It would also provide an additional credit for five years equal to a specified percentage of any employer contributions, subject to a $1,000 per employee cap. Employers with more than 50 employees but fewer than 100 employees could claim the additional credit, but phaseout rules would apply.6
  • Catch-up contributions. The legislation proposes increasing 401(k) catch-up contribution amounts to $10,000 (indexed for inflation) for individuals age 62-64.7 The limit would increase to $5,000 (inflation-indexed) for SIMPLE 401(k) plan participants in the same age group. 401(k), 403(b) and 457(b) plans that allow catch-up contributions would be required to designate them as Roth contributions.8
  • Roth option in SEP and SIMPLE IRA plans. The legislation would allow participants in SEP and SIMPLE IRA plans to make Roth contributions to those accounts.9
  • Faster eligibility for part-time employees.
  • Part-time employees who work at least 500 hours per year for two consecutive years and are 21 years or older would become eligible to join an existing 401(k) plan offered by the employer.10 The current eligibility period for part-time workers is three years.
  • Delay in Required Minimum Distribution (RMD) age. The legislation would increase the age at which an individual must begin taking RMDs from 72 to 73, starting in 2023. The age would then rise to age 74 starting in 2030 and to age 75 starting in 2033.11
  • Matching student loan payments. Employers would be allowed to “match” employee student loan payments by making a contribution to the employee’s 401(k), 403(b), 457(b) or SIMPLE IRA plan.12
  • Dollar limit for mandatory distributions. The legislation would increase the involuntary cash out limit from $5,000 to $7,000.13

What’s in the Senate bills?

The Senate bills contain several provisions that are very similar to SECURE 2.0 but also have some significant differences.

  • Starter 401(k) plans. Under the EARN Act, employers that do not have a retirement plan in place could offer a “starter” 401(k) plan (or a safe harbor 403(b) plan) that requires all eligible employees to be default- enrolled (unless they elect otherwise) at a deferral rate of 3% to 15% of compensation up to the IRA contribution limit, currently $6,000 with an additional $1,000 in catch-up contributions allowed for participants who are 50 years old and up. No employer matching or nonelective contributions would be permitted.14
  • Enhanced savers match. The EARN Act would change the existing savers credit from a credit paid in cash as part of a tax refund to a government matching contribution that must be deposited in a taxpayer’s retirement plan (or IRA). The credit would amount to 50% of the contribution up to $2,000 per year per individual, subject to an income-based phaseout.15
  • Stretch match 401(k) safe harbor. This provision of the EARN Act would offer an alternative method for satisfying nondiscrimination testing requirements for 401(k) plans that default enroll employees and make certain mandatory employer contributions. Default contributions would be set at a minimum of 6% in the first year and increase 1% per year until the fifth and later years, in which case the default must be at least 10%. Required employer matching contributions would be 100% of the first 2% of deferred compensation, 50% of the next 4% deferred and 20% of the next 4% deferred.16 If offered by an employer with 100 or fewer employees, the employer could claim a tax credit for matching contributions made for non-highly compensated employees, limited to the first 2% of an employee’s deferrals for the first five years of participation.17 
  • RMDs. The EARN Act would raise the RMD age from 72 to 75, effective after 2031.18 In addition, starting in 2024, plans would no longer be required to make RMDs from designated Roth accounts during the owner’s lifetime.19 
  • Emergency expenses. The EARN Act would permit one penalty-free distribution per year of up to $1,000 for emergency expenses with the option to repay the distribution within three years. No further emergency distribution would be permissible during the three-year repayment period unless repayment occurs.20 The RISE and SHINE Act would give employers the option to offer emergency savings accounts linked to their defined contribution retirement plans. Employees could be automatically enrolled at no more than 3% of salary (or a lower limit set by the employer), and the accounts would be capped at $2,500. Upon reaching the cap, excess contributions would be directed to the participant’s retirement plan account. Contributions would be made after-tax and be treated as elective deferrals for purposes of retirement matching contributions.21 

It is uncertain which provisions in the proposed legislation will survive exactly as written if the legislation is ultimately passed. Plan sponsors will want to closely monitor further developments.