[Senate Hearing 112-765]
[From the U.S. Government Publishing Office]
S. Hrg. 112-765
SIMPLIFYING SECURITY: ENCOURAGING
BETTER RETIREMENT DECISIONS
=======================================================================
HEARING
OF THE
COMMITTEE ON HEALTH, EDUCATION,
LABOR, AND PENSIONS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
ON
EXAMINING SIMPLIFYING SECURITY, FOCUSING ON ENCOURAGING BETTER
RETIREMENT DECISIONS
__________
FEBRUARY 3, 2011
__________
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COMMITTEE ON HEALTH, EDUCATION, LABOR, AND PENSIONS
TOM HARKIN, Iowa, Chairman
BARBARA A. MIKULSKI, Maryland MICHAEL B. ENZI, Wyoming
JEFF BINGAMAN, New Mexico LAMAR ALEXANDER, Tennessee
PATTY MURRAY, Washington RICHARD BURR, North Carolina
BERNARD SANDERS (I), Vermont JOHNNY ISAKSON, Georgia
ROBERT P. CASEY, JR., Pennsylvania RAND PAUL, Kentucky
KAY R. HAGAN, North Carolina ORRIN G. HATCH, Utah
JEFF MERKLEY, Oregon JOHN McCAIN, Arizona
AL FRANKEN, Minnesota PAT ROBERTS, Kansas
MICHAEL F. BENNET, Colorado LISA MURKOWSKI, Alaska
SHELDON WHITEHOUSE, Rhode Island MARK KIRK, IIllinois
RICHARD BLUMENTHAL, Connecticut
Pamela J. Smith, Staff Director and Chief Counsel
Lauren McFerran, Deputy Staff Director
Frank Macchiarola, Republican Staff Director
(ii)
?
C O N T E N T S
__________
STATEMENTS
THURSDAY, FEBRUARY 3, 2011
Page
Committee Members
Harkin, Hon. Tom, Chairman, Committee on Health, Education,
Labor, and Pensions, opening statement......................... 1
Enzi, Hon. Michael B., a U.S. Senator from the State of Wyoming,
opening statement.............................................. 3
Bingaman, Hon. Jeff, a U.S. Senator from the State of New Mexico. 48
Prepared statement........................................... 49
Murkowski, Hon. Lisa, a U.S. Senator from the State of Alaska,
statement...................................................... 51
Franken, Hon. Al, a U.S. Senator from the State of Minnesota,
statement...................................................... 53
Blumenthal, Hon. Richard, a U.S. Senator from the State of
Connecticut, statement......................................... 54
Whitehouse, Hon. Sheldon, a U.S. Senator from the State of Rhode
Island, statement.............................................. 56
Merkley, Hon. Jeff, a U.S. Senator from the State of Oregon,
statement...................................................... 57
Isakson, Hon. Johnny, a U.S. Senator from the State of Georgia,
statement...................................................... 65
Witnesses
Chatzky, Jean, Financial Journalist and Author, New York, NY..... 5
Prepared statement........................................... 7
Lucas, Lori, Executive Member, the Defined Contribution
Institutional Investment Association, Washington, DC........... 8
Prepared statement........................................... 10
Agnew, Julie, Ph.D., Associate Professor of Economics and
Finance, William and Mary Mason School of Business,
Williamsburg, VA............................................... 14
Prepared statement........................................... 16
Brown, Jeffrey R., Ph.D., William G. Karnes Professor of Finance,
University of Illinois at Urbana--Champaign College of
Business, Champaign, IL........................................ 37
Prepared statement........................................... 39
ADDITIONAL MATERIAL
Statements, articles, publications, letters, etc.:
Women's Institute for a Secure Retirement (WISER)............ 65
The American Council of Life Insurers........................ 67
Larry H. Goldbrum, General Counsel, The SPARK Institute,
Inc., letter............................................... 71
(iii)
SIMPLIFYING SECURITY: ENCOURAGING BETTER RETIREMENT DECISIONS
----------
THURSDAY, FEBRUARY 3, 2011
U.S. Senate,
Committee on Health, Education, Labor, and Pensions,
Washington, DC.
The committee met, pursuant to notice, at 2:03 p.m. in Room
SD-430, Dirksen Senate Office Building, Hon. Tom Harkin,
chairman of the committee, presiding.
Present: Senators Harkin, Bingaman, Hagan, Merkley,
Franken, Whitehouse, Blumenthal, Enzi, and Murkowski.
Opening Statement of Senator Harkin
The Chairman. The Committee on Health, Education, Labor,
and Pensions will please come to order.
I want to welcome everyone to the latest in our series of
hearings focusing on retirement security. This is our first
hearing looking specifically at how to make retirement plans
work better.
There is no question that it's getting harder and harder
for the average person to retire. Families are facing
unprecedented challenges. Saving for retirement is just not an
option for many. Wages have been stagnant for about 20 years,
and people are working longer and harder than ever before, yet
they still do not seem to meet the costs of basic everyday
needs like education, transportation, and housing, let alone
save enough to support them in their old age. Even people who
want to prepare for retirement often find it difficult to do
so. Over a quarter of workers do not have any meaningful
retirement savings at all. Zero. And only a small percentage of
people have a traditional pension.
These days the vast majority of people with any retirement
plan at all have a 401(k). But 401(k)s often do not provide
real retirement security. They, of course, leave workers
exposed to the vagaries of the market and do not necessarily
provide workers with a guaranteed lifetime income stream like a
traditional pension plan. That means families relying on a
401(k) have to roll the dice and pray that they do not outlive
their retirement savings.
We've taken some important steps to improve the 401(k)
system by requiring more transparency, but we still have a long
way to go before the 401(k) system works for everyone. Just
recently I heard from a carpenter who told me that when he
tried to sign up for his plan, his employer handed him a list
of investments two pages long and a 5-inch binder full of
prospectuses. Well, if you're working all day, trying to raise
a family, you don't have time to pour through all of that and
try to figure out what to do. There has to be a way to make
saving for retirement simpler.
Automatic enrollment was a good first step. There's a
considerable amount of evidence that people are more likely to
participate if they are automatically enrolled. The Pension
Protection Act of 2006, which we all worked on and Senator Enzi
was very much involved in, helped encourage automatic
enrollment by removing some of the barriers and giving
employers some peace of mind. Now more and more plans are using
automatic enrollment, and that has gotten more people saving.
The question today is whether we can do more. Can we apply
the lessons of automatic enrollment elsewhere? Can we do a
better job getting people the information they need to make
better financial decisions?
One way to encourage people to boost savings is to give
them an estimate of how much monthly retirement income a person
can expect from their 401(k). Now, people already get that kind
of estimate on their annual Social Security statement. I just
got one several days ago. It tells you exactly how much you get
when you retire. It's very helpful. Of course, I commend
Senators Bingaman, Isakson and Kohl for the work they have
already done on this issue.
Another way to encourage people to save is to allow for
more financial education, especially among young people just
entering the workforce. Every day we see people coming up with
new and innovative ways to educate people about personal
finance. And when people are engaged, they tend to save more.
One study found that 18 percent of people that use an online
retirement calculator increase their contribution rate. Well,
that's going to have a long-term positive effect. How can we
promote that?
As we look at ways to improve 401(k) plans, it's important
to remember that making plans simpler and more automatic does
not always mean that they are safer or more secure. Target-date
funds are a good example. Those funds show considerable promise
as an easy way for people to manage their retirement accounts.
But the effects of the Great Recession highlighted that there
is a still a lot that needs to be done to make target-date
funds safe for workers and retirees.
Going forward, any steps that we may take to make 401(k)s
simpler must be accompanied by protections to insure that
participants are being treated fairly and getting the best
possible value. We also need to remember that a simpler 401(k)
is not going to help the millions of American families barely
scraping by. Those people deserve a secure retirement, too. And
I plan to address the challenges they face and the need for
improved access to the pension system in future hearings on
this subject in this committee.
Retirement issues have always been an area of great
bipartisan interest, so there is a real opportunity to work
together to improve retirement security for families all across
America.
I am confident the hearing today will give us all a lot to
think about. I look forward to working with my colleagues to
find practical solutions to solve this retirement crisis in
America. I thank you all for being here today, and I will yield
to Senator Enzi.
Statement of Senator Enzi
Senator Enzi. Thank you, Mr. Chairman. It's my
understanding that one of our witnesses is stuck in Chicago.
The Chairman. That's right. We are going to have a video
hookup for him.
Senator Enzi. That's a terrible place to be stuck.
[Laughter.]
The Chairman. I didn't say that, did I?
[Laughter.]
I go through Chicago all the time.
Senator Enzi. Oh. I've never made it through yet, so I'll
have to get some advice from you. But it's been over 2 years
ago that you and I held some very successful hearings on the
401(k) fee disclosure.
The Chairman. That's right.
Senator Enzi. At that time, the Department of Labor had
issued a proposed regulation on how to disclose fees, and I
believe that our hearing improved the outcome of the final
regulations issued by the Department last year. That's why I'm
grateful we're holding another hearing on the 401(k) system, to
see what's working and what may need to be improved.
One of the hallmarks of the Pension and Protection Act of
2006 was the provision to allow companies to automatically
enroll their employees in a 401(k) plan and to allow companies
to match contributions. Statistics have shown that automatic
enrollment is a tremendous success, with a great number of new
employees being automatically enrolled. The surge took place
from 2006 to 2009. But since then, the numbers leveled off.
While some of the leveling off can be attributed to the
economy, it may be that we just caught the easy fish and still
haven't caught the hard ones. It appears that the large
companies took advantage of automatic enrollment. However,
automatic enrollment may have been more difficult for smaller
sized companies to adopt. According to Fidelity Investments'
analysis of 17,000 retirement plans, more than 50 percent of
the companies with 5,000 workers or more adopted automatic
enrollment, but only 15 percent of the companies with fewer
than 500 employees adopted automatic enrollment of employees.
A friend of mine, in Sheridan, who has multiple companies
throughout the United States, has a 401(k) plan that he matches
very generously for every employee, and he has tremendous
success signing people up. But it's because part of their
orientation as being part of the company is that if they don't
put in the amount of money that it takes to get it matched,
he's not sure they're smart enough to work for him. And people
should take advantage of those things. I, being a former small
businessman, my wife Diane and I had shoe stores in Wyoming,
and consequently, I think we can do more to help small
companies. I've done accounting for a number of small
companies, and some had 401(k) plans, and some didn't. So, I'm
interested in introducing legislation this spring that would
simplify the 401(k) system even more for small business owners.
Getting the small businesses and their employees into the
system is a critical step toward ensuring a strong retirement
for more people.
Another key group of individuals who need to become
invested is Generation Y, or, the Millenials, who are just
entering the workforce for the very first time. All experts
agree that having workers start investing early in their
careers will save them from catch-up investments later in their
lives. Hewitt just released a report on the 20-something
generation, and they found that, due to lack of participation
in defined contribution plans, low savings rates, and high
rates of cash-out, 8 in 10 Generation Y workers will not meet
their financial needs in retirement unless they significantly
improve their savings and investing behaviors.
Now, with tuition at an all-time high, Americans now owe
more than $875 billion in student loans. I can sympathize with
students entering the workforce trying to pay off their student
loans, while they pay rent or buy a house, and starting a
family, and then have to save for retirement as well. Many
entering the workforce are unprepared for this new financial
reality. I've also noted that a lot of them make more money
than their parents did, but they're not sure what to do with it
all. They know that their parents have a car and a boat and a
house, and a snowmobile, and other things, and what they don't
realize is that they accumulated those over time while they
took care of some of their retirement things. And so, they run
out and buy all those things, and then they get in financial
trouble.
I've been involved in financial literacy for a long time.
When I was mayor, we had to find somebody that could provide
financial literacy to these young people that were making so
much money. The group that was most interested in doing it was
the church. But people didn't see that as a relative place to
go because they're always asking for money. Fortunately, the
credit union stepped up and provided a program, and that had
some credibility to it, and that's been expanded in the
meantime. There's a Jump$tart program now in Wyoming and much
of the United States that helps to provide that kind of advice
to young people. It's a tremendous help. Dave Ramsey also has
some courses that people on my staff have taken a look at, and
it does help them to get out from under their credit card debt.
I know of a couple of instances where they not only have done
that, but they followed the whole plan. They have no debt, own
their home, and have six months worth of finances in the bank.
They're taking financial literacy very, very seriously. I have
been sponsoring and passing legislation that would improve
Federal Government literacy programs.
But one of the concerns I have now is that for young
workers, the best one, and the program they're most likely to
hear about, or, hear little about, especially from the newer
employer, is this 401(k) opportunity. That's because when they
go to work there, they're dumped with this pile of papers that
they have to make decisions on and wander through, not just on
the 401(k), but all the other Federal forms that we force them
to fill out as well. I think that takes away from the big
decision they have to make about retirement.
The people that are doing the plans are a little reluctant
to do them because there is some liability that we placed on
them now, too, because they have to help these people make the
right decision, and nobody knows what the right decision is
until after the market is done. They have to make all their
decisions before the market. So, I do think there are some
things that we can do, and I'm pleased that we have some
experts that can give us some advice on what can be done to
make these more workable for business, more workable for the
employee, and more workable for a lifetime of security.
Thank you, Mr. Chairman.
The Chairman. Thank you, Senator Enzi. You're right. We do
have a great panel of distinguished witnesses and experts.
First we have Jean Chatzky, the financial editor for NBC
Today. If she looks familiar, that's because you've been
watching the Today Show. Ms. Chatzky will provide a general
overview of retirement savings in America and focus on the fact
that people do not save enough.
Next we have Lori Lucas. She is an executive member of the
Defined Contribution Institutional Investment Association, and
is the executive vice president and Defined Contribution
Practice Leader at Callan Associates. Ms. Lucas will summarize
some of the research regarding automatic enrollment and
escalation, and give some recommendations.
Dr. Julie Agnew is an associate professor of Finance and
Economics, and the co-director of the Center for
Interdisciplinary Behavioral Finance Research at the William
and Mary Mason School of Business. She is going to discuss the
role investor psychology and financial literacy play in making
retirement decisions.
Finally, we'll hear, I hope by video hookup, Dr. Jeffrey
Brown, the William K. Karnes Professor of Finance in the
College of Business at the University of Illinois. Dr. Brown
will discuss the ways to shift the way people think about
retirement saving away from asset accumulation to a broader
concept of retirement security. So, I hope that hookup works
all right.
We'll start with Jean Chatzky.
Thank you very much.
By the way, all of your statements will be made a part of
the record in their entirely. We'll just go from left to right,
starting with Ms. Chatzky. If you could just sum it up in 5, 7,
8 minutes, something in that neighborhood, I'd appreciate it.
Ms. Chatzky, welcome. Please proceed.
STATEMENT OF JEAN CHATZKY, FINANCIAL JOURNALIST
AND AUTHOR, NEW YORK, NY
Ms. Chatzky. Thank you so much. Good afternoon, Mr.
Chairman. I want to thank you and the members of the committee
for taking the time to address this crucial issue.
Magazine covers and television ads show us a consistent
picture of retirement. They show us a couple lazing on a beach
and another on a golf course. Unfortunately, for most Americans
these are fantasies. Data from the Employee Benefits Research
Institute shows us that even for good-earning Baby Boomers and
Generation Xers, there is a 50 percent chance of running out of
money in retirement. That means they're not going to have
enough to pay for the basics, let alone added health care
expenses that can run six figures, even more.
According to the research, 4l percent of the people in the
lowest 25 percent of American earners, the lowest quartile,
were likely to run short of money after 10 years in retirement,
and 57 percent after 20 years. Of course, those percentages
continue to shrink as earnings increase, but 5 percent of the
highest 25 percent of American earners are likely to run short
of money after 10 years in retirement, and 13 percent after 20
years. And I have to say, as I watch Willard Scott wish a happy
birthday to what seems like more centenarians every single
week, that is not a comfortable proposition.
Fortunately, we now have at our fingertips other research
that points the way toward solving this problem, or at least
getting a jump on it. The passage of the Pension Protection Act
in 2006 brought down those barriers for those employers who
wanted to auto-enroll people, as you said, into their
retirement plans, and it has been hugely successful. In
companies that have automatic enrollment, 80 to 90 percent of
people are in the company retirement plans. In companies that
don't have it, only half that many people, particularly younger
and lower income workers that you were talking about,
participate. And 401(k) participation alone reduces the risk of
running out of money to 20 percent. That's huge.
But it's not enough. Going further to solve this problem,
to encourage even more Americans to put more of their hard-
earned dollars away for tomorrow, is a matter of doing three
things.
First, using the incentives at your disposal to encourage
more employers, particularly the small ones, to offer plans and
to put an alternative in place for those that don't. Workplace
retirement savings works because it's easy. By taking the money
out of employees' hands before they have a chance to spend it,
it's as if it was never there to begin with. For that reason,
the Auto IRA proposal that was raised last fall needs to be
revisited. By requiring employers who don't sponsor plans to
auto-enroll workers into individual IRAs, you cross the first
hurdle. You make sure individuals have retirement plans. Of
course, employees will always have the right to opt out. But
inertia will win, and they won't.
Second, you need to encourage workers to save more. The
financial community and the media have led workers astray when
it comes to successfully achieving retirement savings goals.
First, Americans were told that investment selection, that
picking the right stocks and mutual funds, was the key to
success. Next they were told it was all about asset allocation,
deciding how much of your retirement pie you wanted to put in
stocks and in bonds and in cash. Neither of these things solves
the problem. The only thing that will get most Americans to a
comfortable retirement nest egg is saving more money. I
attached in my written testimony an analysis by Principal
Financial that compares the three approaches. You should take a
look, because it's eye-opening. You encourage saving more,
again, by letting behavioral finance work its magic.
Automatically escalating workers' contributions until they hit
that maximum contribution levels is key because, again, we
don't miss money when we don't see it in the first place.
But the third component--educating workers--is also
crucial. It also works. The SMarT savings program, an approach
which is short for Save More TomorrowTM, developed by
behavioral economists Richard Thaler of the University of
Chicago and Shlomo Benartzi out of UCLA, the SmarT program is
an auto-escalation program which requires annual contribution
increases of 3 percent until you max out. It was recently
offered, accompanied by financial counseling, to every employee
at a company with 300 workers. One-hundred sixty of them took
advantage, and after 3 years, the savings rate of these
employees jumped from 3\1/2\ percent to almost 12 percent. It
tripled. Other companies have seen even greater success.
As Baby Boomers age, we will continue to see a shift in the
message emanating from Wall Street. There will be more talk
about annuitizing, managing retirement income, and making your
money last. That's all well and good. But it's useless if we
don't tackle the accumulation problem first. We need to make
sure that Americans have enough money to begin with.
Thank you so much.
[The prepared statement of Ms. Chatzky follows:]
Prepared Statement of Jean Chatzky
SUMMARY
Data from the Employee Benefits Research Institute shows us that
even for good-earning Baby Boomers and Generation Xers, there's a 50
percent chance of running out of money in retirement. Fortunately, we
now have at our fingertips other research that points the way toward
solving this problem: The passage of the Pension Protection Act in
2006, brought down the barriers for those employers to auto-enroll
people into their retirement plans. In companies that have automatic
enrollment, 80 percent to 90 percent of people are in the company
retirement plan. In companies that don't have it, half that many people
are in. And 401(k) participation reduces the risk of running out of
money to 20 percent. That's significant--but not enough. We need to do
three things.
First, use the incentives at your disposal to encourage more
employers--particularly small ones--to offer plans. The Auto IRA
proposed last fall should be revisited. By requiring employers who
don't sponsor plans to auto-enroll workers into individual IRAs, you
cross the first hurdle. You make sure individuals have retirement
plans. Second, encourage workers to save more. A successful retirement
does not depend on investment choice or asset allocation, it hinges on
saving more money. (Analysis attached.) Automatically escalating
workers contributions until they hit the maximum contribution levels is
key. And third, couple both of these initiatives with education to
explain to workers why they need to do the right thing.
As Baby Boomers age, we will continue to see a shift in the message
emanating from Wall Street. There will be more talk about annuitizing,
managing retirement income, making your money last. It's useless if we
don't tackle the accumulation problem first. We need to make sure
Americans have enough money to begin with.
______
Good afternoon. I want to thank the committee for taking the time
to address this crucial issue. Magazine covers and TV ads show us a
consistent picture of retirement. A couple lazing on the beach. Another
on the golf course. Unfortunately, for most Americans these are
fantasies. Data from the Employee Benefits Research Institute shows us
that even for good-earning Baby Boomers and Generation Xers, there's a
50 percent chance of running out of money in retirement. This means
they're not going to have enough money to pay for the basics, let alone
the added health care expenses that can run six-figures or more.
According to the research, 41 percent of people in the lowest 25
percent of American earners ($0--$11,700 a year) were likely to run
short of money after 10 years in retirement, and 57 percent after 20
years. Those percentages continued to shrink as earnings increased, but
5 percent of the highest 25 percent of American earners ($72,000 and
up) are likely to run short of money after 10 years in retirement and
13 percent after 20 years. As I watch Willard Scott wish a happy
birthday to what seems like more centenarians every week, that's not a
comfortable proposition.
Fortunately, we now have at our fingertips other research that
points the way toward solving this problem. The passage of the Pension
Protection Act in 2006, brought down the barriers for those employers
who wanted to auto-enroll people into their retirement plans. It's been
hugely successful. In companies that have automatic enrollment, 80
percent to 90 percent of people are in the company retirement plan. In
companies that don't have it, half that many people (particularly
younger and lower income workers) are in. And 401(k) participation
reduces the risk of running out of money to 20 percent. That's
significant.
But it is not enough. Going further to solve this problem--to
encourage even more Americans to put more of their hard-earned dollars
away for tomorrow is a matter of doing three things.
First, use the incentives at your disposal to encourage more
employers--particularly small ones--to offer plans. And put an
alternative in place for those that don't. Workplace retirement savings
works because it's easy. By taking the money out of employees' hands
before they have the chance to spend it, it's as if it was never there
to begin with. For that reason, the Auto IRA proposed last fall should
be revisited. By requiring employers who don't sponsor plans to auto-
enroll workers into individual IRAs, you cross the first hurdle. You
make sure individuals have retirement plans. Of course, employees will
have the right to opt out. But inertia will win--and most won't.
Second, encourage workers to save more. The financial community--
and the media--has led workers astray when it comes to successfully
achieving retirement savings goals. First, Americans were told that
investment selection, picking the right stocks and mutual funds, is the
key to success. Next, they were told it was all about asset allocation,
deciding how much of your pie to put in stocks and bonds and cash.
Neither of these things is true. The only thing that will get most
Americans to a comfortable retirement stash is saving more money. (I
have attached an analysis by Principal Financial that compares the
three approaches. It is eye-opening.) You do this, again, by letting
behavioral finance work it's magic. Automatically escalating workers
contributions until they hit the maximum contribution levels is key. We
don't miss the money when we don't ever see it in the first place.
[Note: Attachment(s) to this statement may be found at
www.principal.
com/retirement/docs/other/h2317.pdf].
But the third component--educating workers--is also crucial. And it
works. The SMaRT savings program (an approach, short for Save More
Tomorrow, developed by behavioral economists Richard Thaler of the
University of Chicago and Shlomo Benartzi of UCLA) is an auto
escalation program, which requires annual contribution increases of 3
percent until you max out. It was recently offered--accompanied by
financial counseling--to every employee at a company of 300 workers.
More than half, 160, took the bait. And after 3 years, the savings rate
of these employees had gone up from 3.5 percent to 11.6 percent. It
tripled. Other companies have seen even greater success.
As Baby Boomers age, we will continue to see a shift in the message
emanating from Wall Street. There will be more talk about annuitizing,
managing retirement income, making your money last. That's all well and
good. But it's useless if we don't tackle the accumulation problem
first. We need to make sure Americans have enough money to begin with.
Thank you.
The Chairman. Thank you very much, Ms. Chatzky. Now we will
turn to Lori Lucas.
Ms. Lucas, welcome. Please proceed.
STATEMENT OF LORI LUCAS, EXECUTIVE MEMBER, THE
DEFINED CONTRIBUTION INSTITUTIONAL INVESTMENT ASSOCIATION,
WASHINGTON, DC
Ms. Lucas. Thank you. Good afternoon, Mr. Chairman and
members of the committee.
Thank you for this opportunity to testify on this very
important topic.
My name is Lori Lucas, and I'm the Defined Contribution
Practice Leader at Callan Associates, one of the largest
investment consulting firms in the country. I am also the
executive chair of DCIIA's research committee, that's the
Defined Contribution Institutional Investment Association, and
they are a non-profit organization dedicated to enhancing the
retirement security of American workers.
Like Jean said, the passage of the 2006 Pension Protection
Act provided valuable safe harbors that allowed plan sponsors
to more freely offer automatic enrollment and automatic
contribution escalation in their 401(k) plans and other DC
plans. That was a huge way that plan sponsors saw the ability
to increase the prevalence of these features in their plans, so
that going from a very nominal amount of plans offering them
prior to the Pension Protection Act, we now see that about half
of DC plans offer automatic enrollment and automatic
contribution escalation.
Research shows that these auto features greatly enhance
saving levels for American workers. They are very effective in
getting people to save more. However, we can do more with
automatic contribution escalation and automatic enrollment.
That's because what we're finding is that they tend to be very
conservatively implemented by plan sponsors. To give you an
example, they may have as their initial contribution rate under
automatic enrollment a mere 3 percent or 4 percent of pay as
the initial deferral rate. Then they might automatically
escalate people up to just 6 percent of pay. Because of the
inertia among plan participants, participants are likely to
stay at these levels for many years and not increase them on
their own. To put that into context, the typical financial
planner will tell you that you need to save between 10 and 15
percent of pay every year during your working life in order to
have sufficient income at retirement. You can see the
disconnect there, and the need to improve how these are being
implemented.
However, a recent EBRI-DCIIA study showed that just by
tweaking the way that automatic enrollment and automatic
escalation are implemented can have a very profound and
dramatic increase on retirement income savings levels. What
DCIIA found was that by increasing the cap on automatic
contribution escalation to levels of, say, 15 percent, and
increasing the initial deferral in automatic enrollment to,
say, 6 percent, the majority of workers were able to save
enough to replace 80 percent or more of income in retirement.
This is a pretty dramatic increase and really shows the
importance of robust implementation of these auto features.
