Lessons from the U.S.

U.S. defined contribution (DC) plans are transitioning from supplemental savings plans to the primary source of retirement income for many employees. The Pension Protection Act (PPA) was enacted to encourage plan sponsors to focus on generating improved outcomes for DC participants. This session examined the history of the U.S. DC plans and the anticipated impact of the PPA on U.S. DC sponsors and their participants.

In the 1980s, the majority of working Americans were covered under a traditional defined benefit pension plan. Only one in three had access to a DC savings plan. During the DC growth years of the 1990s, plans increased their investment options, invested in financial education and communication, and introduced a number of Web tools, brokerage windows, voice response systems and more. All to better enable Americans to save and invest wisely for their retirement.

How did they do? Despite much effort, a shocking number of employees did not join their company retirement plans, those who did often were not saving enough and most struggled to make wise investment decisions. As an example, studies by research firm Dalbar have consistently revealed that the average stock fund investor underperforms versus the S&P 500. Our emphasis on financial education and communication to participants unfortunately did not prevent employees from falling prey to emotions (versus logic) when it comes to investing. A field known as behavioural finance has evolved, which attempts to better understand and explain how emotions and cognitive errors influence investors and the decision-making process.

Fast forward to present day and the passing of PPA. Behind the provisions lay a message: official recognition that 401(k) plans represented the future of retirement savings. At a stroke, the bar was raised and a spotlight was turned on these plans’ weaknesses, leading to strategies such as increasing participation through auto-enrollment, improving savings rates through auto-escalation of contributions and providing better default investment vehicles (e.g., asset allocation portfolios such as target date funds). In other words, using inertia to its advantage.

Today, with a heightened sense of fiduciary responsibility to provide for better participant outcomes in retirement (i.e., income replacement), the 401(k) plan is being redesigned and re-evaluated in light of its changing purpose. According to a 2007 Hewitt study, 34% of companies now offer auto-enrollment (up from 4% in 1997) and 35% offer auto-escalation. Better default investments are also on the rise, with 77% of plans now offering a diversified, pre-mixed portfolio (e.g., target date funds).

So what does the future hold for the DC plan? Perhaps, in the end, it will look more like a traditional DB pension plan. DC plans are leveraging some of the strong characteristics of DB plans, such as automatic participation and asset allocation set by investment professionals. One thing is certain: since the PPA was enacted, 401(k) plans—and the DC system of which they are a part—have gotten serious about coming to terms with their new role. As Matt Smith, managing director of Russell retirement services, says, “DC is new again. We have a chance to build it better this time.”

Heather Dawson is the director, DC strategy and services at Russell Investments (Tacoma).

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© Copyright 2008 Rogers Publishing Ltd. A shorter version of this article first appeared in the April 2008 edition of BENEFITS CANADA magazine.