It’s not their parents’ (or even older siblings’) DC plan anymore.
Many companies now rely less on traditional defined benefit (DB) plans to provide employees’ retirement benefits. Among the reasons for this shift are a sophisticated and mobile workforce that wants control and portability of benefits, HR management models that emphasize self-service for plan participants and market and global pressures that demand greater control over retirement program costs.
For defined contribution (DC) plans to successfully replace DB plans as the definitive retirement vehicle, sponsors will need to get to a different place. As the migration illustrated in Fig.1 progresses, a best-practice DC plan will start to look quite different.
Two best practices among DC plans are features that encourage participation and facilitate retirement. The third is superior practices in investment management. The first two are discussed in more detail below. We will explore the third in next month’s column.
• Plan Participation: The keys to improving the rate of DC plan participation are communication and simplification. Employees—especially young ones who are often the poorest savers—must understand how much money they’ll need to retire and the positive impact that saving at an earlier age will have on future financial security. Plan sponsors can overcome tendencies to postpone saving by:
— Initiating automatic or default enrollment;
—Adding matching contributions, flexible plan incentives, and simplified investment options;
—Increasing contribution levels through:
• Automatic annual escalation, a concept that is being endorsed by legislative proposals
• Catch-up contributions
• Initial seed contributions by plan sponsors
• Contributions options, such as flat dollar amounts.
The company match can provide a line-of-sight to company performance when based on profitability and encourage higher contribution levels. It can also reflect length of service, although this less common practice is subject to special nondiscrimination testing rules.
DC plan statistics show that many participants do not contribute sufficiently to produce a reasonable nest egg at retirement. Structuring the match to encourage higher contributions can help address this shortfall.
The most competitive plans provide some level of fixed employer contribution not tied to employee contributions. A fixed contribution provides a core level of employer-provided retirement benefits and allows management employees to save more for retirement on a tax-favored basis. The level of savings by highly compensated managers is often restricted due to nondiscrimination testing. A fixed contribution can improve test results; for example, by eliminating ADP/ACP testing if designed as a safe harbor or by improving the results of average benefits percentage testing under the coverage rules.
• The Process of Retirement: The growing emphasis on self-service and independence has reduced the number of companies offering retirement counseling support. However, employees in a DC-only environment need retirement counseling more than ever to understand the:
—Retirement income they’ll need and the consequences of inflation, market volatility, and living longer.
—Ability of their account balances to generate adequate retirement income;
—Negative impact of early withdrawals and taxes;
—Account balance distribution options.
Many DB and DC plan sponsors have not considered flexible distribution options a high priority. Yet, as we move from the world of lifetime annuities to unlimited and, in many cases, mandatory lump sums, many employees can benefit from more flexible distribution choices and from the plan sponsor’s buying power. Flexible forms of payment can support long-term retirement needs by providing lifetime installments with annual recalculations of life expectancy, ad hoc access to lump-sum distributions after termination, annuities on financially competitive terms negotiated by the plan sponsor and post-termination rollovers into the plan.
• Conclusion: Employers must help employees succeed as savers by communicating effectively, employing plan defaults to offset inertia, and providing a core employer contribution and flexible retirement options.