Policymakers can help. How they can help, first of all, is
by revisiting the safe harbor for non-discrimination testing on
automatic enrollment that was implemented in the Pension
Protection Act. This safe harbor requires that the initial
deferral under automatic enrollment start at at least 3 percent
of pay. We ask that that be increased to at least 6 percent of
pay to get people started on the track faster. We also note
that the automatic contribution escalation cap under the safe
harbor is 10 percent. We ask that that be increased to at least
15 percent, noting that when people actually choose on their
own what they want their cap for automatic contribution
escalation to be, that they tend to choose at least 15 percent
or more. And remember, people can always opt out.
The second thing we ask is that policymakers make it clear
to plan sponsors that it is a good thing to robustly implement
automatic features, albeit in a prudent and reasonable way, but
to make it a robust implementation. Unfortunately, what we're
seeing happening is that plan sponsors are looking at the non-
discrimination testing safe harbor requirements and inferring,
even if they're not doing the non-discrimination testing safe
harbor, that those are the proper way, or, those are the proper
defaults that they should be using under automatic enrollment
and under automatic contribution escalation, and that's one of
the reasons these are being so conservatively implemented. We
ask that it be clear that there's no fiduciary safe harbor, or
no fiduciary guidance implied outside of the non-discrimination
testing safe harbor for those that use automatic enrollment and
automatic contribution escalation.
Finally, we ask for a fiduciary safe harbor for monthly
income projections in retirement, so that people can actually
see how much their savings will translate into when they get to
retirement. We believe that this will help them to save at
higher levels and discourage opt outs from these auto programs.
In the past, participants might have relied on the stock
market to fill in the gap of poor savings habits. Certainly the
last decade has shown us, if nothing else, that the stock
market will not bail us out if we're not saving enough and
we're not saving early.
The auto features are a tremendous boon for retirement
savings, but they really do need to be properly implemented.
What we ask is that the proper implementation be taken into
consideration as a key goal for policymakers.
Thank you for this, the opportunity to testify.
[The prepared statement of Ms. Lucas follows:]
Prepared Statement of Lori Lucas
SUMMARY
Since the 2006 passage of the Pension Protection Act (PPA), which
provided valuable guidance and safe harbors to plan sponsors seeking to
implement automatic enrollment and automatic contribution escalation,
prevalence of these features within 401(k) plans has increased
dramatically.
Research finds that such features greatly improve the expected
level of savings that workers can achieve in retirement. However,
research also concludes that many plans implement auto features in a
way that is too conservative--reducing the probability that workers
will succeed in saving enough to retire comfortably.
A study by EBRI and DCIIA finds that more robust implementation of
auto features--such as increasing the automatic contribution escalation
rate cap--can dramatically improve savings outcomes for American
workers. Yet, policies such as the PPA non-discrimination testing safe
harbor, actually discourage plan sponsors from robust implementation,
and in fact encourage them to be overly conservative with their
automatic contribution escalation rate caps and other auto features.
Policymakers can help by:
Revisiting the PPA non-discrimination safe harbor to:
increase the maximum allowed cap from 10 percent to a
higher level, or eliminate it altogether so that plan sponsors
can choose their own cap.
start the automatic enrollment deferral at 6 percent
immediately, as opposed to starting it at 3 percent and having
it escalate to 6 percent.
Providing guidance explaining that there is no
``inferred'' safe harbor for non-safe harbor plans and that the
deferral amounts for the non-discrimination safe harbor should not be
viewed as fiduciary guidance.
Policymakers could also explore ways to incentivize plan sponsors
to adopt auto features: One way is to ease the company contribution
requirements under the automatic enrollment non-discrimination testing
safe harbor.
Finally, policymakers may wish to consider a fiduciary safe harbor
that would support plan sponsors in educating participants on how their
savings translates into expected income in retirement. This could
reduce opt-outs and increase savings rates.
INTRODUCTION
Good morning Mr. Chairman and members of the committee. Thank you
for the opportunity to testify at this important hearing.
My name is Lori Lucas and I am the Defined Contribution Practice
Leader at Callan Associates--one of the largest independently owned
investment consulting firms in the country. Our client services include
strategic planning, plan implementation, monitoring and evaluation, and
education and research for institutional investors such as sponsors of
pension and DC plans. We were founded in 1973 and we have $1 trillion
in assets under advisement.
I am also the executive chair of the Research and Surveys Committee
of the Defined Contribution Institutional Investment Association
(DCIIA). Founded in 2010, DCIIA is a non-profit association dedicated
to enhancing the retirement security of American workers. DCIIA fosters
a dialogue among the leaders of the defined contribution community
including investment managers, consultants, law firms, recordkeepers,
insurance companies, plan sponsors and others committed to the best
interests of plan participants.
In today's testimony I will address the following topics:
How automatic features are being implemented in DC plans.
How current implementation of auto features is impacting
American workers' retirement income adequacy.
How we can raise the bar and dramatically improve outcomes
through the use of auto features.
PREVALENCE AND IMPLEMENTATION OF AUTO FEATURES IN DC PLANS
Prior to the Pension Protection Act (PPA) of 2006, which provided
valuable safe harbors to plan sponsors seeking to implement automatic
enrollment and automatic contribution escalation, just one in five (19
percent) 401(k) plans automatically enrolled employees. For the
majority of those plans, the money market or stable value fund was the
default investment fund, and participants were commonly defaulted into
the plan at just 2 percent or 3 percent of pay. Meanwhile, just 9
percent of plans offered automatic contribution escalation prior to the
2006 passage of the PPA.\1\
---------------------------------------------------------------------------
\1\ Hewitt Associates. 2005 Trends and Experiences in 401(k) Plans
Survey.
---------------------------------------------------------------------------
Today, half of DC plans automatically enroll participants. In most
cases, new hires are automatically enrolled, although 4 in 10 large
plans have done a one-time automatic enrollment sweep for existing
employees. Today, asset allocation-type vehicles are the most common
default investment fund by far, largely as a result of the PPA's
qualified default investment alternative (QDIA) provisions. However,
the common default contribution rate remains modest at 3 percent to 4
percent of pay.
Also, currently nearly half of DC plans offer automatic
contribution escalation. The majority does not link automatic
contribution escalation to automatic enrollment, but offers it as an
opt-in option. Most plans with automatic contribution escalation as a
default increase participant contributions by just 1 percent of pay
annually, and cap annual contributions at low rates, such as 6
percent--which might be the company's match threshold.\2\
---------------------------------------------------------------------------
\2\ Callan Associates. 2011 Trends in DC Plans Survey. Preliminary
results of 2011 DCIIA Auto Features Survey.
---------------------------------------------------------------------------
According to the preliminary results of a 2011 DCIIA survey of more
than 100 plan sponsors, there are many reasons that plan sponsors do
not offer automatic enrollment including: it is seen as unnecessary
because plan participation is already sufficiently high, it doesn't fit
into the plan's corporate culture because it is too paternalistic, it
is inappropriate in the current economic environment, and it is too
costly from a company matching perspective. Only a small percentage of
plan sponsors who do not offer automatic enrollment are very likely to
do so within the next 12 months.
Those plan sponsors who do not offer contribution escalation either
haven't considered it, find it too paternalistic, or find it
inappropriate in the current economic and legal/regulatory environment.
Plan sponsors who do not offer contribution escalation say that
increased regulatory/legislation changes/or support would encourage
them to do so, such as by having the safe harbor rules extended to
higher levels of auto escalation. Otherwise, those who don't currently
offer automatic contribution escalation are not very likely to do so in
the next 12 months. Those who do not offer automatic contribution
escalation as a default also cite the fact that their employees would
be upset if they increased rates automatically. Others mention that it
is too paternalistic or that they haven't really considered it.
Today, I would like to make the case that automatic enrollment and
automatic contribution escalation are two DC plan features that can
dramatically improve the retirement income adequacy of American workers
in DC plans. However, these features must be more widely used by plan
sponsors and more robustly implemented in order to have the necessary
impact on workers' retirement savings.
IMPACT OF AUTO FEATURES ON RETIREMENT INCOME ADEQUACY
OF AMERICAN WORKERS
Research by Jack VanDerhei of the Employee Benefit Research
Institute (EBRI) in 2010 simulated the savings differences generated by
plans with automatic enrollment versus voluntary enrollment by
comparing large 401(k) plans given actual plan design parameters based
on participant data from EBRI's 401(k) database. The analysis looked at
all workers, not just those eligible for 401(k) plans. According to the
analysis, when workers aged 25 to 29 under voluntary enrollment are
compared to those under automatic enrollment of the same age cohort,
the difference in projected median 401(k) balances is four times higher
in the auto-enrolled group. Voluntary enrollment was at one and a half
times final earnings whereas automatic enrollment resulted in six times
final earnings. This shows the importance of automatic enrollment in
improving retirement savings levels of workers over their full career.
EBRI and DCIIA then collaborated on a project analyzing how the
probability of reaching a ``successful'' retirement income level
changes with different 401(k) plan design variables and assumptions.
While the definition of success using this simulation model can be
quite complex, the analysis starts out with a very simple definition
for this application: namely, a 401(k) accumulation large enough that,
when combined with the worker-specific benefits projected under Social
Security, will provide a total real replacement rate of 80 percent.
In other words, for purposes of this analysis, we will define an 80
percent income replacement rate as ``success.'' Eighty percent is in
the typical range of replacement rates suggested by many financial
consultants. Importantly, this new analysis looks at workers eligible
for 401(k) plan participation over 30 to 40 years--not all workers
regardless of eligibility.
The analysis found that in the base case--that is, the way that
automatic enrollment and automatic contribution escalation are
implemented across thousands of DC plans--the probability of replacing
80 percent of income in retirement for workers who spend a full career
in the DC system is 45.7 percent for low-income workers and 27 percent
for high-income workers. In other words, these statistics also show
that the current implementation of auto features is not likely to
generate sufficient retirement for most workers.
However, when the implementation of auto features was more robust,
coupled with improvements in employee behavior (described below), the
picture changes. The analysis assumed the following changes to the way
auto features are implemented in DC plans:
Increase in the contribution rate cap (e.g., from 6
percent to 9 percent, 12 percent or 15 percent of compensation).
Increase in the annual contribution rate change (2 percent
vs. 1 percent of compensation).
Successfully educate employees so that they don't opt out
of the automatic escalation program.
Encourage employees to remember and implement their
previous level of contributions and not merely accept the new low
default-contribution rate under automatic enrollment when they change
employers.
In the best-case scenario--when all of these positive changes were
made to auto features and implementation was robust--the probability of
success increased dramatically. In fact, for the lowest quartile income
level, the probability of replacing at least 80 percent of pre-
retirement income increased 33.5 percentage points from 45.7 percent to
79.2 percent. For other quartiles, the probability improvement was
similar. In my experience, there are few DC plan feature changes that
can result in such dramatic improvements in retirement income adequacy.
The results essentially reflect the fact that when auto features
are implemented conservatively--such as with a low initial contribution
default, a small annual increase, and a low cap on contributions--
participants are not prone to override these defaults, instead
remaining with them for many years. This type of participant inertia
has been well-documented for over a decade by researchers such as
Brigitte Madrian and David Laibson of Harvard University. Even
employees who might have participated more robustly under voluntary
enrollment (such as with a 7 percent to 8 percent initial contribution
to the plan) are likely, according to this behavioral research, to
remain with the auto features' less robust defaults, resulting in low
quality participation. As Choi, et al. concluded in their paper,
``Saving for the Path of Least Resistance,'' ``sophisticated employers
should choose their plan defaults carefully, since these defaults will
strongly influence the retirement preparation of their employees.'' \3\
---------------------------------------------------------------------------
\3\ Saving For Retirement on the Path of Least Resistance by James
J. Choi Harvard University; David Laibson Harvard University and NBER;
Brigitte C. Madrian University of Chicago and NBER; Andrew Metrick
University of Pennsylvania and NBER; Originally prepared for Tax Policy
and the Economy 2001 under the title ``Defined Contribution Pensions:
Plan Rules, Participant Choices, and the Path of Least Resistance''
Revised in 2004 to include additional data and analysis.
---------------------------------------------------------------------------
RAISING THE BAR ON THE USAGE OF AUTO FEATURES IN DC PLANS
Given these results, why do plan sponsors implement automatic
features conservatively when it comes to contribution levels? The
reasons include:
(1) Desire to minimize opt-outs: plan sponsors widely believe that
more modest contribution rate defaults minimize opt-outs, and encourage
employees to remain in the plan under automatic enrollment and in the
program under automatic contribution escalation.
(2) Cost: more aggressive defaults (e.g., escalating deferrals at a
2 percent rather than a 1 percent rate; or defaulting at a higher
initial contribution rate under automatic enrollment) may result in
increased matching costs. This can be difficult for plan sponsors to
support, especially in harsh economic times.
(3) Safe harbor effect: even plan sponsors who are not seeking a
non-discrimination testing safe harbor under the PPA may infer that it
is more prudent from a fiduciary perspective to adopt the QDIA safe
harbor for required defaults. Currently, these defaults are
conservative when it comes to deferral rates.
The last consideration is one of particular note for policymakers.
Plan sponsors are as subject to behavioral biases as any other
individual. It is my experience and that of other DCIIA members that
the signals being sent by the defaults, which are used in the automatic
enrollment non-discrimination testing safe harbor, are influencing plan
sponsor decisions when it comes to the implementation of auto features
even for non-safe harbor plans. The safe harbor requires that automatic
enrollment start at at least 3 percent and increase to at least 6
percent over 4 years. The maximum allowed cap under the safe harbor is
10 percent. It is important to note that the EBRI/DCIIA study found
that the single most important factor in improving retirement income
adequacy through more robust auto features was raising the automatic
contribution escalation cap. At a minimum, guidance should be given to
explain that there is no ``inferred'' safe harbor for non-safe harbor
plans and that the deferral amounts for the non-discrimination safe
harbor should not be viewed as fiduciary guidance.
Ideally, the safe harbor cap should be revisited, increasing the
maximum allowed cap from 10 percent to a higher level, or eliminating
it altogether so that plan sponsors can choose their own cap.
Additional, the automatic enrollment deferral should start at 6 percent
immediately, as opposed to starting it at 3 percent and having it
escalate to 6 percent.
As mentioned, a key reason that some plan sponsors do not implement
automatic enrollment at a higher rate (or at all), and do not
incorporate automatic contribution escalation aggressively (or at all)
is the cost associated with matching contributions. Therefore,
policymakers may also wish to explore ways to incentivize more robust
implementation of these features. One way is to ease the company
contribution requirements under the automatic enrollment non-
discrimination testing safe harbor.
Finally, it is important to educate plan sponsors about likely opt-
out rates under various default deferral scenarios. Namely, there is no
empirical evidence that the average plan experiences a higher opt-out
rate when the default deferral level is 6 percent than when it is 3
percent. Because automatic contribution escalation is still relatively
new and not yet widely adopted, we don't have enough empirical evidence
that would confirm or refute the notion that opt-outs are likely to
increase with more robust caps and higher rates. However, most initial
indications are that these design features have little to no impact on
opt-out rates. Further, research shows that when participants do
proactively choose their own automatic contribution escalation maximum
cap, it most commonly is 15 percent or higher.\4\
---------------------------------------------------------------------------
\4\ Hewitt Associates. ``Improving Defined Contribution Plan
Utilization through Retirement IMPACT.'' September 2005.
---------------------------------------------------------------------------
Opt outs can also be mitigated by educating employees on the value
of high retirement savings rates. One way to do this is to show workers
what their savings may translate to in monthly retirement income. Many
recordkeepers already provide monthly retirement income projections on
DC participant Web sites and on statements. Some also even provide
``gap'' analysis--that is, the amount of additional savings plan
participants need to achieve in order to replace sufficient income in
retirement. Policymakers can encourage the use of such projections by
providing a fiduciary safe harbor for plan sponsors.
CONCLUSION
In the past, DC participants--and plan sponsors--may have relied on
the stock market to fill in the gap of workers' low savings and help
them generate a sufficient 401(k) retirement nest egg. However, the
last few years have shown that the market cannot be expected to ``bail
out'' workers who do not save enough. Indeed, a recent Callan
Associates study showed that the annualized total returns experienced
by DC plan participants since early 2006 has been 0.11 percent:
virtually all of the growth in participant balances over that time came
from plan sponsor and participant contributions.\5\ It follows then,
that to ensure retirement income security for workers, plan sponsors
must commit either to contributing more or to finding ways of
increasing participant savings.
---------------------------------------------------------------------------
\5\ Callan Associates. Callan DC IndexTM. June 2010.
---------------------------------------------------------------------------
The EBRI/DCIIA study demonstrates that automatic enrollment and
automatic contribution escalation provide a good starting point to
improve worker behavior with regards to savings. However, insufficient
attention has been given to ensuring that plan defaults lead to robust
outcomes from a retirement income adequacy standpoint. The good news is
that much can be done from a plan sponsor, policymaker and provider
perspective to facilitate positive outcomes within the context of the
existing framework of automatic enrollment and automatic contribution
escalation. Thoughtful plan design and communication can materially
alter the long-term savings levels of millions of Americans. In
contrast, the alternative--plan design and communication that do not
consider long-term income replacement ramifications--may have painful
long-term social and economic consequences when it comes to American's
retirement security.
[Editor's Note: Due to the high cost of printing, previously
published materials are not reprinted in the hearing record. Appendix
materials ``The Impact of Auto-Enrollment and Automatic Contribution
Escalation on Retirement Income Adequacy'' may be found at http://
www.ebri.org/pdf/briefspdf/EBRI_IB_011-2010_No349-EBRI-DCIIA.pdf and
``Raising the Bar: Pumping Up Retirement Savings'' may be found at
http://www.dciia.org/info/publications/Documents/DCIIA%20rESEARCH%20.]
The Chairman. Thank you, Ms. Lucas.
Now we turn to Dr. Agnew.
Dr. Agnew, welcome. Please proceed.
STATEMENT OF JULIE AGNEW, Ph.D., ASSOCIATE PROFESSOR OF
ECONOMICS AND FINANCE, WILLIAM AND MARY MASON SCHOOL OF
BUSINESS, WASHINGTON, DC
Ms. Agnew. Mr. Chairman and members of the committee, thank
you for the opportunity to testify in front of you today. It's
an honor to appear in front of this committee.
Today the goal of my testimony is to share with you
findings from recent research that demonstrates the clear role
investor psychology and financial literacy plays in retirement
decisions, as well as highlight ways, in light of these
results, that we might improve the way people make decisions.
As the committee is well aware, and clearly, from the
testimony that's come before me, research has proven that
automatic features in retirement plans work. The success of
these features is also proof that investor psychology matters.
Unfortunately, as automation in plans becomes more widespread,
plan sponsors and policymakers may come to view plan
communications and financial literacy programs generally as not
needed and believe those who opt out of these automatic
features, that they do so for informed reasons. In my testimony
today I will highlight research that suggests just the
opposite, and I'll argue for the need for more effective
financial education programs that begin early and continue
through life, as well as the need for simple communication
materials that by design are easy to understand and accessible
to individuals--and this is very important--who have limited
interest in finance, insufficient financial knowledge, nor the
time to devote to investment decisions.
Speaking to financial education, the research suggests that
Americans may have limited financial knowledge. Numerous
academic studies have shown that individuals do not understand
basic financial concepts. Even more worrisome is that the
research suggests that those with the most limited financial
knowledge are the least aware of their deficiency, so they may
not even seek advice when they need it. Furthermore, additional
studies show that vulnerable groups, such as those with low
income, low education, and women, are more likely to fall in
this category. This is a concern, as the pension landscape in
the United States continues to shift toward the defined
contribution world and the responsibility to make financial
decisions is increasingly placed on the individual. How can we
expect individuals to make sound decisions when they do not
understand their investment choices, nor appreciate the need to
save?
Yet, it's not just general literacy that's important. Many
participants simply do not understand the features in their
plan. We were curious why individuals might quit an automatic
enrollment plan, and we surveyed employees from two different
plans. Interestingly, we found 18 percent of those who had quit
thought that they were participating, even though they made
that active choice. And 8 percent were not sure of their
status. Moreover, we also find that those who were, who quit
were more likely to not understand that they had a plan match.
Thus, plan sponsors must clearly explain the benefits offered
to participants and non-participants, and periodically remind
all employees of the personal choices they have made.
When communicating with individuals or designing choices
offered in plans, materials from plan sponsors and government
agencies must be kept simple and engaging, and the set of
choices limited. Through my work with CIBFR at the Mason School
of Business, it's clear from the focus groups we have held that
retirement-related decisions and understanding financial
products is overwhelming for many, and related to a high level
of anxiety and stress. When individuals become overwhelmed or
lack sufficient knowledge to make a decision, they can easily
experience what's called information overload. When individuals
experience information overload, it can impair their judgment.
We have found individuals with low financial literacy typically
are more likely to experience information overload. In
addition, I'd like, while my testimony goes into detail about
information overload, to highlight two additional benefits for
limiting this.
First, we find that people experiencing less information
overload are more confident with their decisions when they're
made. Second, regardless of the financial outcome, they're more
satisfied with their choice. This is a worth outcome in itself.
Finally, while automatic enrollment is a success, we should not
believe that those that quit these plans are doing it for fully
informed reasons. As mentioned earlier, these individuals might
not understand the features of the plan. We have also found
that those that quit tend to not trust financial institutions.
Given recent market events, this is certainly not irrational.
But perhaps a better understanding of how their plans work
would reduce the mistrust attributable to simple lack of
literacy.
In closing, recognizing the psychology of investing has led
to useful changes in plan design. This research is important
and must be continued. However, I also believe there needs to
be a better job at integrating financial education into the
daily lives of Americans at an early age, and at points where
they're making important financial decisions. Financial experts
should be used to make sure that the correct lessons are
taught, and marketing experts should be involved so that people
actually listen and are engaged in the message. We also must
test to make sure these methods are effective, because we have
too many examples today of programs that simply do not work.
[The prepared statement of Ms. Agnew follows:]
Prepared Statement of Julie Agnew, Ph.D.\1\
---------------------------------------------------------------------------
\1\ Much of this testimony is based on collaborative works with
Lisa Szykman, Steve Utkus and Jean Young funded through grants from the
Boston College Center for Retirement Research, the Boston College
Center for Financial Literacy, FINRA Investor Education Foundation and
the Social Security Administration. All errors and opinions are my own
and do not represent the views of the Social Security Administration,
FINRA nor the two centers at Boston College.
---------------------------------------------------------------------------
Chairman Harkin, Ranking Member Enzi and members of the committee,
thank you for inviting me to testify. It is an honor to appear before
this committee. Today, the goal of my testimony is to share with you
the findings of recent academic research that demonstrates the clear
role investor psychology and financial literacy plays in retirement
decisionmaking, as well as highlight for you ways, in light of these
results, that we might improve the way people make decisions.
As the committee is well aware, research has proven that automatic
features in retirement plans work. The success of these features is
also proof that investor psychology matters or else these design
changes would be ineffective. Unfortunately, as ``automation'' in plans
becomes more widespread, plan sponsors and policymakers may come to
view plan communications and financial literacy programs generally as
superfluous, and that those who opt-out of the automated features opt-
out because they are simply informed individuals making calculated
choices about their future. In my testimony today, I will highlight
research that suggests just the opposite and I will argue for the need
for more effective financial education programs that begin early and
continue through life, as well as the need for simple communication
materials that by design are easy to understand and accessible to
individuals who have limited interest in finance, insufficient
financial knowledge and/or time to devote to investment decisions.
Speaking to financial education, the research suggests that
Americans today have limited financial knowledge. Numerous academic
studies have shown that individuals do not understand basic financial
concepts. Even more worrisome is that research suggests that those with
the most limited knowledge may be unaware of their deficiencies and
therefore may not seek or even realize they need assistance.
Furthermore, additional studies show that vulnerable groups, such as
those with low incomes, limited education, and women, are most likely
to fall into this category and those in this category are more likely
to succumb to behavioral biases. This is a concern as the pension
landscape in the United States continues to shift towards a defined
contribution world and the responsibility to make financial decisions
is increasingly placed on the individual. How can we expect individuals
to make sound decisions when they do not understand their investment
choices nor appreciate the need to save?
Yet it is not just general literacy that is important, participants
may be failing to participate because they do not understand the
features offered in their plan. We were curious about why individuals
might quit an automatic enrollment plan, and so we surveyed employees
in two different plans. Interestingly, we found that 18 percent of
those who had quit did not realize that they were not participating
despite making this active choice and 8 percent were not sure of their
status. Moreover, we also found that those who quit were more likely
not to know that their plan offered a match. Thus, plan sponsors must
clearly explain the benefits of their plan to both non-participants and
participants and must periodically remind all employees of the personal
choices they have made.
When communicating with individuals or designing the choices
offered in plans, materials from plan sponsors and government agencies
must be kept simple and engaging and the set of choices limited.
Through my work with the Center for Interdisciplinary Behavioral
Finance Research at the Mason School of Business, it is clear from the
focus groups we have run that making retirement-related decisions and
understanding financial products is overwhelming for many and is often
associated with high levels of stress and anxiety. When individuals
become overwhelmed or lack sufficient knowledge to make a decision,
they can easily experience what we call ``information overload.'' When
individuals experience information overload, it can impair their
judgment by causing them to limit their research related to the
decision, rely on simple rules of thumb or resign themselves to
passively accept the default as it represents for them ``the path of
least resistance.'' We have found individuals with low financial
literacy typically are more likely to experience information overload.
More about this can be found in my written testimony but I would like
to highlight two additional benefits of limiting information overload
beyond helping people make more informed decisions. First, we find that
those experiencing less information overload are more confident with
their decisions when they are made and, second, regardless of the
financial outcome they tend to be more satisfied with their choice.
This is a worthy outcome in itself.
Finally, while automatic enrollment is a success, we should not
believe that those who quit are always individuals making fully
informed decisions. As mentioned earlier, these individuals might not
understand the features of the plan. We have also found that those who
quit tend not to trust financial institutions. Given recent market
events, this is certainly not irrational, but perhaps a better
understanding of how their plans work and their asset choices would
reduce the mistrust attributable to simple lack of financial literacy.
In closing, recognizing the psychology of investing has led to
useful changes in plan design. This research is important and must be
continued. However, I also believe that more needs to be done to better
integrate financial education into the daily lives of Americans
starting at an early age and at points where important financial
decisions are being made. Financial experts should be used to make sure
that the correct lessons are being taught and marketing experts should
be involved so that people actually listen and are engaged in the
message. We also must test to make sure these methods are effective,
because we have too many examples today of programs that do not work.
