The Evolution of Retirement Plans

These days, most of the news about the state of our retirement savings is bad news . But a recent study from Fidelity Investments contained two very good pieces of news.

  • The average 401(k) balance among the clients the firm surveyed, rose to $74,900 at the end of the first quarter of 2011. That’s the highest it’s been since Fidelity began tracking account balances in 1998, a 12% increase from a year ago and a 58% jump from the same time period two year earlier.
  • Nearly one in 10 participants increased his or her deferral rate during the first quarter. That’s the biggest move in that direction in the past five years.

To some extent, this good news is a triumph of applied Behavioral Finance. Since academics started parsing investor behavior in 401 (k) accounts several decades ago, it’s become clear that Americans have some dangerously self-destructive tendencies.

In their 2005 study, “Are Empowerment and Education Enough? Underdiversification in 401(k) Plans,” James J. Choi, a Yale Professor,  David Laibson of Harvard and Brigitte C. Madrian of the University of Pennsylvania, found that 401(k) investors are often not sufficiently diversified, holding too much of their employer’s stock. One reason given was loyalty. The other: passivity.

Studies have found that too often, people don’t save as much as they could in 401(k) plans, sometimes even giving up “free” matching employer money and too often, not participating at all. Other mistakes include not rebalancing holdings and taking out loans against 401(k) plans that are often not repaid, according to Alicia Munnell, Director of the Center for Retirement Research at Boston College.

New 401(k) Tools

Acting on those insights, corporate 401(k) plan sponsors have begun to build in some effective tools that are helping employees get better results. More companies require that employees actively opt-out of their 401(k) these days, abandoning earlier “opt-in” policies. Fifty-seven percent of companies responding to plan consultant Towers –Watson’s most recent survey said they employ auto-enrollment with the choice of opting out. And many plans now offer Target Date Funds, which do try to offer thoughtful diversification, even if they don’t always perform as well as expected.

Another important evolution in 401(k) plans which really seems to be making a difference, is automatic escalation of contributions – something the Towers-Watson survey now finds 58% of plans do.  According to the Towers-Watson study:

“Contribution escalation is strongly associated with higher participation rates. Seventy-nine percent of plan sponsors that escalate contribution rates have participation rates of at least 80%, while only 50% of plan sponsors that do not escalate contributions have participation rates of at least 80%.”

This is valuable proof that the payoff of consistent investing works–an investing lesson with application far beyond 401(k)s.

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