Forseeable Consequences

It is all too common in human affairs to make choices that have “unforeseeable consequences.” And then there are those situations where people should have known better. Like the current rumors about capping employee pre-tax contributions at $2,400.

Having the opportunity to put off paying taxes is something that most Americans relish — even those whose tax bracket means they really don’t wind up owing taxes. While there’s plenty of evidence to suggest that it is the employer match, rather than the (temporary) tax deduction that influences worker savings, most are happy to get both. Indeed, the ability to defer paying taxes on pay that you set aside for retirement is part and parcel of the 401(k) (though cash or deferred arrangements predated that change to the Internal Revenue Code).

Enter the talk about “Rothification” — the limit, or perhaps even complete elimination, of pre-tax contributions to 401(k)s. While a definitive notion of how participants would respond remains elusive, recent industry surveys have indicated a great deal of concern on the part of plan sponsors about their response. I’ve little doubt that some people would reduce their savings (if only because they would have less take-home pay), but certainly those who are anticipating a higher tax bracket in retirement than at present (are you listening younger workers?), the ability to pay a low tax rate now, while gaining the tax-free accumulation of earnings, and the freedom from mandated RMDs, makes a lot of sense. Older workers too might appreciate the tax diversification moving to Roth affords.

In considering the potential impact, I also drew comfort from the reality that so many of today’s workers are being automatically enrolled in their workplace savings plan. They may well have contemplated the potential tax implications before allowing that deduction to take place, but I’d guess most had not. And thus, a switch to Roth as an automatic deduction seemed unlikely to me unlikely to raise more than a brief ripple in current savings rates.

There are, however, signs that reactions beyond that of plan participants could produce seismic shocks. There were reports that some plan sponsors were not comfortable simply “flipping” automatic enrollment to Roth from pre-tax, at least not without some affirmative participant direction. Moreover, in recent days, a number of providers have been heard saying that, if a provision that would limit pre-tax contributions to something like the recently rumored $2,400, that they would feel obliged to place that cap in the plans they recordkeep with automatic enrollment provisions — at least until plan sponsors told them otherwise. And if plan sponsors aren’t comfortable making that switch with their automatic enrollment programs — well, you can see how that Roth limit could in short order actually become a limit on retirement savings.

But perhaps the most remarkable thing about the most recent set of tax reform rumors is the $2,400 limit itself. If it strikes you as a pretty low threshold, you’d be correct. None other than the nonpartisan Employee Benefit Research Institute (EBRI) using their Retirement Security Projection Model® (based on information from millions of administrative records from 401(k) recordkeepers), found that more than half of current 401(k) contributors would be impacted by a $2,400 contribution Roth. Even at the lowest wage levels ($10,000 to $25,000), nearly 4-in-10 (38%) of the 401(k) contributors would be impacted by the $2,400 threshold, as would 60% of those in the $50,000-$75,000 salary range. Can you say “middle-income tax increase”?

Tax reform might not happen, and even if it does happen, it might not touch retirement plans, or the delicate balances that incentivize both workers to save, and employers to offer the programs that allow workers to save.

Those who craft such legislation would do well to heed the danger signs already emerging from constraining and/or undermining retirement savings. It’s one thing, after all, to implement change without understanding or appreciating those consequences that are unintended, and something else altogether to know full well that those changes will have a negative impact, and then plow ahead with them regardless.

Those “foreseeable” consequences might — and should — have foreseeable consequences of their own for those who choose to disregard them.

- Nevin E. Adams, JD

Behavioral Finance – the Next Frontier

All too often the innovations honored with a Nobel Prize fly under the radar of “regular” Americans. But that wasn’t the case last week when the work of University of Chicago’s Richard Thaler was acknowledged.

Thaler was, of course, recognized by the Royal Swedish Academy of Sciences, who said that his focus on limited rationality, social preferences and lack of self-control has “built a bridge between the economic and psychological analyses of individual decision-making.” More plainly, to my reading, Thaler (finally) managed to prove to economists that human beings don’t (always) act rationally and/or in their own self-interest.

Now, anybody who has ever actually interacted with human beings knows this. Indeed, in some ways the most amazing thing about Thaler’s insights of this reality is that it is seen as being innovative by economists.¹ I still remember reading the report that Thaler and Schlomo Benartzi authored way back in 2004, “Save for Tomorrow: Using Behavioral Economics to Increase Employee Saving.” That’s where (among other things) I first learned about the concept of what we today call contribution acceleration, based on the premise that people are more likely to act (and act more aggressively) on their good (but painful) intentions in the future than if they had to do so today.

There’s no denying that Thaler’s work has had a big impact on retirement savings (about $29.6 billion worth, according to one estimate). And if Thaler and Benartzi did not exactly create the notion of automatic enrollment, they at least freed it from the “dark” connotations of “negative election,” as it was called at the time.

Today we may wonder at – but no longer question – the notions that human beings rely on heuristics (mental shortcuts) when making complex decisions, that they fear loss more than they value gain, that they tend to diversify across the number of options provided, without regard to what lies within those choices, and that they tend to treat “old” money differently than “new” money. For this, Prof. Thaler and his collaborators over the years deserve our thanks.