The remainder of my testimony elaborates further on these comments.
INVESTOR PSYCHOLOGY AND RETIREMENT DECISIONS \2\
---------------------------------------------------------------------------
\2\ A more comprehensive overview of this growing research area can
be found in the book Behavioral Finance: Investors, Corporations and
Markets (2010). The full citation can be found in the reference
section. This section summarizes and provides direct excerpts from the
one chapter in the book. Please refer to this chapter in the appendix
for more details.
---------------------------------------------------------------------------
Over the past 10 years, administrative data from 401(k) plans have
provided academics a rich and fruitful context for investigating
behavioral finance theories. This growing area of research has enhanced
our understanding of the psychology of investing, provided substantial
support for various theories, and led to significant changes in
retirement plan design that have improved overall savings outcomes.
This section provides a high level overview of some of the research
findings in the area. I highlight several studies that relate to four
important retirement decisions. Those decisions are whether or not to
participate in a plan, how much to contribute to a plan, how to
allocate and trade assets and what to do during the distribution phase.
While this summary is not at all comprehensive, the intent is to
convince the reader by the end of this section that investor psychology
should not be ignored when discussing retirement decisionmaking or
making policy. For those interested in more details, the appendix
includes a recently published book chapter with a more complete
overview.
Participation
Brigitte Madrian and David Shea's (2001) seminal study on 401(k)
participation led to widespread changes in plan design and is one of
the best examples of how applying behavioral finance research can
improve financial outcomes.\3\ These authors analyze one 401(k) plan
transitioning from a voluntary (opt-in) enrollment arrangement to an
automatic (opt-out) enrollment arrangement. According to rational-
choice, this change in enrollment method should not affect
participation levels if individuals have well-defined preferences
because a person will always optimize and select the best option
(Johnson and Goldstein, 2003). Contrary to this expectation, the
authors find participation levels for employees at similar points in
job tenure increase significantly when automatic enrollment is
introduced, from 37 percent to 86 percent. In addition, participation
rates between demographic groups equalize.\4\ This dramatic increase in
participation may be due to, among other things, the tendency for
individuals to procrastinate or because employees view the default
choice as an implicit endorsement from the company.
---------------------------------------------------------------------------
\3\ For those plans not willing to switch to automatic enrollment,
researchers understanding behavioral finance have devised new
approaches that work with voluntary schemes. They include active choice
(Carroll, Choi, Laibson, Madrian and Metrick (2009)), social marketing
(Lusardi, Keller and Keller (2008)) and Quick EnrollmentTM (Choi,
Laibson, and Madrian (2009)).
\4\ These findings have been supported by several other studies
including Choi, Laibson, Madrian and Metrick (2002).
---------------------------------------------------------------------------
Additional research finds other behavioral factors affecting
participation rates. For example, Esther Duflo and Emmanuel Saez (2002,
2003) find that peers influence individuals' choices. Furthermore, the
number of investment choices offered in a plan may influence
participation. Too many choices may overwhelm individuals and make them
less likely to make a decision. In a voluntary plan, the absence of a
decision translates into non-participation. Sheena Sethi-Iyengar, Gur
Huberman and Wei Jiang (2004) find evidence that this type of ``choice
overload'' discourages plan participation. Their analysis suggests that
for every 10 funds added to an investment menu, the probability of
participation decreases by 1.5 to 2 percent.
Less is known regarding why individuals may opt-out of an automatic
enrollment plan. However, we do find in a study that combines survey
evidence with 401(k) administrative data that trust in financial
institutions matters.\5\ Those who distrust financial institutions are
more likely to opt-out of automatic enrollment. This is consistent with
previous research that has shown that distrust of financial
institutions influences general financial behavior, particularly among
households in the lower socio-economic strata.\6\ It is important to
note that distrust is not necessarily irrational and that we gathered
the data prior to the recent financial crisis.
---------------------------------------------------------------------------
\5\ See Agnew, Szykman, Utkus and Young (forthcoming).
\6\ Research suggests that poorer individuals have a culture of
distrust of financial institutions (Bertrand et al., 2006; Szykman, et
al., 2005). In a focus group conducted by Szykman et al. (2005)
respondents expressed feelings of alienation as well as an underlying
belief that banks cannot be trusted to do the right thing. The
respondents also stated that they avoided doing business with banks
because of these perceptions. Finally, Guiso et al. (2007) found that
lack of trust can explain why some people do not invest in the stock
market. Additionally, they find that countries with low stock
participation rates have low trust levels.
---------------------------------------------------------------------------
Contribution Levels
Determining how much to contribute to a plan is another important
decision individuals face when enrolling in their 401(k) plan.
Highlighting the influence of the default bias, James Choi, David
Laibson, Brigitte Madrian, and Andrew Metrick (2004) report that 80
percent of automatically enrolled participants in their study accept
both the default contribution rate and the default investment fund.
Consistent with the status quo bias and inertia, they find that 3 years
later, over half of these participants maintain these default options.
Given that plan providers often set the default contribution rate very
low, this has become one of the few downsides of the trend towards
automatic enrollment.\7\
---------------------------------------------------------------------------
\7\ See Nessmith, Utkus, and Young (2007).
---------------------------------------------------------------------------
In an effort to increase contribution levels, especially as
automatic enrollment has caused many to anchor at low rates, some plans
have implemented an auto escalation feature that takes advantage of
information learned about investor psychology. First engineered by
Thaler and Bernatzi (2004), their auto escalation scheme called Save
More TomorrowTM allows participants to `` `lock-' in'' in to future
increases in savings which helps them overcome self-control issues. In
addition, the program minimizes regret by timing future contribution
increases with pay raises. The plan also relies on inertia, the
tendency for participants to not change their options. In their study,
they find that after the fourth pay raise SMarT participants contribute
on average 13.6 percent to the plan compared to an 8.8 percent
contribution rate for those who instead consult with an advisor. The
contrast is even more dramatic when comparing contribution rates with
those who opt not to see a financial consultant (6.2 percent) or
decline participation in the SMarT plan (5.9 percent).
Asset Allocations and Trading
Another challenging decision that investors face is how to allocate
their savings among assets and when, if at all, they should trade their
positions. Selecting a portfolio is a complicated decision that can be
overwhelming to many. As a result it is not surprising that the
research shows that many individuals exhibit behavioral biases when
making these choices and often rely on simple rules of thumb. For
example, owning a portfolio with a high concentration of company stock
(that is, the stock of your employer) is not consistent with the
diversification recommendations of financial experts because company
stock performance is correlated with employment. It became clear
following the WorldCom and Enron debacles that overinvestment in
company stock was a frequent practice and led to financial ruin for
many employees. Researchers suggest that one reason participants invest
in company stock is a familiarity bias.\8\ They buy what they know. In
addition, other research, including my own, finds that the allocation
to company stock is higher when the past performance of that stock is
higher.\9\ Individuals investing in this manner are most likely
practicing what is called ``excessive extrapolation'' which can be a
poor way to choose allocations.
---------------------------------------------------------------------------
\8\ For example, see Huberman (2001).
\9\ See Benartzi (2001), Choi et al. (2004), Huberman and
Sengmueller (2004), Agnew (2006) and Brown et al. (2007).
---------------------------------------------------------------------------
As a cautionary example against excessive extrapolation, investors
in Sweden's pension scheme may have been using historically high 5-year
fund returns to aid in their fund selection. During the first year of
the program, a technology and health-care fund recorded the best 5-year
fund performance out of all 456 funds. An information booklet given to
all the participants reported these returns. Interestingly, this fund
received the largest percent of the contribution pool (4.2 percent)
when the default fund is excluded (Cronqvist and Thaler, 2004).
Unfortunately for those who selected this fund, by 2003 the Internet
bubble had burst and this fund had lost 69.5 percent of its value.
Regarding trading, unlike retail brokerage accounts, trading in
401(k) plans is characterized by extreme inactivity, or inertia.\10\
Although this behavior in certain cases could be consistent with the
implications of models for optimal portfolio choice, it could also be
the result of procrastination. In this case, if a participant is
defaulted into a fund that is inappropriate for his or her risk
characteristics, the optimal action would be to trade out of the funds.
---------------------------------------------------------------------------
\10\ For example, see Odean (1999), Ameriks and Zeldes (2001),
Madrian and Shea (2001), Agnew, Balduzzi and Sunden (2003), Mitchell,
Mottola, Utkus and Yamaguchi (2006).
---------------------------------------------------------------------------
Distribution Phase
While many researchers have devoted time to studying how behavioral
factors influence decisions in the accumulation phase, it is not until
recently that academics have turned their attention to understanding
the psychology behind how individuals make investment and consumption
decisions upon retirement. Recent research has addressed one such
decision, the decision to buy an annuity, and suggests that framing
plays an important role in this choice.\11\ In an experimental study I
conducted with Lisa Anderson, Jeff Gerlach and Lisa Szykman (2008), we
find a significant influence of negative message framing on whether our
experimental participants chose an annuity option or an investment
option. Brown, Kling, Mullainathan and Wrobel (2008) also find
significant results related to the influence of framing on the
attractiveness of annuities. They use an Internet survey to demonstrate
that the demand for annuities can be influenced by whether the consumer
is viewing the annuity from a narrow investment frame or a broader
consumption frame. The authors find that individuals in the consumption
frame prefer annuities to other non-annuitized products and the reverse
holds for the investment frame.
---------------------------------------------------------------------------
\11\ For an overview of the research in this area, please see Brown
(2008).
---------------------------------------------------------------------------
Research using administrative data and experimental data shows that
excessive extrapolation may also come into play in the annuity
decision.\12\ Both types of research show that individuals are more
inclined to avoid annuities when markets have exhibited higher returns
in the past.
---------------------------------------------------------------------------
\12\ See Agnew, Anderson and Szykman (2008), Chalmers and Reuter
(2009) and Previtero (2010).
---------------------------------------------------------------------------
FINANCIAL LITERACY, FINANCIAL CAPABILITY AND PLAN KNOWLEDGE
The research presented in the previous section should make clear
that behavioral biases influence all types of retirement related
investment decisions. In some cases, a behavioral bias may actually
result in a favorable outcome. For example, the default bias results in
more people saving when automatic enrollment is used. However, the
default bias can also lead to lower savings rates and the wrong
portfolio allocation if those defaults are not carefully chosen for the
participants in the plan. Moreover, the Swedish pension example
mentioned earlier demonstrates the downside of choosing allocations
based on prior returns. There is some evidence that those with lower
financial literacy may be more susceptible to behavioral biases.
Supporting this we find, in an experimental study examining portfolio
choice, that individuals with lower financial literacy are more likely
to choose the default option versus those in the high literacy category
(20 percent vs 2 percent).\13\
---------------------------------------------------------------------------
\13\ See Agnew and Szykman (2005).
---------------------------------------------------------------------------
Unfortunately, the evidence related to financial literacy in the
United States is grim. In a paper prepared for the Financial Crisis
Inquiry Commission, Annamaria Lusardi (2010) provides an overview of
research in this area. The results are disappointing but perhaps not
surprising given recent economic events. Many Americans lack basic
financial knowledge. A large number cannot carry out simple interest-
rate calculations, let alone correctly answer questions about asset
types. Lusardi cites several studies that suggest that those with less
literacy are less likely to plan for retirement, accumulate wealth and
participate in the stock market among other things. She also describes
the results of a National Financial Capability Study funded by FINRA
Investor Education Foundation. In the study, financial capability is
measured in terms of ``how well people make ends meet, plan ahead,
choose and manage financial products, and possess the skills and
knowledge to make financial decisions.'' The results from this study
are equally troubling and suggest more needs to be done to improve
American's ability to make informed and sound financial decisions.
In my research, we find similar evidence of low financial literacy.
In one study, we find that only 37 percent of the participants
understood that high-yield bonds funds were not invested in bonds with
strong credit ratings. In addition, while 84 percent of respondents
knew they could lose money in a stock fund, only 43 percent realized
there was also that risk in a bond fund.\14\ We also find that
individuals' perception of their own relative knowledge and their
actual financial literacy score are often different. This suggests that
some people may not know how little they know. This could be an issue
if they do not realize that they need to improve their education.
Unfortunately, we find those with the least education show the weakest
correlation between their tested ability and their own perception.\15\
This result is also supported by the nationally representative data
sample in the National Financial Capability Study.
---------------------------------------------------------------------------
\14\ See Agnew and Szykman (2005).
\15\ See Agnew and Szykman (2005).
---------------------------------------------------------------------------
In addition to low financial literacy, we find that many
individuals are unaware of their own plan's features. We find that the
probability of participating in an automatic enrollment plan decreases
if the participant is not aware that they have a match.\16\ It is
logical that individuals will not react properly to economic incentives
when they do not understand what incentives they are offered. As a
result, more needs to be done to explain the benefits in plans clearly
to employees.
---------------------------------------------------------------------------
\16\ See Agnew, Szykman, Utkus and Young (forthcoming).
---------------------------------------------------------------------------
Also disturbing is the evidence of a lack of basic awareness
regarding individuals' personal financial decisions. For example, in
the two automatic enrollment plans we studied, 18 percent thought they
were participating even though they opted out of the plan and 8 percent
of the non-participants were unsure of their status. This lack of basic
awareness regarding personal financial decisions is also reflected in
the National Financial Capability Study where 12 percent of those
surveyed could not recall how much they had paid down on their house
and 10 percent did not know the mortgage interest rate they were
paying.\17\ Thus, plan sponsors cannot assume that individuals are
aware of the choices they have made in their plans and periodic
reminders of their decisions and the possible consequences could be
helpful. Finally, there is an alternative explanation for why
individuals who are in automatic enrollment plans are more aware they
have a match than those who opt-out. It could be that they become aware
after they participate through the quarterly statements they receive.
Thus, they are learning because they are participating. If this
alternative theory holds, then it supports adding additional features
to plan designs, such as periodic re-enrollment of those who opt-out.
---------------------------------------------------------------------------
\17\ Summary of these results can be found in Lusardi (2010).
---------------------------------------------------------------------------
FINANCIAL LITERACY AND INFORMATION OVERLOAD
Beyond not being able to make an informed decision, low financial
literacy may make individuals overwhelmed by financial information and
by the presence of too many choices.\18\ This leads to what we call
``information overload.'' When individuals experience information
overload, it can impair their judgment by causing them to limit their
research related to the decision, rely on simple rules of thumb or
resign themselves to passively accept the default as it represents for
them ``the path of least resistance.'' We find in an experiment that
the percentage of those reporting information overload decreases with
tested financial knowledge. Thus, those with lower financial literacy
may be more susceptible to information overload.\19\
---------------------------------------------------------------------------
\18\ See Agnew and Szykman (2010).
\19\ See Agnew and Szykman (2011).
---------------------------------------------------------------------------
There are a number of variables that may contribute to overload.
One source could be how information about choices is presented to
investors. Effectively communicating choice information has long been a
topic of interest for consumer researchers, and nutritional labeling
provides a good example of how information can be presented in a simple
and easily comparable format.\20\ Another potential source of
information overload is the number of investment options offered in the
plan. Research shows that too many choices hamper decisionmaking. As
mentioned earlier, one study finds that 401(k) plans with more options
tend to result in lower participation rates.
---------------------------------------------------------------------------
\20\ The economics of information literature suggests that
consumers tend to use information more extensively if it costs less in
time and/or money to acquire (Stigler, 1961, Nelson, 1970, 1974). These
findings suggest that when information is easier to obtain and
evaluate, consumers are more likely to use it when making decisions or
choices. For example, in the nutritional labeling literature, it has
been shown that as dependable information becomes easier to utilize
(such as information presented in a standardized format), consumers use
the information more to determine food quality, acquire more nutrition
information prior to purchase, and improve their overall decision
quality.
---------------------------------------------------------------------------
We conducted an experimental study to see if reducing the number of
investment choices reduced reported information overload when making a
portfolio allocation decision.\21\ In the experiment, individuals were
asked to make a portfolio allocation from either a large number of
funds (60) or a small number of funds (6). The number of fund choices
impacted the reported overload of the high-knowledge individuals in the
sample. This group experienced statistically greater feelings of
overload with more choices. However, low-knowledge individuals were
overwhelmed regardless of the number of choices offered. This indicates
that changes in plan design, such as decreasing the number of choices
may be effective in reducing information overload, but not for all
participants. In this case, it only helped those with above average
knowledge. For the low-knowledge, a very vulnerable group, it did
nothing. Thus these results provide justification for continued
financial literacy efforts alongside behaviorally motivated plan design
changes.
---------------------------------------------------------------------------
\21\ See Agnew and Szykman (2005).
---------------------------------------------------------------------------
In a separate study of participants' choice between an annuity
vehicle and an investment option, we also found that those who reported
less information overload when making their decision were also more
confident at the time they made the decision.\22\ In addition, after
the experiment was completed and participants knew the final financial
outcome, those with less information overload were still more satisfied
regardless of how well they did financially. One way to interpret this
finding is that when individuals understand their decision, they are
less likely to regret it because they understood the consequences when
they made it. Thus by empowering investors through financial education,
simplified plan design and effective communication, we help investors
make more thoughtful and confident decisions. In addition, it may also
benefit plan sponsors and the entire industry by producing more
satisfied consumers.
---------------------------------------------------------------------------
\22\ See Agnew and Szykman (2011).
---------------------------------------------------------------------------
Anecdotally, participant remarks in recent focus groups conducted
in conjunction with projects affiliated with the Center for
Interdisciplinary Behavioral Finance Research and funded by the new
Financial Literacy Research Consortium suggest that individuals are
often overwhelmed. Many individuals in the groups expressed great
anxiety related to retirement decisionmaking. In one set of focus
groups, participants were asked to choose two or three pictures that
represented how they felt emotionally about retirement. They were asked
to draw them from a sample of several hundred pictures cut out of
various magazines and acquired from different sources. The moderator
encouraged them to choose pictures that represented their hopes and
dreams, as well as their anxieties. The pictures chosen were varied.
Some images depicted idyllic scenes, such as a loving couple relaxing
in a hammock or a man peacefully fishing in the glow of a sunset.
However, many images were disturbing and chosen because they
demonstrated participants' feelings of being stressed and trapped.
Several participants chose the picture below.
It should be noted that these selections occurred just a year
following the
2008-9 financial crisis and one of the worst economic recessions in
U.S. history. Thus it is hard to know whether these images are accurate
images of respondents long-term retirement prospects, or simply an
emotional reaction to recent experience.
In the end, it is clear that many Americans are feeling overwhelmed
at the present time, and that more can be done to help them make more
informed decisions. That said, given evidence suggesting that most
Americans are not interested in finance, the financial lessons must be
taught in an engaging manner that recognizes that people have limited
time and interest. To do this effectively, we must use an interactive
approach and include financial experts, educators and marketers. One
approach that I support is to begin financial education early on in
elementary school and to repeat the important themes with age-
appropriate lessons on through the college years. In addition, making
instruction and information easily available to Americans when they
experience important life events, such as a marriage or a death in the
family, could capture people when they are most interested and
motivated to learn. In this regard, several interesting projects
designed to engage Americans are currently being developed by the three
Centers affiliated with the Financial Literacy Research Consortium
funded by the Social Security Administration. I believe efforts like
these and others have a great deal of merit.
References
Agnew, Julie R. 2006. Do behavioral biases vary across individuals?
Evidence from individual level 401(k) data. Journal of Financial
and Quantitative Analysis 41:4, 939-61.
Agnew, Julie R. 2010. Pension participant behavior. In Behavioral
Finance: Investors, Corporations and Markets, (eds.) Kent Baker and
John R. Nofsinger, 577-94. Kolb Series: John Wiley & Sons, Inc.
Agnew, Julie R., Lisa Anderson, Jeff Gerlach, and Lisa Szykman. 2008.
Who chooses annuities?: An experimental investigation of gender,
framing and defaults. American Economic Review 98:2, 418-22.
Agnew, Julie R., Lisa Anderson, and Lisa Szykman. 2010. An experimental
study of the effect of prior market experience on annuitization and
equity allocations. Working Paper. College of William and Mary.
Agnew, Julie R., Pierluigi Balduzzi, and Annika Sunden. 2003. Portfolio
choice and trading in a large 401(k) plan. American Economic Review
93:1, 193-215.
Agnew, Julie R., and Lisa R. Szykman. 2005. Asset allocation and
information overload: The influence of information display, asset
choice, and investor experience. Journal of Behavioral Finance 6:2,
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Agnew, Julie R., and Lisa R. Szykman. 2010. Information overload and
information presentation in financial decisionmaking, In The
Handbook of Behavioral Finance, (ed.) Brian Bruce. Edward Elgar
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Agnew, Julie and Lisa Szykman. 2011. Annuities, financial literacy and
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Retirement Security and the Financial Marketplace (eds.) Olivia S.
Mitchell and Annamaria Lusardi, 260-97. Oxford, UK: Oxford
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Agnew, Julie, Lisa Szykman, Steve P. Utkus and Jean A. Young.
Forthcoming. ``Trust, Plan Knowledge and 401(k) Savings Behavior.''
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Ameriks, John, and Stephen P. Zeldes. 2001. How do household portfolio
shares vary with age? Working Paper, Columbia University.
Benartzi, Shlomo. 2001. Excessive extrapolation and the allocation of
401(k) accounts to company stock. Journal of Finance 56:5, 1747-64.
Bertrand, Marianne, Sendhil Mullainathan, and Eldar Shafir. 2006.
Behavioral economics and marketing in aid of decisionmaking among
the poor. Journal of Public Policy and Marketing 21:2, 8-23.
Brown, Jeffrey R. 2008. Understanding the role of annuities in
retirement planning. In Overcoming the saving slump: How to
increase the effectiveness of financial education and savings
programs, (ed.) Annamaria Lusardi, 178-208. Chicago: University of
Chicago Press.
Brown, Jeffrey R., Jeffrey R. Kling, Sendhil Mullainathan, and Marian
V. Wrobel. 2008. Why don't people insure late-life consumption? A
framing explanation of the underannuitization puzzle. American
Economic Review 98:2, 304-09.
Brown, Jeffrey R., Nellie Liang, and Scott Weisbenner. 2007. Individual
account investment options and portfolio choice: Behavioral lessons
from 401(k) plans. Journal of Public Economics 91:10, 1992-2013.
Carroll, Gabriel, D., James Choi, David Laibson, Brigitte C. Madrian,
and Andrew Metrick. 2009. ``Optimal Defaults and Active
Decisions.'' Quarterly Journal of Economics 124:4, 1639-74.
Chalmers, John and Jonathan Reuter. 2009. How do retirees value life
annuities? Evidence from Public Employees. Working paper.
Choi, James J., David Laibson, and Brigitte Madrian. 2009. Reducing the
Complexity Costs of 401(k) Participation through Quick
EnrollmentTM. In Developments in the Economics of Aging, (ed.)
David A. Wise, 57-82. Chicago: University of Chicago Press.
Choi, James J., David Laibson, Brigitte C. Madrian, and Andrew Metrick.
2002. Defined contribution pensions: Plan rules, participant
decisions and the path of least resistance. In Tax Policy and the
Economy, (ed.) James M. Poterba, 67-113. Cambridge, MA: MIT Press.
Choi, James J., David Laibson, Brigitte C. Madrian, and Andrew Metrick.
2004. For better or for worse: Default effects and 401(k) savings
behavior. In Perspectives on the economics of aging, (ed.) David
A.Wise, 81-121. Chicago: University of Chicago Press.
Cronqvist, Henrik, and Richard H. Thaler. 2004. Design choices in
privatized social security systems: Learning from the Swedish
experience. American Economic Review 94:2, 424-28.
Duflo, Esther, and Emmanuel Saez. 2002. Participation and investment
decisions in a retirement plan: The influence of colleagues'
choices. Journal of Public Economics 85:1,121-148.
Duflo, Esther, and Emmanuel Saez. 2003. The role of information and
social interactions in retirement plan decisions: Evidence from a
randomized experiment. Quarterly Journal of Economics 118:3, 815-
842.
Guiso, Luigi, Paola Sapienza, and Luigi Zingales. 2008. Trusting the
stock market. Journal of Finance 63:6, 2557-600.
Huberman, Gur. 2001. Familiarity breeds investment. Review of Financial
Studies 14:3, 659-80.
Huberman, Gur, and Paul Sengmueller. 2004. Performance and employer
stock in 401(k) plans. Review of Finance 8:3, 403-43.
Johnson, Eric J., and Daniel Goldstein. 2003. Do Defaults Save Lives?
Science 302:5649, 1338-9.
Lusardi, Annamaria. 2010. ``America's Financial Capability.'' Paper
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Lusardi, Annamaria, Punam Anand Keller, and Adam M. Keller. 2008. ``New
Ways to Make People Save: A Social Marketing Approach.'' In
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Financial Education and Savings Programs, (ed.) Annamaria Lusardi
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Madrian, Brigitte C., and Dennis F. Shea. 2001. ``The Power of
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Mitchell, Olivia S., Gary R. Mottola, Stephen P. Utkus, and Takeshi
Yamaguchi. 2006. The inattentive participant: Portfolio trading
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Nessmith, William E., Stephen P. Utkus, and Jean A. Young. 2007.
Measuring the effectiveness of automatic enrollment. Vanguard
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Appendix
Chapter 31
Pension Participant Behavior \1\
(By Julie Richardson Agnew, Associate Professor of Finance and
Economics, College of William and Mary)
INTRODUCTION
Over the past 25 years, the United States has witnessed a dramatic
shift in pension coverage (for an overview, see Poterba, Venti, and
Wise, 2008). For years, Social Security and defined benefit plans
provided many employees guaranteed support in retirement. In both
cases, difficult savings and investment decisions were not the
responsibility of the participants. Today, the landscape has changed
dramatically. While policymakers debate serious concerns about the
long-term solvency of the Social Security system, defined contribution
plans have become the most common pension offering. From the employer's
perspective, this change is beneficial because defined contribution
plans are less expensive to administer and shift the portfolio risk
entirely to the employee. From the employee's perspective, defined
contribution plans offer portability but also involve the personal
responsibility of making critical savings decisions. For many, these
new and challenging financial decisions are overwhelming and further
complicated by a lack of financial literacy, interest, and time. One
unintended consequence of this shift is that it has provided academics
a rich context for investigating behavioral finance theories. Over the
past 10 years, this growing area of research has enhanced our
understanding of the psychology of investing, provided substantial
support for various theories, and led to significant changes in
retirement plan design that have improved overall savings outcomes. The
purpose of this chapter is to summarize the most significant findings
in this area that relate to behavioral finance and highlight the
successful plan design changes that have resulted.
