Best Intentions: The unintended consequences of plan design

DC plans are complex and changes often bring unintended consequences. The most well-intentioned and carefully considered plan design decisions may have unexpected results and even successful implementations occasionally reveal the limits of some baseline assumptions.

To help understand how this can occur, we take a look at three real-world plan design case studies.

Case study #1: Do auto-features create unintended ceilings?

The scenario:
Five years ago, a large U.S. consumer staples company with over 100,000 participants and $5 billion in assets added auto-escalation as an opt-out for all new participants in increments of 1% annually up to 6%.

The assumptions:
The plan was concerned that if the auto-escalation cap was too high, significant numbers of participants would opt out.

What we found:
Analysis suggested that the modest cap may be limiting saving in the plan.

Figure 1: Active participants save substantially more:

We were able to divide the participant population into “active” participants that had made proactive changes to savings amounts and/or asset allocations beyond the plan defaults, and “passive” participants that accepted the default choices made by their employer. 43% of active participants demonstrate an appetite for saving well beyond the auto-escalation cap of 6%, whereas the majority of passive participants (60%) simply remained within the 6% default range.

As seen in Figure 1, active participants had average deferral rates of 6.8% vs. 4.9% for those considered passive—a difference of nearly 2%.

Passive participants will typically remain at the plan sponsor’s default. This tendency can be used to their advantage by setting defaults higher and increasing auto-escalation caps considerably, or even allowing them to reach IRS contribution limits. The example of the active group with their increased appetite for savings may also be considered an argument in favor of higher caps.

Figure 2: Impact of saving 2% more per year*

Resetting assumptions: 

The unintended effect that setting defaults and auto-escalations too low may have is to undermine the power of these plan design features and ironically prevent some participants from saving more. With that in mind, plan sponsors may want to consider a number of actions to increase savings, including:

• Increasing the auto-enrollment default rate to 6 or 8%.
• Increasing the cap on auto-escalation to at least 10% or the more commonly used 15%.
• Back sweeping all participants below the default savings rate into the higher rate on an opt-out basis.
• Back sweeping all participants into auto-escalation on an opt-out basis, including those who had previously opted out.

Case study #2: Were the most loyal employees left behind?

The scenario:
10 years ago, a U.S. technology company introduced a target date fund as its qualified default investment alternative (QDIA) for new hires. Legacy employees were not reenrolled. Two years ago, the company added 10,000 employees through an acquisition, all of whom were reenrolled into the target date fund. The combined plan now has over 30,000 participants and $6 billion in plan assets – and two very different participant populations with very different return profiles.

The assumptions:
The plan sponsor chose not to conduct a reenrollment from the stable value fund, preferring to avoid disrupting their original legacy employees.

What we found:
The post-acquisition plan unintentionally created two distinct populations with significantly different long-term retirement outcomes. As shown in Figure 3, the acquiring Company A had over the course of 10 years seen participation in the target date fund gradually rise to 42%. However, 25% of participants remained in stable value. By contrast, following the opt-out reenrollment implementation, 61% of the newly acquired employees (shown as Company B) were invested in the target date fund.

Figure 3: Two distinct populations post-merger

The opportunity cost for company A’s longest tenured employees may be significant. Stable value is a relatively conservative vehicle with lower expected returns. As Figure 4 illustrates, higher returns from a target date fund (in blue) compared to a stable value fund (represented in orange) compounded over a career can result in a nest egg that’s 59% larger or would potentially require a participant to save 7% more annually to make up the difference.

Figure 4: Opportunity cost of investing too conservatively*

Resetting assumptions: 

The majority of participants in company B accepted the reenrollment, which is evidence the Company A participants would have done the same. Reenrolling the original legacy population – in effect, offering them the same benefits offered to those more recently hired or newly acquired – is a reasonable and easily justifiable option.

Case study #3: Who really holds company stock ?

The scenario:
Previously, the company match for a large U.S. healthcare company was made in company stock. The plan, with 40,000 participants and over $10 billion in assets, also offered company stock as a menu investment option. The plan has a sizable overall allocation to company stock.

The assumptions:
The plan sponsor assumed that senior managers and executives, who were required to hold a percentage of their assets in company stock, were particularly exposed.

What we found:
Surprisingly, BlackRock’s assessment found that lower income participants allocated 33% of their portfolio to company stock (Figure 5), which is more than twice that of employees in the highest compensation percentiles (15%)

Figure 5: Company stock more popular amongst the lower salaried

Non-investment savvy participants may tend to equate risk with the unknown and may, therefore, think that shares in the company they know first-hand are safer compared to investing in, for example, an S&P 500 index fund filled with many companies they know little or nothing about.

However, research into company stock in 401(k) plans suggests that employees underestimate the risk of owning company stock. They may not recognize that they are already “invested” in the company’s continued financial health in that they depend on it for future wages and continued employment. Furthermore, being concentrated in any single stock increases investment risk for these lower salary workers due to its inherent reduction in diversification. 

Illustrating this risk, Figure 6 uses the S&P Health Care Index as a proxy for the company stock in this case study. In a global shock scenario, the proxy index would drop -22.9% compared to -11.7% for a diversified risk-aware target date fund. The company stock could, of course, be more volatile than its index, creating the potential for even more significant losses.

Figure 6: Risk of low diversification

Resetting assumptions: 

Plan sponsors with company stock allocations should confirm which participant cohorts hold company stock and their allocation percentages. Even if they choose to reduce company stock allocations, it is likely that a sizable exposure will exist for some time. To help mitigate the exposure, any or all of these steps may be taken:

• Conduct a communications campaign on the risk of a large single stock allocation targeted at participants with company stock allocations over a certain threshold.
• Offer an auto-diversification service to participants to systematically reduce the company stock allocation to a set level over time.
• Establish a cap for company stock allocations, typically 20 to 25% with larger legacy holdings “grandfathered” in.
• Freeze the purchase of additional company stock purchases within the plan.

Harnessing Data for
Better Outcomes

The three cases we have explored here are not cautionary tales; they are an argument for better data and deeper analysis. BlackRock’s strategic plan design team cannot only analyze existing plan data to reveal potential obstacles, but has advanced tools for projecting the potential impact of dozens of plan changes, from the investment menu to deferral rates, fees and alpha generation. BlackRock works with plan sponsors to help: 

• Review plan objectives: How are desired participant outcomes defined and how should they be measured?
• Conduct plan and participant analysis: Where on the path of retirement readiness are your participants given your current plan design?
• Test plan changes: Identify the most effective “levers” to close gaps between current and desired participant outcomes.

At BlackRock, we share your continued focus on retirement readiness and the desire to bring the best of your plan to your employees. Contact us for a custom evaluation or a reenrollment consultation.

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