Brigitte Madrian on Americans and Retirement Savings

Interviewed by Doug Gavel on April 12, 2007

More and more Americans are retiring without sufficient savings to maintain their lifestyles into their later years. How workers make choices regarding their 401k and other similar defined-contribution savings plans, and how those choices are affected by employer and government policies, is the focus of Brigitte Madrian's research. Madrian is Aetna professor of public policy and corporate management at the Kennedy School, an affiliate of the Mossavar-Rahmani Center for Business and Government, and a research associate at the National Bureau of Economic Research.

Q: A recent report you co-authored cites how few Americans participate in employer-sponsored 401k plans. What did you find, and what are the possible reasons for these disturbing trends?

Madrian: We found that even older workers who should be getting saving for retirement right - because they've had a lifetime of experience, retirement is staring them in the face, and because most of them have significant amount of tenure and they ought to understand how the savings plan and other benefits that the company offers works - even at companies where employers match employee contributions, half of them are not taking full advantage of the employer match. Of that half, 80 percent of them were not participating at all, and the remaining 20 percent were in the savings plan but were saving less than the amount that they would need to in order to get the full employer match.

And the interesting thing about this group of workers that we studied is that for them, since they were almost all fully vested because they have been with the company for a period of time, they could literally put their money in today and they could take it out tomorrow with the employer match. So they didn't have to wait to get the match; there was no tax penalty for taking it out. And yet half of them were leaving the equivalent of one-point-three percent of their pay on the table every year.

Q: How can employers change their 401k policies to entice more Americans to save more for retirement?

Madrian: 401k plans were never conceived as something that would become the primary retirement savings vehicle for most Americans. When the legislation was enacted that enabled companies to set up these kinds of savings plans, they were viewed as something that would be supplementary to the traditional defined benefit pension plans that most companies were offering back in the early 1980s. But that's not what happened.

What happened is that companies decided that defined benefit plans were very costly and cumbersome to administer, and companies, when given the option of offering the 401k plans, decided to get out of the business of providing defined benefit pension plans - and that's true across the economy with the exception of the public sector - and these have been supplanted by defined contribution plans. And because they were initially conceived of as something that would be supplementary, not a lot of thought was given to designing them in a way that would be user friendly. Their design was such that they were really great if you were financially sophisticated and knowledgeable and you wanted to take control of your retirement savings. They were never designed, at least not initially, for people who did not have some amount of financial knowledge and people who weren't comfortable saving on their own.

The good news is, over time, we've discovered that the plans don't really work so well for a non-trivial fraction of the population, and employers are understanding that, and I think the primary thing employers can do going forward is try to make the plans meet the needs of those employees who aren't really financially knowledgeable. The analogy I like to give is that a lot of us don't know how to fix our own cars. Does that mean that we're all driving around in clunkers? No. When my car has a problem I go to the mechanic and I have the mechanic fix the car. And what the savings plan world has been doing for a long time is, if you don't know how to save they give you a big set of instructions. That's like taking your car into the mechanic and instead of having the mechanic fix the car, the mechanic gives you a 200-page instruction manual and tells you to go fix the car. What we need is to have 'mechanics' who actually 'fix the car' in the savings domain.

We need to make savings plans such that if you're one of these individuals who doesn't really understand financial markets well or doesn't want to take control, a good outcome will happen for you anyway. So companies are starting to do this - through things like automatic enrollment, through contribution escalation, through the addition of investment options where the employee only has to make one choice, and the investment option is well balanced and changes over time as market conditions change, so the individuals don't have to be quite as actively engaged as might have been the case say 15 years ago.

Q: How can government policies be changed in order to entice people to save more and begin saving earlier for their retirement?

Madrian: I think public policy should be focused largely on giving companies the right incentives to set up plans that do right by their workers. There are a lot of individuals who are in companies that don't even offer employer-sponsored savings plans in part because just administering a plan is not an easy endeavor, particularly for a small employer. So encouraging the design of simple savings plans - by passing legislation that makes it possible for companies to offer a simple saving alternative to their workers that doesn't require a lot of upfront administrative cost on the part of employers - I think that would go some way.

The government has recently passed some initiatives that encourage sensible plan design for those companies that already have plans. The Pension Protection Act that was enacted in the fall of 2006 gives companies an incentive to adopt features, such as automatic enrollment, that tend to boost savings plan participation quite substantially. It gives companies incentives to adopt contribution escalation, which helps employees increase their savings rates over time, since many individuals are reluctant to start out saving say 10 or 15 percent of their income, but may feel better about it if you ratcheted it up slowly over time. It also gives companies incentives to choose investment allocations that will have a higher rate of return than some of the options that companies have typically chosen, at least as default investment options. In the past, default investment allocations have been quite conservative because employers have been skittish about possible employee lawsuits if the company picks something more aggressive and then the value of those accounts actually fell. So there are a number of things that governments can do and the good news is that things are happening along that dimension as well.

Q: You write about the advantages of 'time-related retirement funds.' How do they work, and how would they benefit working people saving for retirement?

Madrian: The lingo in the industry is actually 'target maturity funds,' and these are funds that are designed for workers who are going to retire at a particular point in time, and they usually come as a set, so there might be the Retire 2010 Fund, the Retire 2020 Fund, and the Retire 2030 Fund, and these are all targeted toward individuals who are going to be retiring in 2010, 2020 or 2030. The idea is that each of these funds has an asset allocation that is appropriate at every point in time for someone who is retiring in the year that's in the name of the fund, and that asset allocation will change over time.

So if I'm in the Retire 2030 Fund, today, since 2030 is a long way away, that particular fund will have a higher equity allocation, but it will also have some exposure to bonds and perhaps a little exposure to money market funds. And as I get closer and closer to retirement, as we get closer and closer to 2030, the underlying investment allocation in that fund will change in a way that is appropriate for the fact that I am getting closer to retirement. So all I have to do is choose a fund once, and over time the investment allocation in that fund will change to meet my needs.

So the big advantage of this type of investment option is that individuals find it easy to understand and I think they find some comfort in believing that the investment allocation is in fact changing over time to meet their needs so that they don't need to revisit their investment allocation every year as market conditions change. Somebody else is already doing that for them.
These funds aren't necessarily the best funds for everyone. The biggest drawback is that they do come with higher management fees, so if you really did know what the best investment allocation was for you, you could probably do just as well on your own because you would save on some of the management fees. But we know that a non-trivial fraction of the population really doesn't feel comfortable making these kinds of decisions and in fact doesn't understand the underlying financial instruments well enough to do a good job, and for these individuals I think funds of that nature have a lot of intuitive appeal and make it not only likely they might do better on the investment allocation front, but also make it likely that they will in fact be saving for retirement earlier because they don't have to tackle these complicated decisions about which investment allocation to choose in order to start saving in the first place.

Q: Do these issues have international relevance?

Madrian: Yes, the issues that I've talked about are not only relevant in the United States, even though a lot of the research I've done is focused on data that is in the United States and in institutions we have here in the United States. These are issues in a number of countries, and a number of countries are actually adopting interesting public policy initiatives on this front. New Zealand has what they call the Kiwi Saver Program, which also uses features like automatic enrollment to try and get individuals saving for retirement. The U.K has been thinking quite seriously about adopting legislation, and also encourages companies to use a number of these approaches to increase retirement savings as well. So I think there are lessons to be learned on the policy domain in lots of different countries and certainly for employers as well, in helping employees better save for retirement.

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