---------------------------------------------------------------------------
\1\ From Behavioral Finance: Investors, Corporations and Markets,
Kent Baker and John R. Nofsinger, Editors. John Wiley & Sons, Inc.,
2010. Reprinted with permission of the Publisher.
---------------------------------------------------------------------------
This chapter contains six main sections. The first five sections
address the behavioral aspects of five important financial decisions
investors must make in their retirement plans: (1) whether to
participate in the plan, (2) how much to periodically contribute, (3)
where to allocate assets, (4) when to rebalance allocations, and (5)
how to handle the sum they have accumulated once they retire. The final
section discusses how financial literacy and lack of interest may
contribute to the influence of biases and heuristics in these
decisions.
THE PARTICIPATION DECISION
When employers first introduced defined contribution plans,
employees typically joined their retirement plan under a voluntary
enrollment arrangement. This meant they had to consciously ``opt-in''
to participate. Early studies largely focused on rational explanations
for nonparticipation. Often studies used either 401(k) administrative
data or survey evidence to investigate the role of plan features and
individual characteristics. Researchers often found that plan design
elements--such as employer matches and individual characteristics like
age, salary, ethnicity, and job tenure--mattered for participation
rates. Munnell, Sunden, and Taylor (2001/2002) provide a concise survey
of this early work. By the late 1990s, a growing interest in behavioral
reasons for nonparticipation was emerging that led to research evidence
supporting several behavioral biases. Today, the retirement savings
decision is clearly a function of a complex set of factors. In addition
to rational explanations for nonparticipation, behavioral biases can
play an important role.
A popular Madrian and Shea (2001) study led to widespread changes
in plan design. The authors analyze one 401(k) plan transitioning from
a voluntary (opt-in) enrollment arrangement to an automatic (opt-out)
enrollment arrangement. According to rational-choice theory, this
change in enrollment method should have no effect on participation
levels if individuals have well-defined preferences because a person
will always optimize and select the best option (Johnson and Goldstein,
2003). Contrary to this expectation, the authors find participation
levels for employees at similar points in job tenure increase
significantly when automatic enrollment is introduced, from 37 percent
to 86 percent. In addition, participation rates between demographic
groups equalize. The authors are careful in their analysis and make
sure that none of the economic characteristics such as the vesting
schedule, number of investment options, access to loans, and level of
employer matching change during the study. As a result, their findings
strongly point to behavioral explanations. Madrian and Shea provide a
thorough summary of several behavioral theories that explain their
findings and highlight procrastination, in particular, as a very likely
cause.
So what causes individuals to procrastinate when making important
decisions about their long-run financial well-being? At first this
might seem puzzling, but the complexity of these decisions and their
high stakes are the very reasons individuals most likely delay
decisionmaking. O'Donoghue and Rabin's (2001) model predicts that an
individual's tendency to procrastinate increases the more important the
goal and the more options that are available. In addition, the
perceived complexity of the decision is further complicated by the
well-documented lack of interest and knowledge of finance among workers
that is discussed in the last section of this chapter.
Procrastination may also be influence by how aware individuals are
of their own self-control problems. Time-inconsistent behavior, such as
neglecting to save for retirement, can result when individuals' lack of
self-control causes them to pursue immediate gratification over long-
term benefits (Thaler and Shefrin, 1981). O'Donoghue and Rabin's (2001)
model suggests that the more ignorant individuals are regarding their
own self-control, the more likely they are to procrastinate. Laibson
(1997) and Diamond and Koszegi (2003) provide additional research on
time-inconsistent behavior and retirement that focuses specifically on
hyperbolic and quasi-hyperbolic discounting.
Madrian and Shea (2001) also suggest that the status quo bias may
influence their findings. The status quo bias is the tendency for
individuals to do nothing or maintain their current or previous
decision. In Samuelson and Zeckhauser's (1988) experimental testing of
this phenomenon, they find that subjects are significantly influenced
by the status quo even if they do not recognize a bias. According to
these authors, rational reasons including transaction costs (such as
information search costs) and uncertainty, as well as cognitive
misperceptions (such as loss aversion and anchoring), can all lead to
the status quo bias. They also mention that psychological commitments
such as regret avoidance can play a role. Obviously, each of these
factors could come into play in retirement decisionmaking. Therefore,
the different participation rates that Madrian and Shea find are also
consistent with this theory.
The number of choices the individual must make also contributes to
nonparticipation. As mentioned earlier, O'Donoghue and Rabin's (2001)
model predicts that additional choices can increase the probability of
procrastination. In the case of 401(k) plans, if the individual chooses
to participate, he or she then faces several additional decisions such
as how much to save and how to allocate his or her portfolio across a
variety of investment options. This may lead to what is called choice
overload.
Iyengar and Lepper (2000) test the choice overload theory in an
innovative study using consumer goods in field and laboratory
experiments. In one experiment, they present supermarket shoppers with
either a display of 24 exotic jams (extensive choice condition) or six
exotic jams (limited choice condition). While they find more people are
drawn to the extensive choice display (60 percent versus 40 percent),
the individuals who view the limited choice display are actually more
likely to purchase the jams than those who view the extensive choice
set (30 percent versus 3 percent). Thus, Iyengar and Lepper conclude
that too much choice can be demotivating.
To test the influence of the number of fund choices on retirement
plan participation, Sethi-Iyengar, Huberman, and Jiang (2004) use
401(k) administrative data provided by Vanguard. They find that the
probability of participation decreases as the number of funds in the
investment menu increases. Their analysis suggests that for every 10
funds added to an investment menu, the probability of participation
decreases by 1.5 to 2 percent.
Beyond plan features, peer effects may also influence
participation. Survey studies by Lusardi and Mitchell (2006) and van
Rooij, Lusardi and Alessie (2007) report that a high percentage of
respondents consult with family and friends when making financial
decisions. In a study of employees at a university offering a tax-
deferred account, Duflo and Saez (2002) find evidence of peer effects
in their analysis of participation rates and investment decisions.
Using an administrative dataset, they find that when participation
rates increase by 1 percent in a department, the probability of an
individual participating in that department increases by 0.2 percent.
In a separate paper, Duflo and Saez (2003) study the role of social
interactions by conducting a field study in which they invite
individuals who do not participate in their university retirement plan
to attend a benefits fair that encourages enrollment. They promise the
invitees a $20 reward for attending. The authors draw these ``treated''
individuals from a random subset of departments to estimate the role of
social interaction effects. The results show that the treatment
significantly affects the attendance at the benefits meeting. The
treated individuals are five times more likely to attend the benefits
meeting versus the control sample. In addition, Duflo and Saez note a
significant spillover social effect. Individuals not given invitations
but working in a department with treated individuals are three times as
likely to attend the fair versus their controls in departments without
invited employees. The treatment also affects plan participation rates.
Treated departments report higher participation rates. Interestingly,
whether an individual receives an invitation letter does not influence
participation: What matters is whether the individual is in a treated
department. Duflo and Saez's results suggest that small financial
rewards and/or peer effects can significantly influence important
decisions like retirement savings.
Trust may also influence participation. Research suggests that a
lack of trust in financial institutions can influence general financial
behavior, specifically among lower socioeconomic households. For
example, studies by Szykman, Rahtz, Plater, and Goodwin (2005) and
Bertrand, Mullainathan, and Shafir (2006) show that poor individuals
consciously avoid doing business with financial institutions due to
their lack of trust in them. In addition, Guiso, Sapienza, and Zingales
(2008) find that lack of trust may explain why some individuals do not
invest in the stock market.
To explore the role of trust in 401(k) participation, Agnew,
Szykman, Utkus, and Young (2009) use a dataset that combines survey
data with administrative data from three plans, two featuring automatic
enrollment and one with voluntary enrollment. They find lack of trust
in financial institutions lowers the probability of participating in an
automatic enrollment plan. For a married male with average demographic
characteristics based on the data sample, a low level of trust
corresponds to a 15 percent lower probability of participation.
Taken together, the research described above suggests that non-
economic or behavioral motivations can influence participation.
Proponents of Thaler and Sunstein's philosophy of libertarian
paternalism would argue that private and public institutions have a
responsibility to help guide people toward welfare-promoting choices
without eliminating freedom of choice (Thaler and Sunstein, 2003;
Sunstein and Thaler, 2003). Recent and significant changes in plan
design and enrollment techniques in retirement plans suggest that many
plan sponsors are acting consistently with this philosophy.
The most notable change in retirement plans is the widespread
adoption of automatic enrollment. At the time of Madrian and Shea's
(2001) study, this feature was still relatively uncommon but in 2007
the Profit Sharing/401(k) Council of America estimated that 53 percent
of large plans automatically enrolled participants (Wray, 2009). This
change in plan design has led to a significant increase in
participation rates. While the trend toward automatic enrollment
continues, some company sponsors remain resistant to this change and
prefer the voluntary enrollment approach. Fortunately for these plan
sponsors, a growing understanding of behavioral finance has led to some
new approaches that work with voluntary schemes. While the three
alternatives discussed below are successful, none increase
participation to the level of automatic enrollment.
Active choice is an alternative method that institutes a deadline
to require workers to decide whether to participate. Without default
options, workers must make explicit decisions related to contribution
rates and allocations. Under active choice, Carroll, Choi, Laibson,
Madrian, and Metrick (2009) find that enrollment after three months is
28 percent higher compared to a voluntary arrangement. They also
demonstrate that if individuals are likely to procrastinate and have
heterogeneous optimal savings rates, then this method is socially
optimal.
A second approach uses social marketing to promote participation.
Lusardi, Keller, and Keller (2008) employ surveys, focus groups, and
in-depth interviews to identify three barriers to savings by
participants. Considering these obstacles, they devise a planning aid
that helps at-risk, new employees overcome self-control issues. Thirty
days after the first intervention, they find the participation rate
tripled compared to the control group.
Finally, Choi, Laibson, and Madrian (2009) study a program
instituted by Hewitt Associations called Quick EnrollmentTM. This
enrollment method reduces the complexity of the decision by requiring
employees to consider only two choices between nonparticipation and
participation with contribution rate and asset allocation defaults.
They find that quick enrollment triples 401(k) participation rates
after 3 months for new employees and increases participation by
previously hired workers by 10 to 20 percent. However, the authors find
evidence of a default bias associated with the contribution rate and
asset allocations.
CONTRIBUTION LEVELS
Once the employee is enrolled in the plan, there are still several
important decisions remaining. For those who have been voluntarily
enrolled, he or she must now decide how much of his or her paycheck to
contribute to the plan. Research shows that contribution rates often
cluster around several points. Benartzi and Thaler (2007) explain that
this is evidence that individuals may be using different savings
heuristics. They describe several heuristics based on these commonly
found clusterings, including a ``multiple-of-five heuristic,'' a
``maximum contribution heuristic,'' and an ``employer match
heuristic.''
In contrast to the voluntarily enrolled participants, automatically
enrolled participants are not required to choose a contribution rate
because a default rate is available. In the case of automatically
enrolled participants, researchers commonly observe a strong default
bias with the contribution rates anchored to the default. Highlighting
the influence of the default bias, Choi, Laibson, Madrian, and Metrick
(2004) report that 80 percent of automatically enrolled participants in
their study accept both the default savings rate and the default
investment fund. Consistent with the status quo bias and inertia, they
find that 3 years later, over half of these participants maintain these
default options. Given that plan providers often set the default
contribution rate very low, this has become one of the few downsides of
the trend toward automatic enrollment (Nessmith, Utkus, and Young,
2007).
Once the individual sets or accepts a contribution level, Choi,
Laibson, Madrian, and Metrick (2009) find that a naive reinforcement
learning heuristic may lead to subsequent changes in the contribution
level. According to this heuristic, individuals increase weights on
strategies with which they have personally experienced success even
when future success is not logically related to past experience. Using
administrative data, the authors find that investors who have positive
savings outcomes in their 401(k) plans (either high average returns
and/or low variance returns) increase their savings rates more than
others with different experiences.
In an effort to increase contribution levels, especially as
automatic enrollment has caused many to anchor at low rates, several
plans have implemented a new feature that takes advantage of
information learned about investors' psychology. Engineered by Thaler
and Bernatzi (2004), the Save More Tomorrow PlanTM (SMarT) takes into
account the self-control problems. As a result, the program requires
employees to commit far in advance to increases in contribution rates.
This ``future lock-in'' is known to overcome participants' problems
with self-control and is effective in enabling individuals to select
what they ``should'' do over what they ``want'' to do (Rogers and
Bazerman, 2008). The SMarT program also mitigates feelings of loss by
timing the contribution rate increases with future raises. Inertia
works to the participants' advantage because a suboptimal decision is
to change once the initial decision to enroll in the program is made.
That said, consistent with libertarian paternalism, employees may opt
out of the program at any time.
The results from the first implementation of the program show
dramatic increases in savings for SMarT participants. In addition, as
status quo bias theory would predict, few people drop out. After the
fourth pay raise, SMarT participants contribute on average 13.6 percent
to the plan. This compares to an 8.8 percent contribution rate for
those who instead consulted with an advisor. The contrast is even more
dramatic when comparing contribution rates with those who opt not to
see the financial consultant (6.2 percent) or decline participation in
the SMarT plan (5.9 percent).
ASSET ALLOCATION DECISIONS
Once the individual decides on or accepts a contribution rate, he
or she must decide how to allocate the portfolio. This can be
challenging because research suggests that individuals may not have
well-defined portfolio preferences (Benartzi and Thaler, 2002). Not
surprisingly, as with participation and contribution rate decisions,
defaults appear to have an influence (Choi, Laibson, Madrian, and
Metrick, 2002, 2004). As mentioned earlier, Choi, et al. (2004) report
that in their study, 80 percent of automatically enrolled participants
accept the default investment fund. Similarly, in an analysis of 50
retirement plans, Nessmith et al. (2007) find that new hires in
automatic enrollment plans are three times as likely to put all of
their contributions in the default investment fund compared to new
hires in voluntary plans. They also find that 51 percent of individuals
remain in the plan default after 2 years.
While the influence of defaults is obviously powerful, evidence
suggests that the default bias can be overcome through committed and
sustained efforts to encourage active choice. One of the most
interesting examples of this is the Swedish pension system. Under the
Swedish pension scheme, individuals may invest in up to five funds out
of a menu of over 400 fund choices. In 2000, the first year of the
plan, the Swedish government undertook a large advertising campaign to
increase public awareness of options. In the first year of the system,
a large percentage of citizens made an active fund allocation choice
(67 percent). As a result, the initial appearance was that Swedish
investors were far less susceptible to the default bias than U.S.
investors (Engstrom and Westerberg, 2003). However, by 2003, the
advertising level had decreased, and 91.6 percent of new participants
chose the default fund (Cronqvist and Thaler, 2004), demonstrating that
the default bias is not limited to U.S. investors and cannot be
overcome without sustained efforts.
In addition to the default bias, other behavioral biases can
influence allocations. Company stock investment provides an excellent
case study. Given the well-known benefits of diversification, it is
puzzling that investors would invest substantial amounts in one
security, especially one highly correlated with their own human
capital. Several studies detail the potentially large welfare costs
associated with company stock investment (Muelbroek, 2002; Poterba,
2003; Even and Macpherson, 2008). Despite these costs, participants
still concentrate their portfolios in company stock, and recent
research suggests that behavioral biases may be to blame.
For example, Huberman (2001) suggests that a familiarity bias may
influence an investment choice. He asserts that some investors are not
optimizing their portfolios based on risk and return but rather
choosing to invest in what they know. Huberman finds evidence of this
in investing patterns associated with U.S. Regional Bell Operating
Companies. Along similar lines, Cohen (2009) suggests that loyalty may
come into play. He finds that employees of stand-alone firms invest 10
percent more in company stock than employees in conglomerates.
Benartzi (2001) suggests that there may also be an endorsement
effect when the employer restricts the employer match to company stock.
Brown, Liang, and Weisbenner (2006) provide more information about why
employers might provide matching contributions in company stock.
Contrary to rational expectations, Benartzi finds that when the
employer match is in company stock participants allocate more of their
own contributions to this security (18 percent versus 29 percent). He
theorizes that employees are interpreting the company stock match as
implicit investment advice. Using pooled cross sections of data, Brown,
Liang, and Weisbenner (2007) find similar evidence. However, when they
control for firm-level fixed effects, they find this relationship
between match policy and employee contributions to company stock
disappears.
Excessive extrapolation may also affect company stock allocations.
Benartzi (2001) finds that discretionary contributions to company stock
with the poorest 10-year stock performance were lower than those with
the best performance (10.4 percent versus 39.7 percent). Additional
studies also find links between past company stock returns and company
stock holdings (Choi et al., 2004; Huberman and Sengmueller, 2004;
Agnew, 2006; Brown et al., 2007).
Moving beyond company stock allocation decisions, research suggests
that excessive extrapolation can also be a factor in other asset
choices. Returning to the Swedish pension scheme example, investors may
have been using historic 5-year fund returns to aid in their fund
selection process. During the first year of the program, a technology
and health-care fund recorded the best 5-year fund performance out of
all 456 funds. An information booklet given to all participants
reported these returns. Interestingly, this fund received the largest
percent of the contribution pool (4.2 percent) excluding the default
fund (Cronqvist and Thaler, 2004). Unfortunately for those who selected
this fund, by 2003 the Internet bubble had burst, and this fund had
lost 69.5 percent of its value. This example is a cautionary tale about
the potential pitfalls of using simple allocation heuristics.
Past research also suggests that the investment menu may affect
asset allocations. Benartzi and Thaler (2001) find some evidence that
individuals follow a naive diversification strategy called the ``1/n
heuristic.'' Based on this rule of thumb, investors divide their
contributions equally among the n choices available. Depending on the
fund menu, this strategy can easily result in portfolios that are
inconsistent with the investors' risk preferences and lead to large ex
ante welfare losses as documented by the authors. This rule of thumb
appears to become less popular as the number of fund choices increases.
Huberman and Jiang (2006) find that for a menu with a large number of
funds, individuals follow a slightly different heuristic, which they
refer to as the ``conditional 1/n rule.'' Agnew (2006) also finds
evidence of the conditional 1/n rule. According to the conditional
rule, participants will divide their allocations equally among the
number of funds they choose. The number of funds chosen is not
necessarily equal to the total number of funds offered. Huberman and
Jiang (2006) point out that this may not be an irrational strategy.
Brown et al. (2007) provide further evidence of menu-driven
effects. They use aggregate data and find that the number and mix of
investment options significantly affects the allocation of
contributions. They estimate that increasing the share of
equity funds from 1/3 to 1/2 increases overall participant allocations
to equity funds by 7.5 percentage points. Using individual-level
administrative data, Agnew (2006) also finds evidence of mental
accounting (Kahneman and Tversky, 1984; Thaler, 1985, 1999) when
company stock is present. In a variation on the conditional 1/n
heuristic, Agnew finds that individuals appear to allocate their
contributions to company stock and then divide equally their remaining
allocations to the other asset holdings. From these results,
participants are apparently treating company stock as a separate asset
class. This finding supports earlier work by Benartzi and Thaler
(2001). Finally, Choi, Laibson, and Madrian (2008a) find mental
accounting present when employees do not choose their own match
allocation.
Once again highlighting the importance of choice architecture,
Benartzi and Thaler (2007) report surprising results related to subtle
changes to the investment form design. They test whether the number of
lines on a fund election form can influence the number of funds in
which participants invest. In an experiment using Morningstar.com, they
asked participants to allocate money among eight hypothetical funds.
Participants received one of two possible computer forms, one featuring
four lines with a hyperlink to invest in more than four funds and one
with eight lines. The number of lines did significantly influence the
behavior. Only 10 percent of individuals presented with the four-line
form chose more than four funds compared to 40 percent of those viewing
the form with more lines. Benartzi, Peleg, and Thaler (2008) provide
further discussion about choice architecture.
This research has helped plan sponsors recognize the complexity of
the allocation decision and the tendency of employees to rely on simple
heuristics when making allocation choices. In response, 401(k)
providers have become proactive in improving plan design and
introducing new products intended to simplify the process and improve
savings outcomes. Target date funds (sometimes referred to as Life-
Cycle funds) are a recent example of this type of new product. These
funds have rapidly become a common offering in 401(k) menus since the
2006 Pension Protection Act authorized that they could be used as
default options. Nessmith and Utkus (2008) estimate that participants
invested $183 billion in these funds in 2007, and 81 percent of plans
with auto-enrollment used them as their default. While not without
controversy, these funds are theoretically an effective tool to help
individuals maintain a portfolio mix that is appropriate over the long
term. One advantage of these funds is that they reduce the complexity
of the allocation decision for the investor because the participant
need only choose a fund with a date similar to his or her expected
retirement date. Once a participant decides to invest in a target date
fund, the status quo bias and inertia keep the participant's investment
decision on track. Viceria (2008) provides more details about how the
first generation of these products relates to academic models of asset
allocation and suggests improvements for future products.
While an innovative and a seemingly error-proof solution, the way
target date funds are actually used in individuals' portfolios is
perplexing and suggests that individuals may not fully understand this
growing asset class. Nessmith and Utkus (2008) find that just over half
of target date fund investors are ``pure'' investors who hold only one
single target date fund when these products are offered, while the
remaining group represents ``mixed'' investors who combine target date
funds with other investment options. In an analysis of a similar type
of fund that is based on risk preferences, so-called lifestyle funds,
Agnew (2007) finds similar ``mixed'' portfolio results. Of the
participants in her sample, 36 percent held at least one lifestyle
fund, and of that group nearly half (47 percent) invested in multiple
lifestyle funds.
Whether these ``mixed'' portfolios are due to participants
optimizing their overall portfolios or a result of naive decisionmaking
is unclear. However, there is growing evidence that a lack of financial
understanding about these new products may drive this behavior, and
this is discussed later in the financial literacy section. In addition
to financial literacy, Nessmith and Utkus (2008) propose several
rational and behavioral explanations for the mixed portfolios including
naive diversification, inertia, and employer matching effects. Future
research will need to test all these theories. However, existing
evidence shows that defaults can encourage more pure ``single
selection'' investing. Mitchell, Mottola, Utkus, and Yamaguchi (2008)
find that participants are more likely to be ``pure'' investors when
the default option is a target date fund. Once again, if individuals
have well-defined preferences, the presence of a default should not
matter.
With regard to company stock investment, Bernatzi and Thaler (2003)
are developing a new program based on behavioral finance principles
similar to their SMarT program discussed earlier. The results of this
program are still to be tested.
TRADING
Once retirement participants make an asset allocation, they must
then decide if and how to rebalance their portfolio over time. Unlike
retail brokerage accounts, trading in 401(k) plans is characterized by
extreme inertia (Odean, 1999; Ameriks and Zeldes, 2001; Madrian and
Shea, 2001; Agnew, Balduzzi, and Sunden, 2003; Mitchell, Mottola,
Utkus, and Yamaguchi, 2006). Agnew et al. (2003) find that, on average,
investors trade only once every 3.85 years. Mitchell et al. (2006)
discover that almost 80 percent of the 1.2 million workers they study
do not trade over a 2-year period. This behavior is consistent with the
implications of models of optimal portfolio choice with realistic
transaction costs (Lynch and Balduzzi, 2000). However, such behavior
can be a concern if it results from procrastination. For example, if a
participant is defaulted into a fund that is inappropriate for his or
her risk characteristics, the optimal action would be to trade out of
the fund.
This inertia appears to persist even in times of market turmoil
(Mottola and Utkus, 2009). However, evidence suggests that a very small
subset of individuals may be reacting to market returns. Mottola and
Utkus report spikes in the number of investors who completely abandoned
equities during the months of extreme market downturns in 2008.
However, the number of traders represents an extremely small proportion
of the sample. This type of trading is consistent with a positive
feedback strategy where investors buy assets that are increasing and
sell assets that are falling. Using data from only one 401(k) plan,
Agnew et al. (2003) find evidence of positive feedback trading with a
one-day lag. Using a more comprehensive but aggregated dataset of
retirement asset flows representing 1.5 million participants over a 5-
year period, Agnew and Balduzzi (2009) find additional evidence of
feedback trading within the day. Taken together this evidence is a
cause for concern as it suggests that some investors may deviate from
their long-run investment objectives in response to one-day market
returns.
Trading in 401(k) trading plans has also been shown to be influence
by access to the Internet. Choi, Laibson, and Metrick's (2002) study
finds that trading frequency after 18 months of access to Web trading
nearly doubles relative to a control group of individuals without
access. This finding may be a result of the fact that Web trading
reduces time and other transaction costs. Mitchell et al. (2006) also
discover that the most active traders use the Internet. Yamaguchi,
Mitchell, Mottola, and Utkus (2006) find that active trading does not
lead to higher risk-adjusted returns but passive rebalancing through
balanced and life-cycle funds does. Given the documented inertia and
the benefits of rebalancing, plan sponsors have introduced life-cycle
funds that automatically adjust portfolio shares over time, as well as
managed account services.
DISTRIBUTION PHASE
While many researchers have devoted time to studying how behavioral
factors influence decisions in the accumulation phase, far fewer have
studied how these influences affect how individuals make investment and
consumption decisions upon retirement. For most defined contribution
plans, the default is for participants to withdraw their money in a
lump sum after a certain age. At this point, participants face
complicated decisions. Should annuities play a role in their retirement
portfolio? How should they allocate assets, and how much should they
consume so that they do not run out of money?
In response to these questions, theoreticians contend that single,
premium lifetime immediate annuities should play a role in retirement
portfolios. However, the actual market for these products is relatively
small, which is puzzling to academics whose models of rational behavior
predict a much larger demand. Even when theoreticians add extensions to
the basic model, such as adverse selection and bequest motives, they
cannot explain the small size of the actual market. This well-known
fact is commonly referred to as ``The Annuity Puzzle.'' Brown (2008)
provides a thorough and informative summary of the past theoretical and
empirical literature and challenges researchers to consider behavioral
explanations in the future. He offers framing, complexity, mental
accounting, loss aversion, misleading heuristics, regret aversion, and
the illusion of control as possible behavioral reasons for the annuity
puzzle.