That said, it may be worth remembering that while we tend to assume that plan fiduciaries are rational in all their decisions, they too are human beings making complex decisions. Consider that:

• Many remain hesitant to “impose” automatic enrollment for concerns about negative response from workers, though multiple surveys suggest workers would appreciate the move.
• Many continue to auto-enroll new hires, but not current workers.
• Many extend auto-enrollment to eligible workers – once.
• Many choose to implement auto-enrollment – and then wait 3 to 4 years to start contribution acceleration.
• Long-standing (and probably ill-considered) fund choices are routinely mapped during a recordkeeping conversion. Perhaps through multiple conversions.
• Plan committees often seem more worried about the negative reaction to removing a poor-performing fund than the possibility of being sued later on for keeping it on the menu.

That doesn’t mean that there aren’t any number of positive, rational reasons for those decisions (see “Why the ‘Ideal’ Plan Isn’t”). Indeed, most of us are rightly hesitant to superimpose our imperfect judgments on “other people’s” money – even on those on whose behalf fiduciaries are admonished to act.

But as we commemorate – and celebrate – those behavioral finance “nudges” that have done so much to buoy individual retirement security, perhaps some of those fiduciary decisions are worth (re) considering as well.

- Nevin E. Adams, JD

6 Dangerous Fiduciary Assumptions

There’s an old saying that when you assume… well, here are five assumptions that can create real headaches for retirement plan fiduciaries.

Assuming that not being required to have an investment policy statement means you don’t need to have an investment policy.

While plan advisers and consultants routinely counsel on the need for, and importance of, an investment policy statement (IPS), the reality is that the law does not require one, and thus, many plan sponsors — sometimes at the direction of legal counsel — choose not to put one in place.

Of course, if the law does not specifically require a written IPS — think of it as investment guidelines for the plan — ERISA nonetheless basically anticipates that plan fiduciaries will conduct themselves as though they had one in place. And, generally speaking, plan sponsors (and the advisors they work with) will find it easier to conduct the plan’s investment business in accordance with a set of established, prudent standards if those standards are in writing, and not crafted at a point in time when you are desperately trying to make sense of the markets. In sum, you want an IPS in place before you need an IPS in place.

It is worth noting that, though it is not legally required, Labor Department auditors routinely ask for a copy of the plan’s IPS as one of their first requests. And therein lies the rationale behind the counsel of some in the legal profession to forego having a formal IPS: because if there is one thing worse than not having an IPS, it is having an IPS — in writing — that is not being followed.

Assuming that all target-date funds are the same.

Just about every industry survey you pick up verifies that target-date funds, as well as their older counterparts, the lifecycle (risk-based) and balanced funds, have become fixtures on the defined contribution investment menu. For a large and growing number of individuals, these “all-in-one” target-date funds, monitored by plan fiduciaries and those that guide them, are destined to be an important aspect of building their retirement future.

There are obviously differences in fees, and that can be affected by how the funds themselves are structured, drawn from a series of proprietary offerings, or built out of a best-in-class structure of non-affiliated providers.

However, and while the bulk of TDF assets are still spread among a handful of providers, there are different views on what is an “appropriate” asset allocation at a particular point in time, discrete perspectives as to what asset classes belong in the mix, notions that individuals aren’t well-served by a mix that disregards individual risk tolerances, arguments over the definition of a TDF “glide path” as the investments automatically rebalance over time, and even disagreement as to whether the fund’s target-date is an end point or simply a milepost along the investment cycle. Oh, and a new generation of custom TDFs are now in the mix as well.

(See also, “Five Things the DOL Wants You to Know About TDFs.”)

Assuming that hiring a fiduciary keeps you from being a fiduciary.

ERISA has a couple of very specific exceptions through which you can limit — but not eliminate —fiduciary obligations. The first has to do with the specific decisions made by a qualified investment manager — and, even then, a plan sponsor/fiduciary remains responsible for the prudent selection and monitoring of that investment manager’s activities on behalf of the plan.

The second exception has to do with specific investment decisions made by properly informed and empowered individual participants in accordance with ERISA Section 404(c). Here also, even if the plan meets the 404(c) criteria (and it is by no means certain it will), the plan fiduciary remains responsible for the prudent selection and monitoring of the options on the investment menu (and, as the Tibble case reminds us, that obligation is ongoing).

Outside of these two exceptions, the plan sponsor/fiduciary is essentially responsible for the quality of the investments of the plan — including those that participants make. Oh, and hiring a 3(16) fiduciary? Still on the hook as a fiduciary for selecting that provider.

(See also, “7 Things an ERISA Fiduciary Should Know.”)

Assuming that all expenses associated with a plan can be charged to the plan.

Assuming that the plan allows it, the Department of Labor has divided plan expenses into two types: so-called “settlor expenses,” which must be borne by the employer; and administrative expenses, which — if they are reasonable — may (but aren’t required to) be paid from plan assets. In general, settlor expenses include the cost of any services provided to establish, terminate or design the plan. These are the types of services that generally are seen as benefiting the employer, rather than the plan beneficiaries.

