Designing an effective program is not easy. Experience shows that employee engagement in defined contribution (DC) plans is often low and leads to low participation rates in the program, lower savings rates than may be desirable, and failure to actively select/modify an asset mix appropriate for the member’s actual risk tolerance.

Each of these outcomes can be managed with well-designed defaults—“auto features” that direct members to the choices that would naturally evolve if the members gave the decisions the right attention.

Let’s consider how “auto features” can address the key areas.

Low participation

Sponsors offering optional participation in DC plans find themselves with employees who never participate, or who wait too long to join. Employees unprepared for retirement may impact morale and company reputation, and may have financial consequences for the employer that feels compelled to provide other support to help the member into retirement.

To address this, DC programs should enroll members automatically1 upon completing a probationary period. Why not immediately? Two reasons: to avoid allocating inordinate resources to short-term employees, and more importantly, separating the enrollment process from all the other things a new employee has to deal with, will improve the odds of engaging the employee in the retirement plan.

Low contributions

Many programs provide for matching contributions scales (the more the employee contributes, the more the employer contributes). Here again, employees do not always take advantage of the additional employer dollars available.

A default employee contribution rate set at the level that maximizes employer contributions could improve participation. A bigger question is whether the plan design should even require large employee contributions to maximize the value offered by the employer. In earlier and mid-career stages, it may make more sense for a member to reduce their personal debt load.

Members should periodically assess the situation and consider additional contributions to reach retirement goals. As they progress in their careers and pay off debt, there may be more flexibility to make greater contributions to a retirement plan. Unfortunately, the reality is that few members make the effort to actually do this type of assessment. To encourage this behaviour and manage it through plan design, implement automatic employee contribution increases throughout a member’s career. Contributions gradually increase as members are better able to afford them.

Failure to select or manage investment strategy

Knowing how much to contribute is only part of the answer. Appropriate investment decisions—maximizing expected returns within the right level of risk tolerance—are needed too. Given the goal to provide a retirement income, risk assessment should focus more on maximizing retirement income rather than the volatility of the member’s account balance during employment.

Some members do not make deliberate investment decisions. And, even when they do, they may fail to periodically ensure that asset mix is still on track and within their risk tolerance. Many members fail to revisit original investment strategies as they progress through careers. It is unlikely that what was appropriate at the beginning of a career will still be appropriate near retirement.

These pitfalls can be mitigated through a combination of appropriate defaults, investment options, and communications. For example, a series of pre-mixed portfolios will certainly help with rebalancing, and a reasonable default asset allocation fund that considers the typical time horizon for a new entrant will help the initial asset-allocation issue. Some DC providers offer automatic rebalancing features2 to aid members with this important task. But without a rigorous communication strategy, many members would stay in their original asset mix for their careers.

Target date funds can address all three pitfalls. Defaulting members to a target date option closest to their normal retirement date provides a reasonable asset mix for most new entrants. The funds also rebalance themselves automatically to ensure the risk taken stays within acceptable levels. Finally, risk diminishes as retirement approaches.

But watch fees. Some pre-built asset allocation and target date funds come with high investment management fees or fund operating expenses that will have a profound impact on a member’s expected retirement income. While target date funds can be a practical method to help participants manage investment risks, there are not many options available in Canada and some are better constructed than others. And currently, many Canadian record-keepers’ online tools are not well-integrated with these new funds3.

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