One recent study by Hu and Scott (2007) explores how several
behavioral theories such as cumulative prospect theory, loss aversion,
and mental accounting can explain the low demand for immediate
annuities. They find behavioral reasons for the popularity of
guaranteed period life annuities.
Two new studies examine the role of framing in the annuity
decision. Agnew, Anderson, Gerlach, and Szykman (2008) use a large
scale-laboratory experiment to investigate the influence of negative
message framing. They are motivated by the framing work of Tversky and
Kahneman (1981) and more recent studies in the health communications
literature that examine how positive and negative messages influence
recommended health behaviors (Block and Keller, 1995). Agnew et al. ask
participants to play a retirement game with real money where they must
choose between an annuity and an investment. Before making their
decision, the participants see one of three brief presentations that
either (1) favor the annuity choice by emphasizing the potential losses
associated with investing in the market and outliving resources, (2)
favor the investment choice by emphasizing the potential loss from
dying early after purchasing an annuity, or (3) favor neither choice.
The presentations were factual but played on the participants' aversion
to loss. Agnew et al. report a sizeable and significant influence of
the message frame.
Using a different type of frame, Brown, Kling, Mullainathan, and
Wrobel (2008) also find significant results related to the influence of
framing on the attractiveness of annuities. They use an Internet survey
to demonstrate that the demand for annuities can be influence by
whether the consumer is viewing the annuity from a narrow investment
frame or a broader consumption frame. They present individuals with
product choices that represent annuities and competing non-annuitized
products like savings accounts. Some participants view the product
choices from an investment frame where they are discussed in terms of
their account values and earnings. Other participants are presented
with the same products but they are discussed in a consumption frame.
In this case, the discussion centers around how much the consumer can
spend over time with each option. The authors find that individuals in
the consumption frame prefer annuities to other non-annuitized
products, and the reverse holds for the investment frame. For example,
Brown et al. (2008) find that 21 percent of participants in the
investment frame compared to 72 percent in the consumption frame prefer
the life annuity to a savings account.
Finally, very recent working papers suggest that the decision to
annuitize may also be influence by past market returns. Using
administrative data, Chalmers and Reuter (2009) and Previtero (2010)
find an inverse relationship between past market returns and the
probability of annuitization. Agnew, Anderson, and Szykman (2010) find
similar evidence using a laboratory experiment.
These early results suggest that using behavioral finance to
explain annuity demand is a promising area for future research. As more
becomes known about the psychology behind this decision, there are
opportunities for plan providers to devise products and programs that
make annuities more attractive. However, as Brown (2008) points out,
the irreversibility of the annuity decisionmakes this a more
challenging task. For example, simple plan solutions used in the
accumulation phase such as choosing optimal defaults are more difficult
to implement in the case of annuities because the decision cannot be
undone.
FINANCIAL LITERACY
One reason that individuals may succumb to behavioral biases is
that they lack financial literacy and are subsequently overwhelmed by
the decisions they face. Widespread evidence demonstrates that there is
a substantial lack of financial literacy both in the United States and
abroad (Lusardi and Mitchell, 2007). If people do not understand their
financial choices or cannot grasp general financial concepts, they can
easily make mistakes and may be more likely to fall back on simple
heuristics.
This could easily be the case with investment in company stock and
``mixed'' target date investing. An earlier section of this chapter
raised these asset allocation issues. In both cases, evidence suggests
that individuals may not understand these assets. Several studies
demonstrate that individuals often do not realize that investment in
company stock is riskier than investing in the market (for example,
Agnew and Szykman, 2005; Lusardi and Mitchell, 2008). Benartzi (2001)
reports that 84 percent of the respondents in a Morningstar survey made
this mistake. In addition, a recent study by Envestnet finds that 40
percent of respondents in a small survey strongly agreed or somewhat
agreed that target date funds provide a guaranteed return, while 30
percent agreed that they could save less money using these vehicles and
still have sufficient funds to retire (Behling, 2009). Additional
studies show misunderstanding of other basic products.
Yet more than general financial literacy is important to pension
participants. How well individuals understand their own plan features
is also paramount. Choi, Laibson, and Madrian (2008b) find that 21
percent of participants who contribute at a rate below the match
threshold knew their match rate compared to 41 percent of those above
the match threshold in their sample. According to Chan and Stevens
(2006), individuals who are knowledgeable about their plan features are
five times more responsive to plan features than the average
individual.
One issue facing plan sponsors is that efforts designed to help
investors, such as simplifying investment materials or reducing plan
choices, may be ineffective for the financial illiterate. For example,
Agnew and Szykman (2005) use a laboratory experiment to test how the
number of investment choices and information presentation influence
decisionmaking. While reducing the number of choices decreased feelings
of information overload for those with above-average financial
literacy, it did nothing for those with below-average literacy. They
remained simply overwhelmed. Not surprisingly, individuals with below-
average financial knowledge were more likely in the Agnew and Szykman
study to choose the default option than those with above-average
knowledge (20 percent versus 2 percent), suggesting that low literacy
may make individuals more susceptible to biases.
As the shift toward defined contribution plans continues, improving
financial literacy becomes increasingly important. However, evidence is
mixed about the success of current educational efforts. While employer-
sponsored seminars suggest that individuals have good intentions to
improve savings behavior after attendance, there is growing evidence
that they do not follow through with their intentions (Clark and
d'Ambrosio, 2008). Choi et al. (2002) find that after one seminar
nearly every worker not participating in the plan indicated his or her
intention to join, but only 14 percent actually followed through. In
addition, individuals do not seem to learn from the experiences of
others. Choi, Laibson, and Madrian (2005) find that even when Enron
employees were losing their retirements because of investing in company
stock, there was little change in company stock holdings by employees
in other 401(k) plans.
Educators must also consider that individuals tend not to be
interested in financial matters or financial planning, and this leads
to inattention. MacFarland, Marconi, and Utkus (2004) find that at
least half of their sample of retirement investors had limited interest
in topics often presented in current financial education programs.
Additionally, Lusardi and Mitchell (2006) discover that only 18.5
percent of their sample was able to determine how much they needed to
save, develop a savings plan, and actually stick to it. In addition,
individuals may not even realize that they lack financial literacy and
therefore need assistance. Agnew and Szykman (2005) find that certain
groups (for example, low-income individuals) have a low correlation
between their own perceived knowledge and their score on a literacy
test. Lusardi and Tufano (2009) find similar evidence for older
individuals.
This suggests that educators must recognize psychological biases
and be creative in their approach to teaching. Tufano and Schneider
(2008) provide a review of existing financial literacy programs that
include new and innovative approaches for low- and moderate-income
families. In addition, Lusardi (2008) provides insights into improving
the effectiveness of programs in the United States, and Fox,
Bartholomae, and Lee (2005) present information regarding the
importance of financial education evaluation.
SUMMARY AND CONCLUSIONS
The retirement research literature provides solid evidence that
behavioral biases influence every financial decision related to
retirement. In view of the documented lack of financial literacy and
interest in retirement planning, overwhelmed investors often resort to
simple heuristics. The findings in the literature clearly show that
even the most subtle details in plan design influence behavior. A
successful working relationship between practitioners and academics in
this field has resulted in numerous plan design changes that have
improved savings outcomes. While the literature in this field is now
extensive, there is still more work to be done, particularly related to
the distribution phase of retirement and the role of annuities. In
addition, financial education programs can become more effective by
incorporating what is known about behavioral biases and investor
psychology. Given the increasing responsibility of individuals for
their own retirement, the behavioral literature should continue to grow
quickly for years to come and motivate further successful changes to
plan design.
DISCUSSION QUESTIONS
1. Given participants' documented behavioral biases in retirement
decisionmak-
ing, should plan sponsors and policymakers focus on automating plan
design to avoid common mistakes made by plan participants, or work on
improving financial education?
2. Until recently, there has been little behavioral research
related to the distribution phase of retirement, and specifically
annuities. Discuss some possible behavioral theories that might explain
the annuity puzzle.
3. Investing a large portion of one's wealth in an employer's
company stock is contrary to sound investment principles. Discuss some
theories that might explain this questionable investment behavior.
4. Discuss three successful changes to plan design that have
improved savings outcomes, and explain how they relate to behavioral
finance. Are there any associated drawbacks?
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ABOUT THE AUTHOR
Julie Agnew is an associate professor of finance and economics at
the Mason School of Business, the College of William and Mary, and co-
director of the Center for Interdisciplinary Behavioral Finance
Research (CIBFR). Her research focuses on behavioral finance and its
relationship to decisions made in individuals' retirement plans.
Several leading academic journals have published her research using
data from 401(k) plans and laboratory experiments. Often cited in the
business press, she frequently speaks at academic and practitioner
conferences in the United States and abroad. She is a TIAA-CREF
Institute Fellow, a member of the Defined Contribution Plans Advisory
Committee (DCPAC) for the Virginia Retirement System, and a research
associate for the Center for Retirement Research at Boston College. Dr.
Agnew earned her BA in economics from the College of William and Mary
and her PhD in finance from Boston College. A former Fulbright Scholar
to Singapore, she began her professional career in investment banking
and equity research at Salomon Brothers and Vector Securities
International.
The Chairman. Thank you, Dr. Agnew.
Now we'll turn to Dr. Brown. Welcome to Washington.
Mr. Brown. Thank you very much.
The Chairman. He's in Chicago. You're in Chicago right now.
He couldn't make it.
Mr. Brown. Yes, technically, I'm in Champaign, IL.
The Chairman. Dr. Brown, welcome again. Your testimony will
be part of the record. Please proceed.
STATEMENT OF JEFFREY R. BROWN, Ph.D., WILLIAM G. KARNES,
PROFESSOR OF FINANCE, UNIVERSITY OF ILLINOIS AT URBANA--
CHAMPAIGN COLLEGE OF BUSINESS, CHAMPAIGN, IL
Mr. Brown. Thank you.
Chairman Harkin, Senator Enzi, and members of the
committee, thank you for the opportunity to discuss the
important issue of retirement income security with you today. I
sincerely wish that I could be there in person, but the severe
winter weather we've had here recently made travel impossible,
so I'm grateful to the committee staff, as well as our own IT
support here at Illinois for allowing me to testify from a
distance.
I'd like to briefly summarize a few key points from the
longer written testimony that I previously submitted. The
primary overriding message that I would like to leave you with
today is that I think it's time that we shift America's
conversation about retirement away from one that is solely
focused on wealth accumulation, to one that is focused on the
broader concept of retirement income security.
As was noted earlier, saving, investment and wealth
accumulation are absolutely critical for retirement security.
But they're not enough. True retirement security also depends
upon having part of one's retirement resources in the form of a
guaranteed income stream that cannot be outlived. In short, we
need to focus on more than just getting people to retirement.
We need to focus on getting people through retirement.
Life annuities are products that allow individuals to
convert a lump sum of wealth into a guaranteed income stream
that will last for as long as they live. There are decades of
economic theory that indicate how valuable annuities can be as
part of a retiree's retirement plan. Unfortunately,
annuitization is on the decline, for a number of reasons which
I outlined in my testimony, including the declining role of
Social Security going forward, the shift we've witnessed over
the last few decades away from defined benefit plans, which
typically paid out in the form of annuity, and to defined
plans, like 401(k)s, that more often than not do not even offer
access to guaranteed income options. Third, the limited size of
the retail annuity market.
In order to encourage annuitization, I'd like to briefly
mention three ideas, and there are a few others in my testimony
that I submitted earlier. The first is captured in the Lifetime
Income Disclosure Act, with, which a couple members of your
committee were instrumental in putting forth in the last
session. I've conducted academic research that shows that
Americans' views about annuities are very strongly influenced
by the framework in which this information is presented. For
example, when viewed through a frame that emphasizes wealth
accumulation and investment features, only 20 percent, only
about 1 in 5 individuals, think that an annuity looks
attractive in comparison to a simple savings account. The same
holding finds when comparing an annuity against other financial
products.
In contrast, when viewed through what we call a consumption
frame, or a frame that really emphasizes one's ability to buy
the goods and services that they want during retirement, 70
percent of individuals find an annuity attractive.
This is a pretty remarkable shift in preferences from
what's essentially a very small change in the way the
information is portrayed or presented. This research suggests
that when plan sponsors are issuing their annual or their
quarterly statements about, for example, 401(k) balances, that
what we should really also be telling them is how much
retirement income those accounts will be able to provide. The
Lifetime Income Disclosure Act could be a very important step
in reframing the conversation and discussion in a way that
encourages annuitization. This legislation, which, if properly
designed, could be implemented at very minimal cost to
employees and employers, and could have a very significant
impact on the way individuals evaluate how well-prepared they
are for retirement.
Second, I would strongly encourage Congress to rethink the
required minimum distribution rules. These rules were written,
really, from a tax policy perspective to ensure that qualified
plan assets were eventually subject to income taxation. But,
from a perspective of retirement income policy, these rules
were poorly conceived. They encourage individuals to deplete
their assets more quickly than may be optimal, and they have a
number of unintended consequences, including discouraging some
forms of annuitization.
Finally, I think there's a strong case to be made for
extending the idea of automatic enrollment to the annuitization
phase, and thinking about automatically annuitizing a portion
of qualified plan assets in order to overcome some of the
institutional and behavioral biases that currently stand in the
way of retirement income security.
However, as I outline in my testimony, there are a number
of reasons to perhaps go slowly on this front. Before Congress
implements such a policy, I think it would be very useful to
have more research to help us understand both the intended and
unintended consequences for both plan participants and plan
sponsors.
One thing that Congress and, or the Department of Labor
could do would be to provide some safe harbor protection to
employers who would be willing to be leaders or innovators in
this area so that we could all learn from their experience.
Just to conclude, I certainly agree that it is
extraordinarily important that we have policies in place to
encourage participation in retirement plans, to encourage
saving, to encourage wealth accumulation. But we also need to
ensure that public policy is equally supportive of the second
half of the retirement income security equation, which is
encouraging individuals to annuitize some of their retirement
assets so that they can have an adequate income stream for as
long as they live.
Thank you for the opportunity to speak to you today, and I
look forward to your questions.
[The prepared statement of Mr. Brown follows:]
Prepared Statement of Jeffrey R. Brown, Ph.D.
Chairman Harkin, Senator Enzi, and members of the committee, I am
Jeffrey Brown, the William G. Karnes Professor of Finance in the
College of Business at the University of Illinois at Urbana--
Champaign.\1\ I thank you for the opportunity to appear before you
today to discuss the important issue of how to improve our system of
retirement security.
---------------------------------------------------------------------------
\1\ I also serve as Director of the Center for Business and Public
Policy at the University of Illinois, as Associate Director of the NBER
Retirement Research Center, and as a Trustee for TIAA. Previously, I
served on the Social Security Advisory Board (2006-8), on the staff of
the President's Commission to Strengthen Social Security (2001), and as
Senior Economist with the President's Council of Economic Advisers
(2001-2). All views presented in this testimony are my own, and do not
reflect the views of any of the organizations with which I am
affiliated.
---------------------------------------------------------------------------
To start, I would like to ask a question, Why do we save for
retirement?
This may seem like a simple question. There are many possible
answers, but I would like to focus on two, each of which sounds
plausible, but each of which has very different implications for the
optimal design of a retirement system:
1. ``We save so that we will have a large sum of money in our
account at retirement.''
OR
2. ``We save so that will have the income we need to maintain our
standard-of-living throughout retirement.''
The first answer focuses solely on the accumulation of wealth. In
essence, it focuses only on getting people to retirement.
The second answer focuses on getting people not just to retirement,
but also through retirement.
In this sense, the second answer is much more complete. It
recognizes that while saving, investment and wealth accumulation are a
necessary condition for retirement security, they are not sufficient.
This second answer recognizes that true retirement security also
depends on having part of one's retirement resources in the form of a
guaranteed income stream that cannot be outlived.
Ensuring that one's nest egg lasts a lifetime is a complex
financing planning exercise because people face uncertainty about asset
returns, interest rates, inflation, expenses and, perhaps most
importantly, uncertainty about how long one can expect to live.
The good news is that financial products exist that help
individuals address these complex planning problems. For example, a
life annuity is an insurance product that allows an individual to
convert a lump-sum of wealth into a stream of income that is guaranteed
to last for as long as an individual (and if desired, his or her
spouse) lives.\2\ As I will discuss below, economic theory suggests
that life annuities can be enormously valuable to retirees.
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\2\ For purposes of this testimony, I am using the term ``life
annuity'' to refer to products which guarantee income for as long as
the annuitant lives. This excludes some products with the term
``annuity'' in the name that do not offer life-contingent payouts.
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Unfortunately, the U.S. retirement system has evolved over the past
30 years into a system that focuses almost entirely on wealth
accumulation. Many of our public policies, our plan designs, and our
financial planning tools have been designed as if the first answer
provided above--that we save in order to have a large sum of money in
our account at retirement age--is the end goal.
We have paid far too little attention to the equally important
issue of how to ensure that one's accumulated resources are sufficient
to last for a lifetime.
The one, over-riding message that I would like to leave you with
today is that we need to shift America's conversation about retirement
away from a conversation solely focused on wealth accumulation and to a
conversation about the broader concept of retirement income security.
In support of this message, I will proceed with my testimony as
follows:
First, I will provide a very brief overview of the academic
research that indicates the importance of guaranteed lifetime income.
Second, I will briefly discuss a number of factors--including the
declining role of Social Security, the shift from defined benefit (DB)
to defined contribution (DC) plans, and the limited size of the private
annuity market in the United States--which suggest that Americans are
becoming increasingly exposed to longevity risk (i.e., the risk of
outliving one's resources).
Third, I will briefly describe research that I, and co-authors,
have undertaken on how the psychological concept of ``framing'' can
have an important impact on people's perception of the value of life
annuities. I will specifically discuss the implications of this
research for the Lifetime Income Disclosure Act.
Last, but not least, I would like to briefly discuss a few other
policies that might be used to encourage retirement income security.
1. THE IMPORTANT ROLE OF LIFE ANNUITIES: A BRIEF REVIEW OF ECONOMIC
THEORY
Within the economics discipline, there is a very large research
literature exploring the role of life annuities in improving the well-
being of consumers who face uncertainty about their length-of-life.
While the literature is too large to fully summarize here, a fair
characterization of the core theoretical result is that life annuities
can substantially improve consumer well-being.\3\
---------------------------------------------------------------------------
\3\ The seminal paper in this area is by Yaari (1965). The results
of his paper were generalized and extended in Davidoff, Brown and
Diamond (2005).
---------------------------------------------------------------------------
This finding arises from two related benefits: First, annuities
provide a higher rate of return, contingent on survival, than otherwise
similar, but non-annuitized, assets. This arises because the resources
of those annuitants who die relatively early can be used to increase
the rate of return to those who live longer than average. This extra
return is sometimes referred to as the ``mortality premium.''
Second, life annuities guarantee that the annuitant will receive
income for as long as he or she lives.
In essence, life annuities eliminate the need to trade-off two
risks for retirees: (i) that if they consume too much, they will run
out of money before they die, and (ii) that if they want to set aside
enough money to live on even if they live to extremely advanced ages,
they must consume much less during the entirety of their retirement
years.
Simulation studies have suggested that the benefits from having
access to life annuities is equivalent--in terms of consumer well-
being--to a substantial increase in financial wealth.\4\
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\4\ See, for example, Mitchell et al. (1999) and Brown (2001).
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2. ARE AMERICANS UNDER-INSURED AGAINST LONGEVITY RISK?
There are several factors suggesting that Americans are becoming
increasingly exposed to the risk of outliving their resources (a risk
sometimes referred to as ``longevity risk.'')
Let's begin with the U.S. Social Security system. While there are
many ways to describe the Social Security system, for today's purposes
it is instructive to understand that it is the only meaningful source
of inflation-indexed, annuitized income available to most retirees in
the United States. From this perspective, Social Security plays a vital
role in providing a guaranteed income floor.
However, Social Security will play a declining role going forward.
Even without further policy changes, the combination of the increasing
normal retirement age, and the fact that Medicare premiums--which are
netted out of Social Security checks for most Americans--are rising
faster than inflation, means that net Social Security replacement rates
are projected to decline in the future.\5\
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\5\ See, for example, Munnell 2003.
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Furthermore, we must face that undeniable fact that the United
States is on an unsustainable fiscal path, and that the growth in
entitlement programs like Social Security (and even more importantly,
Medicare and Medicaid) must be reined in.
Taken together, these facts make it apparent that future
generations of retirees should not be relying on Social Security to
play as large of a role in their retirement as the program has done for
past generations.
Turning to the private sector, the past three decades have
witnessed a substantial decline in the role of DB plans in the private
sector. Further, many of those that remain are substantially
underfunded. This fact poses risks both for retirees (in particular,
those whose benefits exceed the amount insured by the Pension Benefit
Guaranty Corporation, or PBGC) as well as for taxpayers (given the
large projected deficits facing the PBGC that will ultimately require
an infusion of taxpayer funds to avoid a reduction in insured
benefits).
In the place of DB plans, we have seen the 401(k) plan emerge as
the dominant form of retirement plan in the United States. While 401(k)
plans have many advantages for both employers (e.g., reduced funding
uncertainty) and employees (e.g., increased portability), the recent
financial crisis and recession clearly exposed the long-standing
inadequacy of appropriate risk management in the 401(k) system. A
prominent example of this is the near absence of guaranteed income
options in the typical 401(k) plan. It has been estimated that fewer
than one-in-four 401(k) plans offer participants the option of
converting a portion of their account balances into life annuities.
Further, many Americans do not have access to a retirement plan of
any kind through their employer. For these individuals, as well as for
those with 401(k) plans that lack an annuity option, it is possible to
purchase guaranteed lifetime income through the retail market. However,
the market for such products continues to be small relative to the
retirement income needs of Americans.
As a result of these factors, it is clear that the relative dearth
of opportunities to insure against longevity risk is a serious issue
for U.S. retirement policy.
3. ``FRAMING ANNUITIES''--IMPLICATIONS FOR PUBLIC POLICY
Much of the academic research on annuities has focused on how to
explain the lack of a more robust annuity market. Having concluded that
this literature was limited in its ability to explain empirical
regularities in this market, I began to work with several colleagues to
explore various psychological, or behavioral, biases that might be
limiting the demand for annuities.
In 2008, we published a paper in the American Economic Review
(Brown, et al. 2008) showing that individuals' perceptions of life
annuity products are strongly influenced by what psychologists and
economists call ``framing.'' Framing is simply the idea that people may
be induced to change the behavior by changing the way information is
communicated (even when the actual information content is itself
unchanged.) \6\
---------------------------------------------------------------------------
\6\ In perhaps the most famous example of framing, Tversky and
Kahneman (1981) showed that citizens would choose very different
policies to address a public health threat depending upon whether the
information was provided in terms of ``lives saved'' or ``lives lost.''
---------------------------------------------------------------------------
Our paper was motivated by a simple insight. As noted earlier, the
dominant frame in the U.S. retirement system is an ``investment,'' or
wealth accumulation, frame. Individuals have been conditioned to think
of account balances as the appropriate yardstick for measuring their
retirement preparedness.
In such an investment frame, life annuities look relatively
unattractive. Indeed, they may even look risky, because the amount of
money that one receives depends on how long one lives.
In contrast, when viewed through a frame that emphasizes the
ability to sustain monthly consumption during retirement, life
annuities are quite attractive because they can guarantee this outcome.
In short, whereas annuities look risky in an investment frame, they
look like a valuable form of insurance in a consumption frame.
In our study, we conducted a survey of over 1,300 Americans age 50+
and presented them with information about various financial products.
We randomly divided individuals into groups that were presented with
the same information but in different frames.
Our results were supportive of the importance of framing. When
viewed through an investment frame, only about 20 percent of
individuals thought a life annuity looked attractive in comparison to a
simple savings account. When viewed through a consumption frame, over
70 percent of individuals preferred the annuity. This is a remarkable
shift for what is essentially a small change in the way the information
is portrayed.
This research has led me to believe that one simple, but
potentially very powerful, way to encourage annuitization is to change
the way that plan sponsors communicate about participants' 401(k)
plans. Put simply, rather than focusing solely on how much wealth one
has accumulated in their plan, we should be telling people how much
retirement income their account balance will be able to provide them.
This research has implications for the bipartisan Lifetime Income
Disclosure Act that was introduced in 2009. Indeed, the research
suggests that the core idea of that act--to require that plan sponsors
provide information about the retirement income that their 401(k) could
provide--could help re-frame the retirement discussion in a way that
encourages annuitization. If enacted, this legislation could have--over
time--a very significant impact on the way individuals evaluate their
preparedness for retirement.
Of course, it is important that the provisions of the Lifetime
Income Disclosure Act, if passed, be enacted in a manner that keeps the
message simple for consumers. It is equally important that the rules be
structured to keep the cost of compliance to a minimum, particularly
for small businesses. We must remember that employers who offer
retirement plans to their employees do so voluntarily. Thus, even the
most well-intentioned policy can end up harming retirement security if
it imposes costs on employers that lead them to stop offering an
employer-provided plan.
Fortunately, the Lifetime Income Disclosure Act should impose
minimal, if any, additional costs on employers, at least as long as it
is efficiently designed and implemented. For example, in order to avoid
forcing small employers to become annuity valuation experts, the
Department of Labor could provide a very simple table or formula (i.e.,
based on standard annuitant mortality tables and an interest rate
assumption) that converts a given account balanced into a monthly or
annual annuitized income stream. If implemented in a simple way, plan
sponsors would be sending the same quarterly or annual statements that
they do now, but with two numbers (account balance and monthly income)
instead of one (account balance).
Of course, some plan sponsors may wish to provide more
comprehensive or detailed projections--and, indeed, some already do so.
The act should certainly allow plan sponsors to continue to provide
such projections. In addition, plan sponsors who offer annuities in
their plan should be permitted to use actual annuity payouts from their
plan, rather than the example payouts.
4. OTHER POLICIES TO ENCOURAGE ANNUITIZATION IN QUALIFIED PLANS
In addition to reporting 401(k) and other DC balances in terms of
monthly income, there are numerous other policies that Congress could
consider to encourage annuitization. As noted above, it is extremely
important to weigh the advantages of these approaches against the
potential costs of imposing additional burdens on plan sponsors.
a. Required Minimum Distributions (RMD's)
The required minimum distributions appear to have been designed
solely from the perspective of tax policy--in essence, with the goal of
ensuring that the income is eventually subject to income taxation.