Administrative expenses include fees and costs associated with things like amending the plan to keep it in compliance with tax laws, conducting nondiscrimination testing, performing participant recordkeeping services, and providing plan information to participants.

Assuming that the worst-case deadline for depositing participant contributions is the deadline.

The legal requirements for depositing contributions to the plan are perhaps the most widely misunderstood elements of plan administration. A delay in contribution deposits is also one of the most common signs that an employer is in financial trouble — and that the Labor Department is likely to investigate.

Note that the law requires that participant contributions be deposited in the plan as soon as it is reasonably possible to segregate them from the company’s assets, but no later than the 15th business day of the month following the payday. If employers can reasonably make the deposits sooner, they need to do so. Many have read the worst-case situation (the 15th business day of the month following) to be the legal requirement. It is not.

(See also, “5 Little Things That Can Become Big 401(k) Problems.”)

Assuming you have to figure it all out on your own.

ERISA imposes a duty of prudence on plan fiduciaries that is often referred to as one of the highest duties known to law — and for good reason. Those fiduciaries must act “with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”

The “familiar with such matters” is the sticking point for those who might otherwise be inclined to simply adopt a “do unto others as you would have others do unto you” approach. Similarly, those who might be naturally predisposed toward a kind of Hippocratic, “first, do no harm” stance are afforded no such discretion under ERISA’s strictures.

However, the Department of Labor has stated that “[l]acking that expertise, a fiduciary will want to hire someone with that professional knowledge to carry out the investment and other functions.” Simply stated, if you lack the skill, prudence and diligence of an expert in such matters, you are not only entitled to get help — you are expected to do so.

- Nevin E. Adams, JD

Generations ‘Grasp’

If you’re still struggling to figure out how to reach Millennials (even if you are a Millennial), take heart – there’s (already) another generational cohort entering the workforce.

This new cohort is called Generation Z (at one point, Millennials were referred to as Gen Y, so…) – they are, generally speaking, children of Gen X – born in the mid-1990s, and separated from Millennials by their lack of a memory of 9/11.

Gen Z is, in fact, already entering the workforce – and, according to the U.S. Census Bureau, they currently comprise a quarter of the population. They are seen as being more “realistic” when it comes to life and working than Millennials, who have been characterized as more “optimistic.” Gen Z is said to be more independent and competitive in their work than the collaborative Millennials, more concerned with privacy (Snapchat versus Facebook), and are said to have a preference for communicating face-to-face. It’s said they’ll eschew racking up big college debt, and are said to be interested in multiple roles within a single employer, rather than multiple employers (role-hoppers versus job-hoppers). They have been called a generation of self-starters, self-learners and self-motivators – and they’ve never known a world without the Internet and a smartphone to bring it to their fingertips wherever they are.

Unlike previous generations, whose parents didn’t mention money or focus on financial topics with their kids, more than half (56%) of Gen Z have reportedly discussed saving money with their parents in the past six months. The result, according to researchers, is a young generation that “behaves more like Baby Boomers than Millennials,” is making plans to work during college, to avoid personal debt at all costs, and… to save for retirement. Indeed, 12% of Gen Z is already saving for retirement, according to a recent research report.

Behavior ‘Patterns’

Now, as different as individuals in various generational cohorts can be, I’ve never been inclined to assign those behavioral differences to their membership in any particular cohort. Rather, I think there are things that younger workers are inclined to do (or not do) that workers in every cohort were inclined to do (or avoid) when they were younger. Do Millennials change jobs more frequently than their elders? Sure. But they didn’t invent the phenomenon; for a variety of reasons, younger workers have long been more inclined (or able) to pull up stakes and seek new opportunities (American private sector job tenure has actually been remarkably and consistently “short” running all the way back to WWII). Similarly, younger workers tend to put off saving (certainly for something as far away and obscure in concept as retirement), and when they do start saving, tend to save less than their elders. This was true of the Boomers, of Gen X and Millennials, and – despite their more rapid savings start – will almost certainly be true of Gen Z, left to their own devices.

That last part is a potentially critical difference, of course, in that today plan design differences like automatic enrollment were a relative rarity when the Boomers were coming into the workplace. Some of it is that – at least supposedly – their parents didn’t need to save because they had defined benefit pension plans to secure their retirement. But, even for those who were covered by those plans (and most weren’t) – the DB promise was of little value at a time when 10-year cliff vesting and 8-year workplace tenures were the order of the day. Moreover, Boomers would typically have had to wait a year to start contributing to their DC plan when they entered the workforce.

Headlines tout today’s improved behaviors – more diversified investments, an earlier savings start, a greater awareness of the need to prepare for retirement – as evidence of refined education efforts, or a heightened awareness of the need to save by generations who are more attuned to financial realities. Those are indeed welcome and encouraging signs.

Still, it seems to me that many in these newer generational cohorts are – as are their elders – really the beneficiaries of innovative plan designs – things like target-date funds, as well as automatic enrollment and contribution acceleration, and a heightened focus on outcomes – developed to overcome the behavioral shortcomings of human beings – regardless of their generational cohort.

- Nevin E. Adams, JD