A successful defined contribution pension plan maximizes employee participation. Members who make meaningful contributions to their employer-sponsored plans early and often, choose proper investment vehicles and don’t make withdrawals are most likely to save enough to live comfortably in retirement. Yet this approach faces strong headwinds of passive behavioural resistance.
Members often embrace the concept of saving for retirement but fail to take the right long-term actions to achieve it. In 2014, Statistics Canada reported Canadians were saving, on average, only about 4% of their disposable income—down from 19% in 1990. Data from the most recently available tax year (2012) show just one-quarter of eligible tax filers contributed to any type of RRSP, whether through a group plan or individual savings. Meanwhile, consumer debt is rising, with household debt to disposable income reaching an all-time high of 162.6% in early 2014, according to Statistics Canada data released in December 2014.
If employees have access to a group retirement plan, why isn’t there 100% participation—particularly when there’s a matching employer contribution? Behavioural finance offers two key explanations: inertia and myopia.
1. Inertia. Many people would rather not go through the effort of enrolling in a group retirement plan and fail to take action. Essentially, they make a default choice not to participate rather than expending effort to achieve a positive outcome.
Behavioural economist Shlomo Benartzi says employers can help procrastinators save by changing the plan’s default options so employees are automatically enrolled unless they actively opt out. And U.S. studies confirm this: auto-enrollment results in an employee participation rate ranging from 86% to 96% after six months—15% to 25% higher than plans requiring employees to enrol on their own.
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In the U.K., phasing in auto-enrollment began in October 2012, requiring larger employers (those with 250-plus employees) to implement it by February 2014. In 2013, the number of employees in a U.K. workplace pension plan increased to 50%—the first increase since 2006. By March 2014, more than three million eligible members had automatically enrolled, with an average opt-out rate of approximately 10%.
Another important consideration in the face of inertia is the default investment choice, such as a target date fund, which self-adjusts depending on the individual’s risk profile and retirement time horizon. This simplifies the investment decision-making process for members who may be overwhelmed by the number of options or who aren’t confident they will make the right selections.
2. Myopia. Short-sightedness manifests when members know the benefits of saving for the long term but choose to spend money on short-term desires instead (e.g., taking an expensive vacation instead of contributing to an RRSP).
Auto-escalation of contributions is designed to help overcome myopia. Member contribution rates gradually increase over time, usually in lockstep with salary increases. When combined with restrictions on withdrawals, these contributions are no longer readily available for short-term spending.
Employers can supplement this approach by offering a voluntary group tax-free savings account (TFSA) for plan members with shorter-term, non-retirement savings goals (e.g., funding their own or their children’s education or buying a home).
What employees want
Benefits Canada’s 2014 CAP Member Survey found the majority of Canadian capital accumulation plan members (69%) and non-members (54%) would support auto-enrollment in their employer-sponsored retirement plan.
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In the U.K., many workers who opt out after being automatically enrolled understand the need to save but question whether auto-enrollment is the best approach to increasing their retirement savings. They cite frustration at being coerced and mild annoyance that “the onus [is] on them” to take action to opt out, says a U.K. Department for Work & Pensions report.
In the U.S., employers have the opportunity to engage slow or stagnant savers by re-enrolling non-contributors. Currently, about one-quarter (26%) of employers actively re-enrol these people, says a Towers Watson report. But the same can’t be said for auto-escalation, as the percentage of U.S. companies mandating it remains relatively low. Of those offering auto-enrollment, only 35% mandate auto-escalation.
Are they saving enough?
Benartzi recommends plan members save 10% of pay toward retirement, which assumes a generous employer match. In the U.S., Vanguard research notes the average combined employer/employee contribution rate is 7%, with a third of plan participants achieving a combined rate of less than 4%.
One possible deterrent for plan sponsors to match contributions is the increased cost resulting from a higher participation rate. However, matching formulas can address this concern.
An Aon Hewitt study suggests sponsors “stretch the match” by increasing the member contribution required to trigger the maximum employer match. For example, employers offering a dollar-for-dollar match on 3% of salary could consider a 50-cents-per-dollar match on 6% of salary instead. This formula results in higher overall member contributions with the same level of employer contributions.
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The 2014 CAP Member Survey found a significant proportion (42%) of Canadian plan members believe their employers ultimately have a responsibility to ensure they will retire with enough funds to live at an acceptable standard of living. Yet Towers Watson research shows nearly one-third of U.S. plan participants save only enough to trigger the maximum employermatching contribution. In Canada, that statistic is 19%, according to the CAP Member Survey. Presumably, employees think this will be enough to meet their retirement needs.
These assumptions should concern employers. Unless members are making meaningful contributions, there’s no guarantee they will reach their retirement goals—even with auto features and restricted withdrawals in place.
A Towers Watson report finds U.S. employers are increasingly aware of the financial risks associated with delaying retirement when employees continue to work only because they can’t afford to retire. According to the report, these older employees tend to be less engaged and productive than their peers, command relatively higher salaries, incur greater healthcare costs and present obstacles to succession for younger employees. Awareness of these risks may be one reason why the U.S. has been more assertive than Canada in implementing auto features.
The Canadian opportunity
As the U.S. and the U.K. surge ahead with auto features, Canada can catch up and build these features into registered pension plans.
First, make early participation mandatory. Second, make the total contributions meaningful—at least 10%, including the employer match. Employers can also opt to achieve higher overall savings rates through auto-escalation. Third, offer a reasonable default investment choice, such as TDFs geared to the retirement dates members choose for themselves. And finally, offer a group TFSA for non-retirement savings goals.
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However, only 1% of companies with DC plans and 2% of those with group RRSPs are considering switching from a voluntary plan to a mandatory one, says the 2014 CAP Benchmark Report. And only Quebec has taken the bold step of introducing auto features in its voluntary retirement savings plan.
All provinces should follow suit with harmonized legislation that helps employers offer their employees universal access to retirement savings plans and locks in contributions to preserve accumulated assets earmarked for retirement savings.
Jeff Aarssen is senior vice-president, group retirement services, wealth management, with Great-West Life. jeff.aarssen@gwl.ca
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