From the perspective of retirement policy, these rules run counter
to the idea of promoting retirement income security. The rules
encourage individuals to spend their resources down more quickly than
is, in all likelihood, optimal for most retirees. Indeed, simple
simulations have shown that following some of the RMD rules can lead to
the virtual exhaustion of all of one's retirement wealth long before
individuals reach their maximum possible lifespan.\7\
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\7\ For example, see Brown et al (1999).
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As such, Congress may wish to consider how to design the RMD's from
the perspective of promoting retirement income security.
b. Annuities in Qualified Default Investments Alternatives (QDIAs)
The Pension Protection Act took a very important step in
recognizing that individuals who are automatically enrolled into a
401(k) or other qualified plan should have their contributions placed
in a well-diversified investment vehicle.
Looking to the future, I would like to see the market evolve in the
direction of incorporating lifetime income into these life-cycle or
target-date funds.
To put it simply, in addition to thinking about the ``glide path''
for the allocation between stocks and bonds (and other asset classes),
I would like to see products which also automate the ``glide path''
between annuitized and non-annuitized assets. The gradual, and partial,
annuitization of accounts would be a very natural and very welcome
evolution of these plans.
I am not suggesting that such an approach be mandated. Rather, I
would like to see such an approach encouraged--or at least not
discouraged--through the regulatory framework. Providing plan sponsors
with clear fiduciary safe harbors for providing such products is one
important consideration.
c. Auto-Annuitization
Research in behavioral economics has clearly demonstrated the
strong influence that default options can have on behavior. As you
know, the Pension Protect Act took very important steps in expanding
automatic enrollment in 401(k) plans, as well as the automatic
escalation of contributions.
Looking to the future, it is reasonable to ask whether ``automatic
annuitization'' is a natural next step in this progression.
As I have written elsewhere, this idea has considerable merit as a
way of overcoming the policy, institutional and behavioral biases that
currently stand in the way of annuitization.\8\
---------------------------------------------------------------------------
\8\ In 2009, I authored a white paper (Brown, 2009) on behalf of
the American Council of Life Insurers in which I discussed the case for
an automatic annuitization policy, and outlined how such a program
could be implemented. While that research was sponsored by the ACLI,
the views and opinions expressed therein are mine alone and do not
necessarily represent the views of the ACLI or its member companies.
---------------------------------------------------------------------------
However, the merits of this idea must also be weighed against the
fact that designing an ``auto annuity'' program is much more complex
than automating other aspects of the 401(k). There are several reasons
for this. First, as noted above, most 401(k) plans sponsors do not even
offer life annuities through their plans. Thus, it is not a simple
matter of defaulting individuals into an already-existing option.
Requiring plan sponsors to provide access to annuities would impose
additional cost and complexity on plan sponsors.
Second, unlike the state of affairs prior to the passage of the
Pension Protection Act--when academic researchers had produced
substantial empirical evidence about the effects of automatic
enrollment--we have very little empirical evidence on how an annuity
default would work in practice. Ideally, some plan sponsors will take
the lead in voluntarily adopting such an approach in the coming years
so that the program can be carefully evaluated. But no such studies
exist today in a U.S. context.
Third, the ``downside risks'' to consumers in an automatic annuity
program are greater than is the case with automatic enrollment. Under
auto-enrollment, if an individual determines that it was a mistake to
be enrolled, they can ``undo'' it by pulling their money out of the
qualified plan at a relatively low cost. In contrast, typical life
annuity contracts are often irreversible (to avoid adverse selection),
and it could actually harm some consumers if they were automatically
annuitized when an annuity was clearly sub-optimal for them (e.g.,
someone with a terminal disease and a short remaining life expectancy).
It is possible to design an auto-annuity program that overcomes
this and other problems (see Brown 2009 for an example of such a
framework). However, doing so is necessarily a complex exercise.
All-in-all, while I continue to believe that automatic
annuitization may be a desirable feature of DC plans, it is premature
to consider such an approach in the near-term. At minimum, we need much
more research to fully understand both the intended and unintended
effects on plan sponsors and participants.
With this in mind, policymakers might wish to consider whether
there are steps that could be taken to encourage plan sponsors to
implement such a program voluntarily. For example, it might be
desirable to provide fiduciary safe harbors for plan sponsors who wish
to do so.
5. CONCLUSIONS
It is important to continue to pursue policies that encourage
Americans to save and invest. However, it is equally important that
plan participants have the knowledge, the opportunity, and the access
to products which allow them to convert their accumulated savings into
a secure source of retirement income. The Lifetime Income Disclosure
Act would be a useful first step in changing the national conversation
about retirement in this direction.
Thank you for the opportunity to speak here today. I would be happy
to take your questions.
References
Brown, Jeffrey R. 2009. ``Automatic Lifetime Income as a Path to
Retirement Income Security.'' White Paper prepared for the American
Council of Life Insurers.
Brown, Jeffrey R. 2001. ``Private Pensions, Mortality Risk, and the
Decision to Annuitize,'' Journal of Public Economics, Vol. 82, No.
1, October, pp. 29-62.
Brown, Jeffrey R., Jeffrey Kling, Sendhil Mullainathan, and Marian
Wrobel. 2008. ``Why Don't People Insure Late Life Consumption? A
Framing Explanation of the Under-Annuitization Puzzle.'' American
Economic Review, 98(2): 304-9.
Brown, Jeffrey R., Olivia S. Mitchell, James M. Poterba, and Mark J.
Warshawsky. 1999. ``Taxing Retirement Income: Non-Qualified
Annuities and Distributions from Qualified Accounts,'' The National
Tax Journal, Vol. LII, No. 3, September, pp. 563-91.
Davidoff, Thomas, Jeffrey R. Brown, and Peter Diamond. 2005.
``Annuities and Individual Welfare,'' The American Economic Review,
Vol 95, No. 5, December, pp. 1573-90.
Mitchell, Olivia S., James M. Poterba, Mark J. Warshawsky and Jeffrey
R. Brown. 1999. ``New Evidence on the Money's Worth of Individual
Annuities,'' The American Economic Review, Vol. 89, No. 5, December
1999, pp. 1299-1318.
Munnell, Alicia H. 2003. ``The Declining Role of Social Security.''
Boston College Center for Retirement Research. Just the Facts Issue
No. 6.
Poterba, James M. 1997. ``The History of Annuities in the United
States.'' NBER Working Paper No. 6001.
Tversky, Amos and Daniel Kahneman. 1981. ``The Framing of Decisions and
the Psychology of Choice.'' Science, 211(4481): 453-58.
Yaari, Menahem E. 1965. ``Uncertain Lifetime, Life Insurance, and the
Theory of the Consumer.'' Review of Economic Studies 32(2): 137-50.
The Chairman. Thank you so much, Dr. Brown. Can you hear us
and see us all right?
Mr. Brown. I sure can. Thank you.
The Chairman. Thank you very much. We'll start our 5-minute
rounds of questioning. I'll start with Ms. Chatzky. I think
there's a lot of misinformation about investments. A lot of
fact sheet marketing materials. I get them in the mail and I
look at them, and they sound great. I don't understand a lot of
them, to tell you the truth, and I'm sure a lot of other people
don't. But, where does a person go to really get good,
impartial advice about 401(k) plans?
Ms. Chatzky. They tend to go to the benefits department at
their employer. They tend to read Money Magazine, USA Today,
listen to what's happening on CNBC. The answer is, they often
wind up with information overload, feeling confused and unable
to make a decent decision. Anything that we can do to simplify
the process, to make the defaults better--and I understand all
of the limitations of the target date funds, but I think that
was definitely a step in the right direction. To provide
children as young as middle school, but definitely into high
school and college, with more financial education so that they
understand how to read the basic documents and how to speak the
basic language, will be moving the ball forward.
The Chairman. Anyone else want to respond to that question?
Where do you get more impartial information? That's readable.
It's so confusing. I'm a college-educated person, graduate, law
degree, and I can't understand it. How do you expect the
average person out there that doesn't have any financial
information or advice to understand?
Ms. Agnew. Well, I have a Ph.D., and I know that some of
the information that I'm presented is also confusing to read.
Oftentimes, it's because plans are thinking about, perhaps,
some legal concerns that, it needs to be written in a language
where they will not be sued. But unfortunately, what happens
then is that it's written in a way that the average person
can't understand it. So, it really, it does need to be
simplified.
I do believe that, you said middle school. I even think
getting into elementary school and teaching lessons about
savings, making these things familiar, so that when individuals
are actually faced with a decision when they graduate from
college, that they're able to understand it, is incredibly,
incredibly important.
There are ways to make the information easier. There was a
lot of work done in the nutritional labeling research area. I
think most of us can go to a cereal box and understand how to
compare calories and sugar content. And we need to be able to
do that when we're looking at plans. We need to make this
information very clear.
I do know that there are efforts out there right now. I
know the Social Security Administration has funded a financial
literacy research consortium, and the job there is to produce
literacy products that are unbiased, that help people make a
good decision. I think those are worthy efforts that should be
pursued.
Then, finally, I'd like to say, Anna Maria Lucardi at
Dartmouth has done some very, very good research. One of her
research pieces was using social marketing to get people to
participate in 401(k) plans. Basically, she held focus groups
with the people at Dartmouth, found out what was keeping them
from participating, came up with a one-pager with steps on what
they needed to do to participate--it was an automatic
enrollment--saw how that worked, tweaked it again with more
focus groups, and eventually was able to significantly increase
participation by simply making things easier to understand, and
the steps that need to be taken easier to understand. So, I
think there's a lot we could do.
Ms. Lucas. Chairman Harkin, I would like to just add that I
think what we're getting at is the reason why auto features
have become so critical to 401(k) plans and other defined
contribution plans. Because it's not only difficult for people
to understand this very complex topic. They don't have time,
they don't have the interest. And so, they're really faced with
the notion that, I have many things on my plate, and this is my
last priority. To simplify, sometimes it's not even enough.
What we do find is that people will respond to something as
simple as a postcard that says, if you want to enroll in this
plan, check the box. Something as simple as that, they will
respond to. But, as you said, getting reams of paper is,
they're not going to go through it. It's going to be a very low
priority.
The good news is that as people get older and retirement
approaches, say, in their 40s, and they do begin to pay a lot
more attention to this, they will use things like managed
accounts, and actually input their circumstances and situation
into the software to understand what is a better allocation for
them than a simple target date fund. But for young people, the
decisionmaking has to be so simple and so straightforward.
That's the reason that defaults are critical for people in
their twenties who are just starting out.
The Chairman. Dr. Brown, did you want to weigh in on this
at all?
Mr. Brown. Sure. Yes. I think I agree with most everything
that's been said. I will say that, I think it was Ms. Chatzky
that pointed out that one of the first places people go is to
their HR office, to their employer.
The Chairman. Yes.
Mr. Brown. I think it's very important to remember in this
process that the employer does play oftentimes a very important
intermediary role, and, in many cases is a trusted source of
information. For good reasons, we have put restrictions on what
employers can do in terms of providing advice and so forth to
the employees. But I think we need to be careful not to go so
far as to make employers or plan sponsors, who would like to
provide access to unbiased advice, be concerned about doing so
out of fear of violating fiduciary rules.
Employers really do play a central role in all of this, and
I think the more we can do to make that easier for them to pass
along useful information, the better.
The Chairman. Well, thank you all very much. My time has
well run over. But, you raise a question about, how about the
small employer that doesn't have an HR department.
Senator Enzi. That's right.
The Chairman. But, I'll yield to Senator Enzi.
Senator Enzi. Thank you, Mr. Chairman. I'm working on a
solution to that. Yes. I'm going to have a bill that will allow
small businesses to group together to do a 401(k) plan, so that
they can hire some expertise that can handle all the problems
that come up with that.
Ms. Lucas, in your testimony you mentioned some problems
with non-discrimination and other tests that have to be done.
Could you run through a few of those? Just mention them?
Problems that employers have to run into in order to be able to
do one of these 401(k)s?
Ms. Lucas. Yes. One of the things that was very attractive
with the Pension Protection Act was the non-discrimination
testing safe harbor that allowed plan sponsors who used
automatic enrollment and several other criteria, to not have to
engage in non-discrimination testing, which can be costly and
difficult for them, and an obstacle for plan sponsors. These
safe harbors that eliminate the need to do non-discrimination
testing is very, very important.
I think the non-discrimination testing safe harbor was very
well received. But the way that it was implemented within the
legislation was quite conservative, and so you expect that,
because people could opt out, maybe you would have a pretty
high contribution escalation cap, so that people who are
automatically enrolled, could be escalated to 15 or 20 percent
of pay, which is quite a robust rate, and if they didn't like
to be escalated up to 15 or 20 percent of pay over time, they
could simply opt out. Instead, the cap was put at a very low 10
percent of pay. Why that seems strange to me was that when we
did analysis of participants that we saw who had actually gone
in and proactively selected to choose what they would like
their automatic contribution escalation cap to be, they chose a
much higher number than 10 percent. They wanted to be escalated
up to 15 percent or more. There's an artificial barrier that's
been put in these safe harbors that are actually inhibiting
people from saving as much as they might naturally want to.
Senator Enzi. Thank you. As the accountant, I have some
more technical questions, but I won't put those out for
everybody. But I would appreciate an answer from you when we
get them to you.
Professor Agnew, I understand that you ran some focus
groups, and when they were presented with the normal 3 inches
of paper that employers have to give employees, that there's a
little bit of stress involved, and sometimes they break down
crying. I'd like to know what you think we ought to do to
relieve that stressful situation. What kind of things could we
be doing?
Ms. Agnew. Well, it was very enlightening. We've done a
series of focus groups for several different projects. I was
actually surprised at the reactions when we asked people to
express their feelings towards making retirement decisions. If
you see in my testimony, there's a picture at the very end. I
know others can't see it. But it's a little bit disturbing.
People obviously are very concerned. This picture shows a
fellow getting shaved. He's in a chair, and the person shaving
has a long knife, but looks very distracted, like he's about to
cut his throat. This is how some people, or, many people in our
focus group are feeling about these things. I think that what
we learn from these focus groups is, a lot of people just were
saying, there are so many different choices, I just don't know
what to do. I'd like somebody to help me and to tell me what to
do.
There was also this feeling of mistrust. It was
interesting, one of our focus groups was asking about target-
date funds. One thing that you find with target-date funds is,
they're designed that you just invest in one target-date fund.
You're going to retire in 2020, and so you buy the 2020 fund.
But we find, actually, that there are many people that invest
in multiple target-date funds, or target-date funds and
additional funds. What we've learned is that many people don't
understand what the target-date funds is. Some did, and were
actually trying to dial up the risk and were just fine. Others
had trust issues, and they didn't want to put it all in one
fund. They wanted to move it around. A certain level of
mistrust is a bit healthy, especially in this environment. But
if it's because you just don't understand the product, I think
we need to do better in terms of explaining these products.
Everybody on the panel has already mentioned, people have
limited time--
Senator Enzi. Yes.
Ms. Agnew [continuing]. And have limited interest. So, we
have to figure out how to catch them. Once again, going back to
the marketers. The marketers know how to get people in 30
seconds to think about things that they might not normally
think about. By engaging them with financial experts, I think
we can get important messages across.
Senator Enzi. Well, the Department of Labor has refused to
embrace some of the new technologies that could provide more
information to people, too. They consider some of the
comparison tools to be investment advice, and that has some
fiduciary duties attached to it, too, that I think we need to
solve. I have a lot more questions, but my time has run out.
The Chairman. Interesting.
Senator Bingaman.
Senator Franken. Yes. Thank you all for your testimony.
The Chairman. I said Senator Bingaman.
Senator Franken. Oh. I'm sorry, Senator.
[Laughter.]
Bingaman, Franken, they just sounded the same to me. I'm
sorry.
[Laughter.]
Senator Bingaman. I'll jump ahead of you here.
Senator Franken. You're ahead of me.
Statement of Senator Bingaman
Senator Bingaman. Let me thank the Chairman and Senator
Enzi for having the hearing. I think it's very useful.
Dr. Brown spoke about the Lifetime Income Disclosure Act.
Johnny Isakson, Herb Kohl, and I introduced the bill today. I
wish all members would look at that. I think it's a very good
proposal. What it does, basically, is provide the opportunity
for us to do the same things with regard to 401(k) plans that
Congress did in 1989 with regard to Social Security. Back in
1989, Congress enacted a provision leading all Americans to
receive annually a benefits statement from Social Security that
tells you how much you can expect to receive each month when
you retire. What our bill does is to say we should do the same
things with 401(k) plans. We should have protections for the
employer to hold them harmless, as long as they follow the
procedures set forth by regulations. I think it's a very good
bill. I hope we can get it passed in this Congress.
Mr. Brown, you spoke about this bill in your testimony.
Maybe you'd want to make another comment on it.
Mr. Brown. Sure. I'm quite supportive of this bill. As I
mentioned in my opening remarks, our research suggests that
when you get people to think in terms of monthly income in
retirement, they have different preferences. They express
different views about what's important to them. I think it's a
more accurate view, in the sense that, ultimately, when we're
planning for retirement, that monthly or annual consumption is
what we're ultimately saving in order to provide for. I think
that this act could be a very important first step in sort of
changing the conversation, and changing the way that people
think about retirement planning.
Senator Bingaman. Yes. My understanding is that this
information changes people's view of their retirement assets,
and in doing so, it encourages them to save more, which is one
of the big things that I think I was hearing from the witnesses
we ought to be doing.
Ms. Chatzky.
Ms. Chatzky. That's absolutely one place where I think it
could be incredibly useful, but not the only place. Senator
Enzi spoke about the student loan problem that we're having in
this country right now, and the fact that the student loan debt
is out of control. I believe that if students were shown the
monthly pay back amount that they were taking on at the time
they borrowed, we would make big strides to solving that
problem, too.
Senator Bingaman. That's another good suggestion. Let me
also--
Mr. Brown. Could I add one other comment?
Senator Bingaman. Yes. Sure.
Mr. Brown. In general, there is a phenomenon known in the
behavioral economics literature that people are not very good
at being able to translate lump sums of wealth into flows of
income, and vice versa. Ms. Chatzky's right, that that is a
more general phenomenon than what we have just in the context
of retirement income. But this is clearly a case where it's
really, really important. If you ask people, What would you
think if you had $100,000 in retirement? They feel like that's
a lot of money. Then when you tell them what that translates
into in terms of the actual monthly income that it can provide,
suddenly they don't feel so rich anymore. That's where the
incentive to save more comes in. So, I think it's quite
important.
Senator Bingaman. Great.
Ms. Chatzky, you also talked about the Auto IRA bill. Well,
that's another bill I hope all Senators will look at. I
introduced that in the last Congress. We're going to try to
introduce it again, but we'd like to get some cosponsors. We
think that that bill is designed in a way that does not put a
burden on small business, but does provide an opportunity for
folks that don't have 401(k)s to still put some money away in a
retirement account before they actually get it in their
paycheck. That's the purpose behind it. I think it would be a
major step for the American worker.
Ms. Lucas, there is a T. Rowe Price study on the same issue
that Dr. Brown was just talking about on the question of
savings patterns that people will follow in their 401(k) plans
based on their knowledge about what this translates into on a
monthly basis. Are you familiar with that?
Ms. Lucas. Well, there have been a number of recordkeepers,
T. Rowe Price among them, who have done an excellent job of
providing projections for participants for their retirement
needs. So, you'd look on their Web site. It might be on their
statement. It tells you, if you continue to save at this level,
given what we know about you, at retirement here's what it will
translate into monthly income. It might even have a gap
analysis on it in case you are not saving enough. It might say,
you need to save X amount more in order to reach a 80 percent
income replacement level. So, there's a lot of good work that's
already being done, very sophisticated work. It would be my
hope that whatever the bill is that is being proposed would
also provide a fiduciary safe harbor for this type of analysis
that's already being done by many of the recordkeepers.
Senator Bingaman. Thank you very much, Mr. Chairman.
[Prepared statement of Senator Bingaman follows:]
Prepared Statement of Senator Bingaman
I would like to thank Chairman Harkin and Senator Enzi for
convening this afternoon's hearing, to highlight how insights
from behavioral economics can be applied to raise our Nation's
retirement savings rate.
As this committee is well aware, defined benefit pension
plans--to which employers make regular fixed contributions--
have become relatively rare. So those who receive any form of
workplace retirement account are increasingly offered the
opportunity to contribute to defined contribution plans, like
401(k)s, to which their employer may or may not provide a
matching contribution.
But the shift from DB to DC plans means that plan
participants need to be even more proactive in planning for
their retirement. Right now, 401(k) plan statements typically
provide a total account balance, but not a monthly income
equivalent. This leaves many participants unprepared to
evaluate whether they are saving adequately to maintain cost of
their current standard of living in retirement. Take for
instance a 55-year-old secretary at a law firm in Albuquerque
with a $75,000 balance in her 401(k). That balance may be
significantly larger than her annual salary. But while she may
think that is enough to carry her through retirement, in
reality, even when combined with Social Security, that $75,000
probably will not last long enough. We need to ensure that she
has the benefit of full information.
And to address this challenge, I am pleased to have joined
today with our fellow committee member, Senator Isakson, as
well as with Senator Kohl, to reintroduce the Lifetime Income
Disclosure Act. Our bill would require DC plans annually to
include ``lifetime income equivalents'' on benefit statements
they already provide employees. A lifetime income equivalent is
the monthly payment that would be made if the employee's total
account balance were used to buy a guaranteed lifetime income
product that begins at the plan's normal retirement age.
In 1989, Congress passed legislation that has resulted in
all Americans receiving an annual Social Security benefit
statement, which informs them how much to expect in monthly
benefit payments at retirement. Our bill would round out the
retirement income picture. Knowing the amount of monthly income
they can expect from Social Security and their DC plan will
help employees determine whether they are on the path to a
secure retirement. Undoubtedly, many will decide to dial up
their contribution rates.
We have worked hard to ensure that this proposal does not
impose a burden or potential liability on employers. So the act
directs that within a year, the Department of Labor must issue
assumptions that employers may use in converting a lump sum
amount into a lifetime income equivalent. DOL would further be
directed to issue, within a year, a model disclosure. And the
act also provides employers with a clear path to avoid any
liability whatsoever.
Mr. Chairman, our proposal is a small step, but one that
can make a significant difference in beginning to tackle a key
policy challenge. I am pleased that the act enjoys the support
of many leading voices on retirement policy, from AARP to the
National Women's Chamber of Commerce to American Society of
Pension Professionals and Actuaries, the Nation's leading
association of retirement plan professionals. And I look
forward to working with you, Chairman Harkin, with Senator
Enzi, and with all of our colleagues on this committee to enact
this common-sense approach into law.
Senator Enzi [presiding]. Senator Murkowski.
Statement of Senator Murkowski
Senator Murkowski. Thank you, Mr. Chairman. Senator
Bingaman, I am looking at the legislation that you have
introduced, the Lifetime Income Disclosure Act, as one way to
again help with this financial literacy. I guess, a question
that I would ask of you, Mr. Brown, and something that I'm
still looking into, is this concern about any associated
liability that may attach about assumptions that are made. Can
you just speak to that as an issue?
Mr. Brown. Sure. I'd be happy to.
I always think it's very important to step back and
remember that plan sponsors are not under any obligation to
offer a plan in the first place, and that under current law
they're not obligated to offer a lifetime income option.
Anytime that we impose fiduciary risk or a liability on them
we've run the risk, no matter how well intended the regulation
is, we've run the risk of providing a disincentive for them to
be providing these plans in the first place. So, I think it's
very important that we keep an eye on that at all times.
I think, in this context I think it can be easily handled
in the sense that if, for example, the Department of Labor were
to lay out a very simple formula or a table that plan sponsors
can look up and simply say, well, if an individual has, say,
$100,000 in their account, here is the amount that they can now
report to that individual as an example of the monthly income
that they would receive, and that as long as a plan sponsor
follows that, it essentially provides them a safe harbor so
that they are protected from those fiduciary concerns.
However, I do agree with the prior comment as well, that
there are a number of companies out there that are actually
doing a very sophisticated job, probably a more sophisticated
job than we would expect through a safe harbor provision. I
think it's also important that we allow those companies to
continue to do that as well.
I do think it's an important concern, but I think it's one
that could be quite easily addressed in the legalization.
Senator Murkowski. Let me ask you this as a general
question, some discussion about financial literacy amongst
young people, and how we effectively reach out to them. I think
we're all learning the benefits, certainly, of the social media
and Facebook and Twitter, and some of the other methods of
communication, videos out there on YouTube. Are we using these
tools in any kind of an education effort to reach out to the
kids that are my kids age, that really could care less at this
point in time about their future retirement? What's available
to them? Ms. Chatzky.
Ms. Chatzky. I have a 16-year-old and a 13-year-old.
Senator Murkowski. So, you're engaged.
Ms. Chatzky. So, I'm in there.
Senator Murkowski. Yes.
Ms. Chatzky. One of the things that I know from dealing
with my own kids and their friends is, you have to get them
where they are. You have to reach them at a point where they
actually have a reason to want the information, even if their
reason isn't the same as your reason. I have believed for quite
some time that a very effective way to move some financial
education through the channels would be to put 10 to 20
financial education questions on the driver's license permit
exam.
[Laughter.]
Senator Murkowski. There you go.
Ms. Chatzky. Well, and it makes economic sense, because
auto insurers price based on your credit score. So, if we could
work together with them to show that these kids who pass this
section of the exam are more likely to have better credit
scores simply because they understand the information, then
parents who pay those premiums would have an incentive to get
their kids to study for that portion of the test.
Senator Murkowski. Interesting.
Any other suggestions, Ms. Agnew? Got any great ideas?
Ms. Agnew. Well, I think that's a fantastic idea. You
definitely--I have three children, and you have to get them
where they are. I do think that there are ways we might be able
to integrate it into the school, but I'm not saying another
requirement for the schools.
I was talking to a superintendent of the school district
yesterday, and they're tight-staffed, and to ask a teacher to
come up with more to teach in a limited amount of time is a lot
to ask for. But I think there's a lot that could be done with
people in academia that could put together some off-the-shelf
lessons that could be integrated into the school, that could
pool and hit on standards that need to be met in math and
social studies.
I think that there are ways that we in academia can help
the actual schools. Make it fun, though. It has to be fun.
Worksheets don't work for 7-year-old boys,.
