|Documented Results from Automatic Plan Features
In our previous newsletter, we addressed the potential benefits to participants of automatic escalation features. This month we will look at the results being achieved by actual plans.
Some employers offer automatic annual escalation of salary deferrals as a feature for which participants can sign up on a voluntary basis. Others make the escalation a default, where those who do not opt out will automatically see their plan contributions increase by 1% or 2% per year. The different impact produced by these two approaches – one active and the other passive – is striking. According to the Principal Financial Group’s 2011 Retirement Readiness Survey, only about 6% of participants will sign up for auto escalation on their own, but if introduced as a plan default, 80% will allow the escalation. In the end, the “auto” feature overcomes participant inertia and is an important step towards pursuing retirement income adequacy.
The Employee Benefit Research Institute (EBRI) studied the impact of auto enrollment and auto escalation and how these two plan features can positively impact retirement income adequacy. The EBRI used a database that included individual information on:
- Over 24 million 401(k) participants
- Over 54,000 401(k) plans
- Over $1 trillion in assets
They defined success as “a situation that produces a combined real replacement rate from Social Security and 401(k) projected balances of at least 80 percent.” They looked at the results of those participants whose pay ranked them either in the lowest 25% or the highest 25%. The results showed very similar findings for the two pay groups:
- Lowest paid 25%: The probability of success jumped from 46% to 79% when automatic enrollment and auto escalation features were included in a plan.
- Highest paid 25%: The probability of success jumped from 27% to 64%.
Employers who are concerned about their employees’ ability to retire with adequate income should consider the very positive reception and measurable results being achieved by organizations that offer automatic enrollment and escalation services.
Investment Commentary: Specialty Funds and Retirement Plan Implications
The term “specialty fund” generally refers to funds that invest in focused and/or relatively small market segments in the global market place. Some of the more common include emerging markets funds, science and technology funds and real estate (REIT) funds. While specialty funds can add value to a portfolio when used properly in an investor’s overall asset allocation, they can also be extremely risky and deteriorate the value of a portfolio if used improperly. This can occur when utilizing specialty funds as a substantial part of a portfolio, or even when diversifying across a number of specialty funds, which can lead to a false sense of security.
Science and technology fund investors provided us evidence that the risk of a large loss is possible in a very short period of time during the dot-com bust (2000-2002). According to Morningstar’s Technology fund universe, if an investor bought into technology at its high point and sold at the bottom that investor would have lost 82%, a devastating impact to any individual’s retirement plan.
Not only do specialty funds provide participants with volatile investment options that can hinder them in attaining their retirement goals, but the fiduciary is also charged with an additional responsibility to educate participants on how these investments work and how they should be used. This can be a complicated task due to the unique nature of specialty funds, but is a very necessary one considering that participants are generally unaware of the associated risks. Only after understanding all of the issues associated with specialty funds can the fiduciaries make the best determination of their suitability in the plan.
Could You Save Enough for Retirement If You Had $2,200,000?
If you had $2,200,000 what would you spend it on? Would you be able to save enough for retirement? Your answer probably isn’t along the lines of spending it on random “stuff” or that saving wouldn’t be a problem. Unfortunately, many people spend $2,200,000 or more without having much idea of what they purchased, and still don’t have enough money saved for retirement.
This sounds crazy doesn’t it?! It’s not so crazy after all. If a participant starts making $30,000 a year at age 25 and gets a pay increase of 3% a year to keep up with inflation, by the time they reach age 65 they will have earned and spent just over $2,200,000!! If they're married with a combined income of $50,000 a year they would go through almost $3,800,000!
The truly crazy part is that so many participants actually believe they don’t have enough money to save for their retirement. A key reason is because they choose to make acquiring “stuff” a top financial priority, and saving is something that happens if there’s anything left over.
A financially secure retirement does not just happen as a footnote to our lives. Participants must be purposeful with their finances if they don’t want to look up one day and have virtually nothing to show after earning millions of dollars during their working years.
A good analogy is that when training a dog you must be purposeful with your actions and orders by telling it to behave. Its path must be directed with purpose, otherwise it’s going to think it is the master and run around randomly, which means you may never see it again. The same principle applies to your plan participants’ finances. They'll want to direct the path of their hard-earned income and tell it to behave or their paycheck may go every random direction, never to be seen again.
Here are two action items to put this into place:
- Be purposeful with your finances. The starting point of having enough money to save for retirement is in your budget. Make saving at least 15% of your income for retirement as a top item after the necessities such as shelter, groceries, etc. Most experts agree that if you want to replace roughly 80% of your income in retirement, then you need to consistently save 15% of your annual income. The older you are and the less you have saved, the more that percentage goes up. If you aren’t able to save 15% or so right now, save as much as you can and place an urgency on getting to 15% quickly.
- Tracking is a key to making a real, lasting change. Write down and track everything you spend for one month. If you can do this for two or three months that’s even better, since expenses tend to vary from month to month. Once you’ve done this, look at your “want” items and your “need” items. Eliminate or cut back as many of your “want” items and redirect that money to retirement savings. If you can’t cut back your spending by 15% now, how could you possibly cut back 60% or more in retirement because you haven’t saved enough?
David M. Montgomery, AIF®, CRPS
Seeds of Investing
For a copy of this month’s Seeds of Investing newsletter, formatted for distribution to retirement plan participants, contact David Montgomery at DMontgomery@m-rpa.com or 813-868-1930.
This material is intended for informational purposes only and should not be construed as legal advice and is not intended to replace the advice of a qualified attorney, tax adviser, investment professional or insurance agent. Montgomery Retirement Plan Advisors does not warrant and is not responsible for errors or omissions in the content of this newsletter.