Senator Murkowski. Well, and I know my time is up. But, I
think an important thing to recognize is, we can't talk about
investments unless you've saved for it. We save pennies with
the kids when they're little, but then when they hit 17 and 19,
like my boys are, they're saving for the car, and beyond that,
there's not a lot that they are saving individually. As
parents, we try to set the example--save for college, save for
their future. But are we doing a better job generally with
young people in encouraging them to save? I don't think that we
are. But do the statistics prove me wrong?
Ms. Lucas.
Ms. Lucas. I'd like to go back to automatic enrollment
again. The amazing thing about automatic enrollment is that,
regardless of demographic group--young people, old people, low
salary workers, high salary workers, across different ethnic
groups--the opt-out rate is almost identical, and so we see
people in their twenties who, if they were to save on their
own, maybe half of them or less would save. Under automatic
enrollment, closer to 90 percent are saving, just because of
inertia. They are in the plan, and somehow, even though they've
said, ``Oh, I can't afford to save.'' When it's taken out of
their paycheck before they have an opportunity to spend it,
suddenly they can afford to save.
Senator Murkowski. So, we help them along initially with
the enrollment.
Ms. Lucas. I think automatic enrollment for young people is
really one of the most effective ways to get them to save in
the plan.
Ms. Chatzky. We can do the same for our kids. If, it's
parental. It's not systematic. If we want our kids to be
savers, then we take part--saving money is no fun, but having
money saved is a lot of fun. So, we force them into a position
where we take part of their allowance, and that goes into
savings. And when they see that money piling up, all of a
sudden we can feel good about that.
Senator Murkowski. Thank you, Mr. Chairman.
The Chairman [presiding]. Thank you, Senator Murkowski.
Senator Franken.
Statement of Senator Franken
Senator Franken. Thank you, Mr. Chairman.
Ms. Chatzky, Ms. Agnew, you both have been talking about
financial literacy, and possibly teaching that in school. This
committee is reauthorizing ESEA this year, we hope. I'd just
like to ask you some questions about how to do that. You've
been talking about it a little bit. I know we don't want to put
another burden on people and require them to do another thing.
But this seems to be a good--I like your idea about putting it
in math. I liked your idea about putting questions about
financial literacy for your driver's permit.
I think we should be teaching home ec again, and home ec
should really be home ec. It should be home economics,
including how to cook healthy food, and fruits and vegetables,
and the whole panoply of home economics and family economics.
You know, we're talking today, really, about defined
contribution plans because the defined benefit plans are
basically going away. One, I just wanted to touch on Social
Security a little bit, because Social Security is still a
defined benefit plan. What percentage of people rely on Social
Security, Ms. Chatzky, for almost all, or all of their
retirement?
Ms. Chatzky. I don't actually know the numbers off the top
of my head.
Senator Franken. Does anyone?
Ms. Chatzky. Thirty-seven.
Senator Franken. Thirty-seven percent. OK. And compared to
other defined benefit pensions in this country, how's Social
Security doing in terms of solvency, would you say?
Ms. Chatzky. I would say there are an awful lot of people
out there who are convinced that it won't be there for them.
Senator Franken. That doesn't answer my question, though,
really.
Ms. Chatzky. If you look at the numbers, it's 2037 that
it's supposed to, the trust fund is supposed to run out of
money. At least, that's the last number that I saw. So, not
well.
Mr. Brown. Senator, can I jump in here?
Senator Franken. Yes. Please.
Mr. Brown. Yes. The difficulty in comparing Social Security
to either private sector or public sector defined benefit plans
is that both in the public and private sector, either by choice
or by requirement, they're trying to fully fund their pensions.
Social Security's not really designed as a fully funded
retirement system. It's a pay-as-you-go system, where today's
retirees are supported by the tax payments of today's workers.
So, the difficulty facing Social Security is the fact that,
because we don't do a lot of pre-funding, just the demographic
changes that we have coming make that a difficult system to
sustain without having tax rates rising. In a sense, even
poorly funded State and public defined benefit plans are better
funded than Social Security, in the sense that they actually
have made an attempt to pre-fund the benefits.
Senator Franken. Right. But, this was started in 1935, and
has worked in this system. In 2037 Social Security doesn't run
out of money, so, that's the day until which everyone is
guaranteed the full benefit. And at that time--you said it
exactly right--you're paying for your parents. It's a
generation legacy that started then, right?
Mr. Brown. That's correct.
Senator Franken. Let me talk about annuities a little bit.
We have some testimony in a Special Committee on Aging hearing
that said that most seniors actually believe they're going to
live a shorter period of time than they actually are,
actuarially. Is that correct?
Mr. Brown. There have been a number of academic studies
done comparing expectations to actual survivor tables. What we
find is that, on average, that's right. But what that disguises
is, a large number of Americans are overly optimistic, and a
large number overly pessimistic. So, there are a lot of people
who fall under the category. There are others on the other
side.
Senator Franken. I know I'm out of time. I just want to ask
one question. Can I ask one more question about annuities? Is
distrust of financial institutions, that they're going to be
there 20 years from now, a big part of people's reluctance to
buy annuities?
Mr. Brown. Yes. The concern about what economists call
counterparty risk, the concern of whether the insurance company
will be there, is something that we think is driving some
consumers' aversion to annuities. Not a lot of empirical
evidence to support just how important it is, but I certainly
believe that it is a factor, and ever more so after the most
recent recession and financial crisis in which some of the
longstanding financial institutions ceased to exist. That is an
issue that, there are some ideas out there about how to address
it. But it's certainly one that needs some thought.
Senator Franken. Thank you.
Thank you, Mr. Chairman.
The Chairman. Thank you.
Senator Blumenthal.
Statement of Senator Blumenthal
Senator Blumenthal. Just, first, about appealing to
potential young drivers. I don't know whether you've been
through the driver's application process with any of your
children, but it can be a very trying time, and so, focusing
their attention on retirement then may not be the best way to
do it.
[Laughter.]
Having been through the process with four children.
I want to raise a larger issue which concerns the
confidence people have in the financial system these days.
Having just been through a deeply traumatic experience, many of
them losing their life savings, I'd be interested in your
perspective on, No. 1, isn't it necessary to restore confidence
in this system which has really betrayed so many of our
seniors, as well as other age groups? In particular, to pursue,
perhaps even more aggressively some of the regulatory reforms
that the Congress adopted during the last session? Because many
of these regulations, obviously, will be issued in the next 6,
12 months.
Ms. Lucas. I'd be happy to address that. At Callan
Associates we have an index called the Callan DC Index, in
which we track the movement of money across participants'
plans. And while, certainly, participants did move money, more
often than not, toward principal preservation vehicles during
the financial crisis, we did see that the money was remarkably
sticky within target-date funds. They were not moving money out
of target-date funds. And in fact, every quarter throughout the
financial crisis, there was net inflows into target-date funds.
Further, there's very little evidence that people reduced their
savings levels during the financial crisis.
So, I think you can look at 401(k) participants' inertia as
a very positive thing during times like that, that certainly
they do not tend to react in a large number, they stick with
their allocations and be very willing to continue to look to
the long term, as opposed to having knee-jerk reactions.
Senator Blumenthal. Do the rest of you concur on that view?
Ms. Agnew. I do. I've done some research in inertia, and it
is a fact that in some cases it actually is helpful with people
not reacting. One study I did do using some data, though, did
show that there was a very, very small portion of people that
did have reactions. The problem was, inertia then took hold and
they never switched back their allocations. So, you know, I do
agree, as long as the institutions are acting correctly, I
think it's good to instill confidence in people in the
institutions.
Senator Blumenthal. The other trend that, obviously, is at
play here is the higher ratio of debt to wealth. I wonder if
you could comment on whether you've seen any impact as a
result, whether there's any research that shows any impact
resulting from that current economic trend. Obviously, the debt
ratios are coming down now. But, it's still an important
factor.
Ms. Chatzky. We know as consumer debt picked up the savings
rate went down. I think if you look at whether it's mortgage
debt or auto loan debt or credit card debt, debt is really a
savings killer. Particularly, that high interest rate credit
card debt. There are a number of pieces of research that would
support that. We have seen the savings rate come back a bit
over the last couple of years. I think we want to get on that
band wagon, and we want to encourage people to soft-pedal the
plastic, and really continue to put more away, if that's the
path that they've gotten themselves on.
Senator Blumenthal. So, soft-pedaling the plastic really is
profoundly important, not only in an immediate economic sense,
but also in terms of the long-term trends that you've
identified?
Ms. Chatzky. I believe that it is. We're starting to see,
particularly in the younger generation, more of a reliance on
debit, less of a reliance on credit, a shift toward the other
products in the marketplace. Again, not enough education out
there about what are the differences, what are the pros and the
cons of all of these tools, because that's what they really
are, and how to use them wisely. But I think things are moving
in the right direction.
Senator Blumenthal. My time is up. But I want to thank you
for being here today and giving us this very, very important
and helpful testimony.
Thank you, Mr. Chairman.
The Chairman. Thanks, Senator Blumenthal.
Senator Whitehouse.
Statement of Senator Whitehouse
Senator Whitehouse. Thank you, Chairman.
First of all, thank you for what you've said about the need
to clarify for folks who are looking at retirement what their
real situation is, and give people a better appreciation of
what they have to look forward to.
I noticed in Ms. Chatzky's testimony, you said that 50
percent of even, I think your phrase was ``good-earning baby
boomers and Gen-Xers'' will run out of money in retirement.
Some of the other figures you used were that 41 percent of
Americans who are in the lowest income quartile, the lowest
income, 25 percent, would run out of money in 10 years. Even in
the top 25 percent income bracket, that 5 percent would run out
money in 10 years, and 13 percent would run out of money in 20
years. So, even for top earners I assume that actuarially
somebody who's a top earner can be expected to live, on
average, more than 20 years after retirement, correct?
Ms. Chatzky. I think actuarially, I mean--
Senator Whitehouse. That was the breakdown.
Ms. Chatzky [continuing]. I don't know where the breakdown
is. But I would assume, with better access to healthcare and
the access to the best doctors, sure, those numbers would go
up.
Senator Whitehouse. So, for those people who are running
out, those 50 percent of the population, their only safeguards
at that point are Social Security and Medicare, correct?
Ms. Chatzky. Correct.
Senator Whitehouse. Without them, what?
Ms. Chatzky. They move in with the kids.
Senator Whitehouse. I'm sure a lot of kids will be thrilled
to think about that.
[Laughter.]
At the time that they're running out, 10 years or 20 years
after their retirement, do you have any information on what
their earning capacity is at that point?
Ms. Chatzky. I don't. This is an EBRI study that I was
citing. I'd be happy to forward it to your office.
Senator Whitehouse. Presumably, it's pretty negligible.
Ms. Chatzky. Twenty years out, yes.
Senator Whitehouse. Say, you've retired at 65, you're now
85.
Ms. Chatzky. I would say negligible.
Senator Whitehouse. It's a tough time to be asked to go
back into the job market, isn't it?
Ms. Chatzky. Yes.
Senator Whitehouse. So, it reinforces how vital Social
Security and Medicare are to our safety net and to assuring
that Americans have a decent standard of living in their old
age.
Ms. Chatzky. Absolutely.
Senator Whitehouse. All right. I appreciate your testimony
very much. Thank you all.
The Chairman. Thank you, Senator Whitehouse.
Senator Merkley.
Statement of Senator Merkley
Senator Merkley. Thank you very much for the testimony from
all of you. This is near and dear to my heart because when I
was the director of a non-profit I wanted to encourage all my
employees to start with the assumption that they would sign up
and then decide later if they wanted to opt out, knowing from a
variety of sources that they're much more likely to save
especially if they start savings early in their career. We had
a lot of young employees who we would help over the long term.
I have had one concern about the default sign-up. That is,
how a company goes about setting out the default allocation of
the funds that are being saved. We had a company in Oregon,
PGE, that had a situation where the employees' funds were
largely invested in Enron stock, and there was a lot of risk to
that concentration in a single area. So, are there any
guidelines for companies that are kind of best practices about
starting? If they're starting with a default option--and I
understand they have to give 30 days notice to the employee,
and give the employee an opportunity to change it--is there any
kind of best practices guideline that encourages companies to
start with, a diversified portfolio, or in some other way,
reduce the risk profile of the choice?
Ms. Lucas.
Ms. Lucas. I would like to address that. I think one of the
key features, and most important features, for a defined
contribution perspective of the Pension Protection Act, was
that it did provide a safe harbor called the Qualified Default
Investment Alternative safe harbor, for plans that wanted to
adopt automatic enrollment. It was hugely successful. It
outlined that there are three possible, qualified default
investment alternatives, target-date funds, asset allocation
funds, and managed accounts, all of which are well-
diversified investment vehicles. Today, according to a recent
survey that I saw, about 70 percent of plan sponsors are using
target-date funds, highly diversified, well-managed funds for
the qualified default investment alternative. If you look at
prior to that, sometimes, indeed, company stock was the
default, often it was stable value. So, plan sponsors were
simply putting people in stable value at a 3 percent
contribution rate, and then saying, ``Good luck getting to your
retirement.'' So, this has been a very big improvement in
getting people to save in a well-diversified plan.
Senator Merkley. When you speak about safe harbor,
essentially, let me describe what I think you mean, and then
you can clarify if that's right. Companies were told, you're
immune from lawsuits if you put folks into this structure as a
default option. Additional legal protection. Is that what the
safe harbor means?
Ms. Lucas. Certain legal protections. The plan sponsor is
liable for the selection of the fund, but the individual is
responsible for any losses within the fund. So, the plan
sponsor is not liable, as long as it's a prudent fund, for
losses within that fund. It doesn't immunize them against
lawsuits, but it forms a defense within a lawsuit.
Senator Merkley. Anyone else want to come in on this?
Earlier you addressed teenagers and how to do better
financial education with teenagers. I wanted to ask you to
address either the challenge of financial education for low-
income families, or financial education specifically for women,
whether there is any distinction, or any special strategies or,
for that matter, special strategies for men that we should be
thinking about?
Ms. Chatzky. I'll address the women question. I do think,
and it's definitely controversial, because we know that stocks
are not pink or blue, right? Money's green. It's definitely a
controversial proposition. But, women are behind the 8 ball,
because we live longer. We're the ones who still take breaks
from the workforce to care for the kids and to care for older
parents. As a result, our retirement balances, even if we have
the same starting salary, tend to be lower than those of men.
So, an argument should be made that women almost need the
education more, to a greater degree. If you look at survey
after survey, you'll see that women are not feeling prepared at
all.
There is an argument to be made for educating women in
groups of women, that there are certain comfort zones where
people feel more able to receive the information, more able to
take it in. I believe that that, almost a Weight Watchers type
model where people come together and they have a group, and
they discuss the issue. Whether it's in churches, which have
been a great place to receive this information over years, or
schools, or other sorts of community outposts is, might be
helpful. If we could come together on a single curriculum that
would provide the information, through an organization like
Jump$tart, or through the government, I think that would be
very, very helpful. Because right now there are so many forces
working toward the same direction, the same mission, but
competing endeavors that a lot of times we find that we're
getting in each other's way.
Mr. Brown. Could I throw something in here?
Senator Merkley. Yes.
Mr. Brown. Thank you. There undoubtedly is important
heterogeneity within the population in terms of how effective,
and the type of financial education that's needed. This may
sound a little self-serving coming from an academic researcher,
but I think one of the important things that I would stress in
all of this is how important it is to have well-designed
research to actually assess the effectiveness of any financial
literacy intervention.
We do know that financial literacy programs can be
effective, but they also can be quite expensive, and it's
important if we have to stretch resources to dedicate to this
that we really study that. Oftentimes, you know, studies will
find that it's very simple things that get in the way of a
program being effective. Dr. Agnew mentioned earlier the
Financial Literacy Research Centers that are sponsored through
Social Security. They're doing a lot of work in this area.
There are other organizations doing that as well. I just
thought that it's really critical as we move forward in this
area.
Senator Merkley. Thank you very much to all of you. My
time's expired. I very much appreciate your testimony.
The Chairman. Thank you, Senator.
Ms. Chatzky, going back to a point that was raised earlier,
I think by Mr. Franken, the Social Security trustees say that
by 2037 the Social Security Trust Fund will then only be able
to pay out 75 percent of benefits. It will not go broke.
Ms. Chatzky. Right.
The Chairman. And that 75 percent continues, and I don't
know the answer. I think it's 25 years or 30 years until all
the baby boomers die off, then it bounces back up slightly.
Ms. Chatzky. OK.
The Chairman. To the response that you gave about a lot of
young people don't think it's going to be there. I run into
that in town meetings all the time, and when I talk to young
people, ask them if they believe that Social Security will be
there for them, and not very many people raise their hands.
I always like to inform them that, I ask them if they
believe that the United States of America will exist, will even
exist when they're that age. Every hand goes up. Well, I say to
them, if the United States of America exists, your Social
Security will be there for you, because it is the only
retirement system backed by the full faith and credit of the
U.S. Government. It has to pay it out. So, therefore, if the
United States of America exists, Social Security will have to
pay it out, because it is backed by the full faith and credit
of the U.S. Government. None of these other retirement systems
are. Financial institutions can go bankrupt, you can lose your
money, all kinds of things. They're not backed by the full
faith and credit of the U.S. Government. That's why I've always
been such a strong supporter of a basic social safety net that
is backed by the strength and power of who we are as a nation.
And that's what Social Security is.
Over and above that, you need some retirement security to
have a little bit better lifestyle. You mentioned, correctly,
that, I think, right now it's around 35 percent-- somewhere in
that neighborhood--of present retirees, depending on Social
Security for 100 percent of their retirement income. I think a
lot of people in that regard probably wish they could have
saved more when they were younger. But when you're young, you
have a short horizon. The horizon is very short. So, that's why
this whole idea of financial literacy, of getting young people
involved in automatic savings as early as possible in their
lifetimes, where you build up a culture, a culture of saving,
is so important. We've just not had that very much in our
country. We've become more a culture of debt than of savings.
So, I'm hopeful that, again, what, or, if I've heard all of
you, Dr. Brown, everybody say is that we do need to have a
better sense of--you say financial literacy, but, what it means
to save money, and what it means to save, not just for wealth
accumulation, but what it means for how you will live when you
are in the later part of your life.
I'm always looking for ways of, that we can promote, or
incentivize at the earliest possible time in life, that you
could, you would have something that all the time would remind
you that you're putting money away for retirement.
I would throw one out for your consideration. That every
single dollar of Federal money that goes out, or State money,
or local tax money, anything that goes out, from the public
treasury of any sort, that goes out in any form of a payment to
any individual, that right off the top, a certain portion is
taken and is put into a retirement account. Not Social
Security. I'm not talking about Social Security. I'm talking
about a 401(k) type of a system. And so, that could be
everything from your local Head Start recipient, at the
earliest possible age, to maternal and child health care
programs, to education, of course, all kinds of things. So that
right off the top you know that a certain amount of that money
is going to be put into a retirement system. As I said, not
Social Security. I'm talking about over and above what Social
Security is, which is not, as someone pointed out, it's not a
retirement saving. It's a generational transfer of money, is
what Social Security is.
Again, I go off on this vein only to encourage you to help
us start thinking about different ways, I'm looking for new
ideas on how we can start this younger generation, knowing that
whenever they make a buck, some of that is put away,
automatically put away, for retirement. How we do it in concert
with the Constitution. It has to be constitutional. But somehow
starting this at the earliest possible age. Like I said, there
may be ideas out there. Dr. Brown, maybe you have some
thoughts. We need to have the best ideas on how we start this
culture of savings in our country.
I don't know if any of you have a response. I went over my
own time just talking. Didn't even ask a question. But do any
of you have any responses to that, or any other ideas on
starting this, either now or later on?
Well, with that, I'll turn to Senator Enzi.
Senator Enzi. Thank you, Mr. Chairman. We were talking
earlier about driver's licenses and financial literacy. I'm
usually in Wyoming on the weekends. I usually get there on
Friday and quite often talk to some school classes. And one of
the things that fascinates me is finding out how much they
think they could make when they're in junior high, if they get
a high school diploma and go into the job market. Most of them
expect that they will make $50,000 a year. I take copies of
Parade Magazine with me. They do, I think it's a semiannual
review of what real people make. And that's usually quite an
eye-opener to find out that some people in real estate make
$3,000 a year. Of course, they include the sports figures, too,
so there are still going to be kids out there dribbling a
basketball so they can make $25 billion a year. But that's been
a big help in financial literacy.
It's kind of interesting how this committee has changed,
because before the downturn one of the things we were
concentrating on was how to keep people in the job market
longer so that all the jobs could be filled. Of course, now we
have a surplus of workers compared--although the front page of
the paper, the Washington Post, yesterday pointed out that
there are a lot of jobs in the United States, but we don't have
the skills to match up to them. So, I'm going to put in a plug
for getting my Workforce Investment Act passed.
[Laughter.]
That's one of the ways for them to stay viable, which is if
they stay in the market longer.
Ms. Chatzky, you said that people aren't saving enough, and
I think that everybody would agree with you on that. What
strategies would work best for someone who has been in the
workplace a few years? I'm not talking about those 8th graders
that I talk to, or the seniors, but the ones in between. What
retirement savings advice would you give to young workers? How
much of their paychecks should they be putting away?
Ms. Chatzky. I tell them, something. Because you have to
start someplace. Although I completely agree in theory with
Lori's suggestion to increase the default to 6 percent, I worry
that might, I think it needs to be tested and to see where
people feel like the number is so high that they would start
opting out. If you've tested it already, and I don't know,
please forgive me.
People need to start where they feel that they can start,
and then they need to ratchet it up from there. I would love to
see everybody putting aside 10 to 15 percent, including what
sort of match, whatever match they're getting from their
company. I think if we look at the data, that's the range that
shows to work. But people start to feel good about their
savings when they're putting away 5 percent, we know, and they
start to feel that it's possible when they put away something.
Senator Enzi. Ms. Lucas.
Ms. Lucas. I did test it.
[Laughter.]
There is no empirical evidence at all that opt-out rates
increase when the automatic enrollment default is 6 percent
versus 3 percent. Opt-out rates are the same. I think plan
sponsors are, harbor the myth that opt-out rates will increase,
but we've done tests on it, and we see no empirical evidence.
I'd also like to say, you know, I have done a number of
surveys of participants in 401(k) plans, asking them, ``Why
don't you save.'' They invariably say, ``Well, I can't afford
to save.'' Then you keep kind of going through the questions
and asking them a variety of different questions, and it
becomes apparent that the reason they don't save is not because
they can't afford to save, but because they don't want to. They
have other priorities. They want to spend. Perhaps they want to
save for other things. It's not that they don't have the
wherewithal to save. It's just, it's not a priority. That's why
you can increase the automatic enrollment default. You can get,
they can, actually, save more, and not suffer from not being
able to make ends meet.
Senator Enzi. I think you suggested, too, that with the
optimal escalation, that the top level ought to be raised, too.
But here's a little different question. Is there an optimal
level for employer contributions? Has anybody had any
experience with that? What encourages the people the most to
get into that?
Ms. Lucas. I could answer that. What we find is that, as
long as the employer contributes something, that has a huge
impact. It almost doesn't matter whether it's 25 cents on the
dollar or 50 cents on the dollar, as long as there's a
contribution.
What does make a big impact is the level at which the
contribution ends. So, if they only contribute, if they're
doing 50 cents on the dollar up to 6 percent, people will
contribute up to 6 percent. If it's a smaller amount, up to 8
percent, they will contribute up to 8 percent. So, there's a
huge influence in terms of the level at which the employer
contribution ends. We often encourage employers to have very
high levels of--it can be economically neutral for them, but
get the level of the employer contribution to a very high level
of pay deferral.
Senator Enzi. Thank you. And for all of you, are there any
viable advice options, viable places to get investment advice?
I know one of the automatic things would be at universities,
but a lot of people don't go to the university, don't start
making those decisions until after they've been to the
university, and maybe miss that. So, what are some viable
options for investment advice?
One of the problems that businesses run into is whether,
when they elicit those investment advice places, whether
they're going to be liable for the advice that their employee
gets.
But putting that part aside, what are the good sources of
investment advice?
Ms. Chatzky. Sorry. I think it's the job of the employer,
it should be the goal of the employer to make the least biased
sources of that investment advice available. The Morningstar
Ratings, for example. If you're offering your employees mutual
funds, that would allow them to compare them like they compare
one car against another car when they're shopping.
There are a number of--Value Line--and a number of
different organizations that do these unbiased comparisons. I
think just putting them out there in as simple and abbreviated
form as possible, while still containing the necessary
information, would be helpful.
Senator Enzi. OK. Anyone else? Yes.
Ms. Lucas. I would like to offer that what we've
experienced within the defined contribution system is that
there's been many attempts to offer advice, online advice, and
other types of services, and the utilization has been quite
low. And part of it is just a lack of confidence that people
have in really understanding the advice and having confidence
that if they implement it, it will be good advice. So, where
we've seen more, actually, more success, is through managed
accounts, when not only has the advice been given, but
discretionary control has been taken of the account, and the
advice provider actually manages the account on behalf of the
participant. That's been proven to be much more effective. It
actually changed, in, getting people to have confidence in the
advice that's given.
Senator Enzi. Ms. Agnew. Dr. Agnew.
Ms. Agnew. Yes. May I also say, I did a research project
where I compared people that used online advice and managed
accounts, and we found that managed accounts were appealing
across demographic groups. But typically, with online advice,
it's people with higher salaries that were interested in using
it. Basically, people are using it that understand what they're
doing and they're looking for someone to say, ``You're on the
right path.'' So, it's supporting what you have just said.
Senator Enzi. Thank you.
I would mention that that takes me back to one of the ideas
that I mentioned about being able to pool a bunch of small
businesses to get the investment advice, because Morningstar,
for example, is expensive for a small business to be able to
purchase.
Ms. Chatzky. So are managed accounts.
Senator Enzi. Yes. Yes.
The Chairman. Senator Blumenthal.
Senator Blumenthal. Thank you, Mr. Chairman. I would just
add a footnote to your comments, which I found very pertinent,
about welcoming new ideas, particularly, ideas aimed at not
only men and women, but boys and girls. Because I think that,
as one of you suggested, there's never too early an age to
begin. In fact, I think a very strong argument could be made
that the driver's license age is almost too old, or maybe
there's no place to get them at that age that will work. Maybe
if you lose them at an early age, you don't reach them until
some later point in their lives when they really come back to
earth. So, any ideas you have about that age group, I
personally would very much welcome.
The Chairman. Anything off the top of your head right now?
Senator Blumenthal. Thank you, Mr. Chairman.
The Chairman. Well, thank you.
I really don't have any more. I really appreciate your
testimonies and your expertise, and your views on this.
I'm anxious to see your legislation. I'd like to, because I
think it has a lot of merit. I always worry about people that
only have 2, 3, or 4 employees. They can't do this kind of
stuff. So, if you can get consortiums of them together, that
seems to make good sense.
Any closing comments or observations by anyone?
Dr. Brown.
Mr. Brown. Yes. I appreciate the opportunity to speak here
today, and I think you were asking a lot of very important
questions. I look forward to continuing our communication in
these areas.
The Chairman. Thank you, Dr. Brown.
Ms. Chatzky, any last thing.
Ms. Chatzky. I would very much echo that thank you for
inviting me here today. It's been very interesting.
The Chairman. Thanks for being here.
Ms. Lucas.
Ms. Lucas. Thank you. I guess the one comment I'd like to
make is that, another area that is of great concern for the
overall retirement income adequacy of participants is plan
leakage. Not only getting money into the plan, but keeping it
there through preventing excessive loans, withdrawals.
The Chairman. Oh, yes.
Ms. Lucas. I think that that's another very important area
that needs further investigation and further support.
The Chairman. Well, I'm getting ready to gavel this shut,
but you just opened up a whole new avenue, and that's the whole
idea that people that get in stressful situations borrow the
money out. My professional staff has told me it stayed pretty
stable over the last 20 years. But, during the recent economic
recession there was an uptick in loans. But, before that it was
pretty stable. But it is a concern. People borrow the money out
of their plan, and then they either have to pay it back, or
they pay taxes on it. And the taxes are less than paying it
back, so you pay the taxes, and then your plan's depleted. I
think that's part of what you were getting at.
Anything else.
Dr. Agnew.
Ms. Agnew. Well, many of the Senators asked the question,
where can people get information?
I think one thing that we do need is a trusted source that
people can go to. I know in New Zealand they have a Web site
called sorted.org. Many New Zealanders use it, actually, to get
information about different life and financial decisions. I do
know that there are certain groups with the Financial Literacy
Research Consortium that are working to build a Web site like
that, that would be engaging people, and that people would want
to go to. I think that's very much a worthwhile effort and
should be pursued.
The Chairman. Thank you all, very much.
The record will stay open for 10 days for any comments or
further questions.
This is an area of deep interest to this committee on both
sides. And, that is, this whole idea of retirement security. We
will continue to have more hearings on this this year, and
trying to see what else we can do to help secure retirement
savings for American citizens.
Thank you very much for being here.
The committee will stand adjourned.
[Additional material follows.]
ADDITIONAL MATERIAL
Prepared Statement of Senator Isakson
I thank Chairman Harkin for calling this hearing and I
welcome the witnesses.
I am proud to be a cosponsor, along with Senators Bingaman
and Kohl, of the Lifetime Income Disclosure Act, which would
amend the Employment Retirement Income Security Act of 1974 to
provide 401(k) participants with an estimated monthly value of
their benefits if they were to convert it to a guaranteed
lifetime income stream upon their retirement.
Our bill models this notice upon the annual report workers
already receive from the Social Security Administration.
As the witnesses will attest today, too many Americans are
dangerously underprepared for retirement. Our bill will
increase financial literacy, promote increased savings, and
encourage participants to think of their 401(k) balance as a
vehicle for lifetime income.
For instance, let's imagine a 29-year-old participant who
has been saving for 7 years has accumulated a $10,000 account.
Under the bill, he would be informed that upon his retirement
at age 65, he could expect a guaranteed lifetime income stream
of about $600/month. That amount tells the participant that he
is doing well in saving for retirement, but has a long way to
go.
The estimated value would be derived from a government
formula that assumes a normal retirement age. The plan sponsors
and the providers would both remain completely free from
fiduciary liability on the accuracy of the estimation, as long
as they used the government formula.
It is important what the bill does NOT do. It does not
affect the tax treatment of 401(k) funds, nor does it mandate
participants choose any particular retirement option. It merely
provides participants with additional information so they can
make informed choices about retirement.
I am happy to sponsor this bipartisan legislation that will
foster increased preparation for retirement for millions of
American workers.
Prepared Statement of the Women's Institute for a
Secure Retirement (WISER)
The Women's Institute for a Secure Retirement (WISER) is pleased to
submit this testimony for the record, relative to the Senate Committee
on Health, Education, Labor, and Pensions hearing on encouraging better
retirement decisions.
WISER is a non-profit organization whose primary mission is to
focus exclusively on the unique financial challenges that women face
and provide the crucial skills and information women need to improve
their long-term economic circumstances and financial quality of life.
WISER supports women's opportunities to secure adequate retirement
income through its research, training workshops, education materials
and outreach.
WISER's major objectives are to: (1) Educate women age 18-70 to
improve their financial decisionmaking; (2) Provide clear up-to-date
information that moderate- and low-income women can use to mitigate the
risks they face with respect to retirement income security; and (3)
Raise awareness among policymakers and the public on these issues.
WISER also operates the National Education and Resource Center on
Women and Retirement Planning (The Center) under a cooperative
agreement with the Administration on Aging. The Center is a one-stop
gateway of information created with strategic public-private coalitions
to provide hard-to-reach women with financial tools. The Center's goal
is to help women make the best decisions they can with their limited
income.
The Center has directly reached tens of thousands of women through
our workshops and our partners' workshops, and we have further reached
millions with our publications and Web site. WISER's approach is to
bring financial planning back to the basics, and our strength is to
provide women and minorities with core financial knowledge that
encourages them to make financial and retirement planning a priority in
their lives. The initiative began in 1998 and now includes numerous
partners, including employers, aging and women's organizations, and
community organizations.
We support the committee's efforts to find ways to meet the
financial capability needs of all plan participants, avoid poverty in
retirement, and to raise awareness among policymakers and the public on
the unique challenges women face.
RISKS WOMEN FACE
The term ``lifetime'' takes on a whole new meaning for retiring
women. Millions of women will live a third of their lifetimes after
they reach their 60s. Thirty years is a long time to make savings last,
putting women at high risk for poverty in their old age.
Many of the risks women confront, like longevity, simply come with
the territory of being a woman in the United States. Women get paid 78
cents on the dollar for the same work men do. Many work in low-paying
industries where benefits are scarce. When it comes to family
caregiving needs, the vast majority of the responsibility falls on
women who take time out of the workforce to raise kids or care for
adult family members. Women often end up alone in retirement, which
substantially increases the risk of poverty. They are also more likely
to have chronic illness and require institutional care.
The most pressing threat women face in retirement is outliving
their assets. Running out of money in retirement is too large of a risk
to self-insure, but that is what millions of retirees do in an era of
lump sum distributions from defined contribution plans. Women need
information and access to safe, affordable lifetime income products.
THE IMPACT OF RETIREMENT RISK ON WOMEN
A report recently released by the Society of Actuaries and co-
sponsored by WISER, The Impact of Retirement Risk on Women, finds that
women have special retirement planning needs that are largely being
ignored. The report details why it is particularly critical that women,
who outlive men by 3 to 4 years on average, understand--and act on--the
post-retirement risks they face.
Here are five key reasons women's retirement could be at risk:
Reason No. 1: Planning horizons are too short. Most women can
expect to live 20 or more years after age 65. However, 9 out of 10
women in retirement or close to retirement do not plan nearly that far
into the future.
Reason No. 2: Outliving assets is a risk. On average, women live 20
years after age 65, while men live 17 years. So women are more likely
than men to outlive their assets. In fact, 4 out of 10 women over age
65 who are living alone depend on Social Security for virtually all
their income.
Reason No. 3: Married women need to prepare for widowhood. Because
men tend to marry younger women, and women tend to outlive men, periods
of widowhood of 15 years or more are not uncommon. The numbers show
that 85 percent of women over age 85 are widows, while only 45 percent
of men over age 85 are widowers. Yet there is a planning disconnect
here. Only 17 percent of female retirees and 27 percent of female pre-
retirees said they would be worse off if their husband passed away; the
majority of married women think that their financial situation would be
the same or better if their husband passes away. However, the reality
is that most widows have significantly lower income after their husband
dies.
Reason No. 4: Women need to plan for long-term care. Women are more
likely than men to have chronic disability in their later years and
need care in a long-term care facility, or need a paid caregiver. The
expected average value of the cost of lifetime long-term care services
is $29,000 for males and $82,000 for females, although these amounts
can get far higher for some people.
Reason No. 5: Women have a greater need to plan for medical
expenses. Retirement incomes are generally less for women than for men,
but they do not have lower health care costs. And women are less likely
to have medical insurance from their employer, compared to men.
For most women, there's little room for error, and being unprepared
for nearly a third of their lives will have consequences.
THE NEED TO EDUCATE ON THE IMPORTANCE OF LIFETIME INCOME
Combined with Social Security, immediate annuities represent a
meaningful channel through which millions of women can live out their
years in comfort and dignity. Yet, despite their availability, few
retirees opt for lifetime income products. Only 18.6 percent of
retirees aged 65 and over receive retirement income in the form of an
annuity.\1\
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\1\ Employee Benefit Research Institute. Income of the Elderly
Population, Age 65 and Over: 2007. EBRI Notes, Vol. 30, No. 5. May
2009.
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Education plays a crucial role in achieving lifetime income
security. Policy discussions on retirement security focus largely on
asset accumulation. The same holds true for all of the financial
information swirling around for people to try to make sense of.
Accumulation is, of course, a critical ingredient to retirement
income security. But we need to help people see the big picture: how
can they make use of what they have earned and saved to make their
money last as long as they do? The pursuit of lifetime income--not the
prospect of a one-time lump sum check, is the goal of retirement
planning. We need to build better awareness about the tradeoffs of
retirement income options.\2\
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\2\ For an in-depth discussion, please see WISER's report: How Can
Women's Income Last as Long as They Do? Thought Leaders Discuss
Managing Assets in Retirement. June 2009.
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We need to help participants learn how to manage assets in
retirement, and reframe the discussion.
LIFETIME INCOME PRODUCT LIMITATIONS
Lifetime income products are not without their limitations. For
example, they typically do not adjust for inflation, eroding the
annuitant's purchasing power over time. Providers are increasingly
coming up with features to address issues like this, but they come at
the cost of higher expenses and lower income payout.
Also, the decision to accept a lifetime annuity is typically
irreversible. Studies show that people fear this aspect, on the chance
they may die long before they have received the cost of the annuity
back.
THE IMPORTANT ROLE OF ANNUITIZATION
In spite of limitations, WISER sees immediate annuities as an
important resource for millions of women, even those who have modest
retirement assets. One hundred percent annuitization would make little
sense for most (if not all) retirees. On the same hand, a retiree
managing 100 percent of her retirement assets does not make much sense
for most (if not all) retirees either. But we believe the option of
annuitizing some portion of retirement assets is critical.
As Professor and Wharton Fellow, Dr. David Babbel, notes:
``Lifetime income annuities may not be the perfect financial
instrument for retirement, but when compared under the rigorous
analytical apparatus of economic science to other available
choices for retirement income, where risks and returns are
carefully balanced, they dominate anything else for most
situations. When supplemented with fixed income investments and
equities, it is the best way we have now to provide for
retirement. There is no other way to do this without spending
much more money, or incurring a whole lot more risk--coupled
with some very good luck.'' \3\
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\3\ David F. Babbel. Lifetime Income for Women: A Financial
Economist's Perspective. Wharton Financial Institutions CenterPolicy
Brief: Personal Finance. 2008.
On behalf of the Women's Institute for a Secure Retirement, thank
you for your consideration of this submission for the record. We
welcome the opportunity to discuss these comments with committee
members and staff.
Prepared Statement of The American Council of Life Insurers
The American Council of Life Insurers (ACLI) commends this
committee for holding hearings on the growing retirement security
crisis. We applaud Chairman Harkin (D-IA) and Ranking Member Enzi (R-
WY) for focusing on what can be done to help Americans save more for
retirement and make informed decisions about their retirement savings.
In particular, we believe that as Congress examines ways to preserve
and enhance the current system, special attention should be given to
help workers understand how their savings can provide them income they
cannot outlive in retirement. ACLI believes that by providing a simple
illustration of retirement savings as guaranteed lifetime income
directly on defined contribution plan statements, workers will better
understand whether they need to increase their savings, adjust their
investments, or reconsider their retirement date, if necessary, to
assure the quality of life they expect when they retire. It will also
fundamentally change the way workers view their retirement savings, not
only as a lump sum, but also as a source of guaranteed lifetime income.
The American Council of Life Insurers is a national trade
organization with over 300 members that represent more than 90 percent
of the assets and premiums of the U.S. life insurance and annuity
industry. ACLI member companies offer insurance contracts and
investment products and services to qualified retirement plans,
including defined benefit pension, 401(k), 403(b) and 457 arrangements
and to individuals through individual retirement arrangements (IRAs) or
on a non-qualified basis. ACLI member companies' also are employer
sponsors of retirement plans for their employees. As service and
product providers, as well as employers, we believe that saving for
retirement and managing assets throughout retirement are critical
economic issues facing individuals and our Nation.
As the first wave of the baby boom generation reaches retirement
age this year, it is timely that this committee is looking at the
retirement savings plan system's ability to provide sufficient
retirement income for these and future retirees. Many current retirees
are fortunate in that they are receiving lifetime monthly income from
both Social Security and an employer-provided defined benefit (DB)
pension. That situation is rapidly changing. Today, more workers have
retirement savings in defined contribution plans, which largely do not
offer the option to elect a stream of guaranteed lifetime income. This
change leads to questions of how individuals will manage their savings
to last throughout their lifetime. Workers need to understand the value
of their retirement savings as a source of guaranteed lifetime income.
With this information, workers would be in a better position to
consider augmenting their Social Security benefit with additional
amounts of guaranteed lifetime income so that anticipated monthly
expenses can be covered, shifting the risk of outliving one's savings
to a life insurer.
With the passage of the ``Lifetime Income Disclosure Act,'' which
was reintroduced today by Senators Bingaman, Isakson and Kohl, Congress
will move one step closer to helping individuals think of defined
contribution plan savings as not only a lump sum balance, but also as a
source of guaranteed lifetime income so that retirees can plan for a
predictable standard of living. With this additional information on
one's statement, workers will receive a ball park estimate, which when
coupled with their Social Security statement, visually displays how
much monthly income they could potentially receive in retirement based
on their current savings. Workers can better decide whether to increase
their savings, adjust their 401(k) investments or reconsider their
retirement date, if necessary, to assure the quality of life they
expect when their working days are over. From a recent survey, workers
find it valuable to see how much guaranteed lifetime income they could
obtain with their retirement plan savings.\1\
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\1\ ACLI Study on Retirement Choice, Mathew Greenwald & Associates
2010 (see Appendix 2).
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As an addendum to this statement, ACLI has outlined a number of
other recommendations to encourage employers to offer guaranteed
lifetime income options. Additionally, the prior survey notes that
workers are also interested in guaranteed lifetime income options.
In conclusion, workers need additional information and access to
lifetime income options if they are expected to successfully manage
their savings throughout retirement. To this end, a lifetime income
illustration will help workers visualize how their savings will address
their basic month-to-month living expenses after retirement. Taking
this important step today can help address tomorrow's retirement income
security crisis.
ADDENDUM
New laws and regulations can help employers assist their employees
in obtaining guaranteed lifetime income in the same way they have
assisted employees in obtaining life insurance, disability insurance,
and other financial protection products. New laws and regulations can
also create an incentive to use guaranteed lifetime income as part of
an employee's overall retirement income plan.
Recommendations to Encourage Employers to Offer Annuities
1. Provide Employers with Guidance on Lifetime Income and
Education. The ACLI urges the DOL to revise and extend Interpretive
Bulletin 96-1 beyond guidance on investment education to include
guidance on the provision of education regarding lifetime income and
other distribution options, both ``in-plan'' and outside the plan, to
assist participants and beneficiaries in making informed decisions
regarding their distribution choices.
2. Help Employers Select an Annuity Provider. The DOL took an
important step by changing the so-called ``safest annuity standard'' in
Interpretive Bulletin 95-1 by adopting a safe harbor for the selection
of annuity providers for individual account plans. While this
regulation provided some helpful guideposts, it contains a requirement
that the fiduciary ``conclude that the annuity provider is financially
able to make all future payments.'' This standard is difficult to meet,
in part because it is hard to know how to draw this conclusion. While
it is part of a ``safe harbor,'' this prong makes it difficult to use
the safe harbor and thus is an impediment to the offer of annuities in
defined contribution plans. ACLI believes that changes can be made to
these rules which will make it easier for employers to meet their
duties while at the same time ensuring a prudent selection. We plan to
work with the Department of Labor to simplify this requirement so that
an employer can more easily and objectively evaluate the financial
stability of the annuity provider.
3. Annuity Administration. Employers take on a number of duties in
administering a retirement plan, and the administration of an annuity
option would increase those duties. The qualified joint and survivor
annuity (``QJSA'') rules provide important spousal protections. The
notice and consent requirements provide spouses with an opportunity to
consider the survivor benefits available under a joint and survivor
annuity. However, these rules add an additional layer of administrative
complexity as well as technical compliance issues that most plan
sponsors choose to avoid by excluding annuities from their plans.
There are a number of ways that the rules can be modified to make
it easier for employers to administer this important requirement while
protecting survivors, including:
model plan amendments for employers to add guaranteed
lifetime income options;
simplify QJSA notice requirements; and
the use of electronic signatures, widely accepted in
financial transactions today.
ACLI proposes allowing those employers who choose to do so to
transfer the duties and liabilities of administering qualified joint
and survivor annuity rules to an annuity administrator. Also, employers
need guidance that confirms that a participant's purchase of
incremental deferred payout annuities should not be subject to the QJSA
rules until the participant has elected to take the annuity payout.
4. Partial Annuitization Option. Some employers view annuitization
as an ``all-or-nothing'' distribution offering. In our RFI submission,
we asked the Departments to provide guidance making clear that plans
may provide retirees with the option to use a portion of the account
value to purchase guaranteed lifetime income, including model
amendments to simplify the adoption of such a provision.
Recommendations to Encourage Workers to Elect Annuities
1. Illustration. To reframe retirement savings as a source of
lifetime income, ACLI supports legislative proposals to include an
illustration of participant accumulations as monthly guaranteed
lifetime income on defined contribution plan benefit statements. ACLI
thanks Senators Kohl, Bingaman and Isakson for their bi-partisan
sponsorship of S. 2832, the Lifetime Income Disclosure Act, in the
111th Congress. This bill would help workers understand how their
retirement savings might translate into guaranteed lifetime income.
2. Information. The ACLI has asked the Treasury Department to
modify the 402(f) rollover notice requirements and the safe harbor
notice to include information on guaranteed lifetime income, including
the importance of income protections and the availability of lifetime
income plan distribution options, if any, as well as lifetime income
options available outside the plan.
Attachments
[Editor's Note: Due to the high cost of printing previously
published materials are not reprinted in the hearing record. The
material, ``ACLI Retirement Choices Study,'' by Mathew Greenwald &
Associates, Inc., April 2010 may be found at www.acli.com.]
______
``ENCOURAGE ANNUITY OPTIONS FOR DEFINED CONTRIBUTION PLANS,'' ACLI
PROPOSAL, FEBRUARY 2009
Problem: Currently, about one-half of employees' retirement savings
is in defined contribution plans. Most defined contribution plans do
not contain guaranteed lifetime income (annuity) distribution options
notwithstanding that annuitization of account balances on retirement is
the best way of assuring that retirement funds will not be exhausted
during the participant's life. Early exhaustion of account balances may
also adversely affect surviving spouses.
A major reason that defined contribution plans do not provide
guaranteed lifetime income options is that, if they do so, the plan
must then comply with burdensome statutory requirements relating to
joint and survivor annuities. The J&S rules impose costly and
burdensome administrative requirements involving notifications to
spouses, waivers by spouses, and prescribe the form and amount of
spousal benefits. A major reason for the shift to defined contribution
plans is a desire by employers to avoid the administrative cost and
complexity associated with defined benefit plans, including compliance
with joint and survivor annuity requirements.
A potential solution to this problem would be for the plan sponsor
to outsource the administration of the joint and survivor annuity rules
to the annuity provider. However, in the event of a failure of the
annuity provider to properly administer the rules, the plan and plan
sponsor would still be liable for a claim for benefits under Section
502 of ERISA.
Solution: Where the plan sponsor and the annuity provider have
agreed that the annuity provider will be responsible for administration
of the joint and survivor annuity rules, provide that enforcement
actions for failure to comply with the joint and survivor annuity rules
may only be maintained against the annuity provider, provided that the
plan sponsor or administrator has prudently selected and retained
selection of the annuity provider. Make this provision applicable only
to administration of the joint and survivor annuity rules under defined
contribution plans. The electronic delivery rules should be modified to
allow greater use of electronic means for administration of the J&S
rules.
Rationale: The ability to shift responsibility for the
administration of the joint and survivor annuity rules would make
guaranteed lifetime income (annuity) options more attractive to plan
sponsors and could result in significantly wider availability of such
annuity payment options under defined contribution plans. While this
approach would retain the cost and complexity of the annuity rules, it
would preserve spousal protections and would permit the plan and plan
sponsor to shift responsibility to an experienced third party annuity
provider. This provider would be an insurance company with experience
in annuity administration and a secure financial ability to pay
annuities. These factors makes shifting responsibility to annuity
issuers more beneficial to and protective of plan participants,
beneficiaries (including surviving spouses) and the plan sponsor than
leaving responsibility with the plan and plan sponsor.
Electronic administration is more cost-efficient and has become
more widely used. DOL has indicated that they are modifying their
regulation on electronic delivery, although it is not known whether the
modification will cover the QJSA rules.
SECTION--
(a) AMENDMENTS TO THE EMPLOYEE RETIREMENT INCOME SECURITY ACT OF
1974.--
(1) IN GENERAL--Section 402(c) of the Employee Retirement Income
Security Act of 1974 (29 U.S.C. 1102(c)) is amended--
(A) in paragraph (2) by striking ``or'' at the end;
(B) in paragraph (3) by striking the period at the end and
inserting ``; or''; and
(C) by adding at the end the following new paragraph:
``(4) that a named fiduciary, or a fiduciary designated by a
named fiduciary pursuant to a plan procedure described in section
405(e), may appoint an annuity administrator or administrators with
responsibility for administration of an individual account plan in
accordance with the requirements of Section 205 and payment of any
annuity required thereunder.''
(2) Section 405 (29 U.S.C. 1105) is amended by adding at the end
the following new subsection:
``(e) Annuity Administrator
If an annuity administrator or administrators have been appointed
under section 402(c)(4), then neither the named fiduciary nor any
appointing fiduciary shall be liable for any act or omission of the
annuity administrator except to the extent that--
(1) the fiduciary violated section 404(a)(1)--
(i) with respect to such allocation or designation, or
(ii) in continuing the allocation or designation; or
(2) the fiduciary would otherwise be liable in accordance with
subsection (a).''
(3) Section 205(b) (29 U.S.C. 1055) is amended by adding at the end
the following new sentence:
``Clause (ii) of subparagraph (C) shall not apply if an annuity
administrator or administrators have been appointed under section
402(c)(4).''
(b) AMENDMENTS TO THE INTERNAL REVENUE CODE OF 1986--
(1) IN GENERAL--Section 401(a)(11) of the Internal Revenue Code of
1986 (relating to requirements of joint and survivor annuities and pre-
retirement survivor annuities) is amended by adding at the end the
following new sentence:
``Clause (iii) (II) shall not apply if an annuity administrator
or administrators have been appointed under section 402(c)(4) of the
Employee Retirement Income Security Act of 1974.''
(c) ELECTRONIC DELIVERY
(1) IN GENERAL--The Secretary of the Department of Labor shall
modify the regulations under section 104 or section 205 of the Employee
Retirement Income Security Act of 1974 to provide a broad ability to
administer the requirements of section 205 of the Employee Retirement
Income Security Act of 1974 by electronic means.
______
The SPARK Institute, Inc.
Simsbury, CT, 06070,
February 14, 2011.
Hon. Richard Burr,
U.S. Senate,
217 Russell Senate Office Building,
Washington, DC 20510.
Re: Proposal for a Universal Small Employer Retirement Savings Program
Dear Senator Burr: On February 3, 2011, the Senate Committee on
Health, Education, Labor, and Pensions (``HELP''), held a hearing on
``Simplifying Security: Encouraging Better Retirement Decisions.''
During the hearing Senators Enzi and Harkin, among others, called for
the best new ideas that would help Americans save for a more secure
retirement. The SPARK Institute \1\ understands the challenges for
small employers and Americans, trying to figure out how to save for
retirement. Consequently, we developed a simple and cost-effective
employer-based retirement savings plan alternative to the plans that
are currently available and to the proposed mandatory payroll deduction
IRA.
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\1\ The SPARK Institute represents the interests of a broad-based
cross section of retirement plan service providers and investment
managers, including banks, mutual fund companies, insurance companies,
third party administrators, trade clearing firms and benefits
consultants. Members include most of the largest firms that provide
recordkeeping services to employer-sponsored retirement plans, ranging
from one-participant programs to plans that cover tens of thousands of
employees. The combined membership services approximately 70 million
employer-sponsored plan participants.
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Our Universal Small Employer Retirement Savings Program (the
``Program'') was developed specifically to address and overcome the
roadblocks in the current system that have been identified by small
employers, American workers and service providers. For example, the
Program addresses employers' concerns about costs, complexity and
potential fiduciary liability. Simplified administration will make it
possible for service providers to cost-effectively take on more
responsibility for employers. The Program also leverages automatic
enrollment and escalation features that have been successful in getting
employees to start and continue to save. A copy of the Program is
attached for your review.
We welcome the opportunity to discuss the concept with you as
Congress considers new ways to help Americans save for retirement. We
also welcome the opportunity to share our ideas with the HELP Committee
at future hearings. If you have any questions regarding this
information, please do not hesitate to contact me at (704) 987-0533.
Respectfully,
Larry H. Goldbrum,
General Counsel.
[Editor's Note: Due to the high cost of printing, previously
published materials are not reprinted in the hearing record. The above
referenced material may be found at http://www.sparkinstitute.org.]
[Whereupon, at 3:50 p.m., the hearing was adjourned.]