Can Regulatory Clarity Increase Retirement Savings?

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Federal auditor says that more detailed regulation may expand participation in certain retirement programs.

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Stories of America’s retirement savings crisis pepper the news. According to a report released by the National Institute on Retirement Security this year, about 40 million U.S. families have no retirement savings at all. Although few solutions exist for a challenge of this magnitude, nudging people toward savings by switching employees’ retirement savings participation from an opt-in to an opt-out decision – a process known as auto-enrollment – offers one solution to help slow the savings crisis. A recent report by the U.S. Government Accountability Office (GAO) examined whether clarifying auto-enrollment regulations could encourage more employers to adopt the practice, and thus lead to more American workers saving for retirement.

Many employers offer sponsored retirement accounts, commonly referred to as 401(k) plans, in which employees invest a portion of their pre-tax earnings. 401(k) plans are an attractive investment option for employees because total earnings for income tax calculations are reduced by the amount saved in the 401(k) plan and companies often match a percentage of each employee’s savings. The Pension Protection Act of 2006 permitted companies to enroll new workers in 401(k) plans by default, resulting in more workers saving for retirement. This outcome is consistent with behavioral science research indicating that people are more likely to participate in an activity if the choice to participate is made for them.

When employees enroll in savings programs by default, however, employers must invest those savings in a default fund. This exposes employers to risk of legal actions by employees over how retirement savings are invested. The U.S. Department of Labor therefore issued “safe harbor” regulations in 2007, which protect firms from such legal actions so long as the funds are invested in one of three qualified default investment categories and the company complies with certain notification requirements to participants. The combination of express permission under the law and employer protections under the regulations has dramatically increased auto-enrollment: according to a recent study by the investment company Vanguard, the percentage of employers using automatic enrollment increased from just one percent in 2003 to forty percent by 2013.

In light of the growing popularity of auto-enrollment in 401(k) plans, Senator Elizabeth Warren (D-MA) recently asked the GAO, Congress’s independent auditor, to evaluate whether the Labor Department’s safe harbor regulations could be improved to encourage even greater participation. Senator Warren also asked the GAO to report the challenges employers face in complying with the safe harbor regulations.

To address Senator Warren’s questions, the GAO examined industry surveys, questionnaire responses, and market data, and conducted nearly 100 interviews with employers and investment experts. The resulting GAO report revealed several key areas of regulatory uncertainty, which inhibit some firms from making optimal investments on behalf of their employees and may stop other companies from using auto-enrollment at all.

The safe harbor rules identify three categories of permitted investments: target date funds, which assess the investment risk portfolio based upon the individual employee’s anticipated retirement date; balanced funds, which invest based upon mean age of the employee pool; and managed accounts, which account for other factors such as gender and salary. In selecting one of the three default fund categories, current safe harbor regulations require consideration of just one demographic factor: age. The firm can calculate each employee’s age individually, or use the average age of the worker group. Although a 2013 GAO report suggested inclusion of additional demographic factors, the Labor Department, in an attempt to clarify compliance, declined to change the exclusive focus on age.

Despite the Labor Department’s attempt to make compliance with safe harbor regulations more straightforward, the GAO found that some firms still face challenges in selecting qualified investment funds. For example, some companies were unsure which population to consider when making an age assessment, which informs the level of risk an investment fund should tolerate. As a worker gets older, the level of risk in his or her retirement investments should decline. In determining risk calculations, should companies consider the age of current participants only, or combine potential and current participants? Other companies wondered which type of retirement investment fund optimally matched the age distribution of participating employees. Such questions suggest that the Labor Department’s singular focus on age in the safe harbor regulations would benefit from more detailed descriptions of who should be considered and how companies can best calculate age profiles to investment fund types.

In surveys and interviews with the GAO, firms also expressed confusion about whether different categories of default investment vehicles offered more robust legal protection than others. Some employers thought simple investment funds, which are easier for employees to understand, offered the clearest path to compliance with the safe harbor rules. Other companies told GAO that a more complicated design actually correlated to increased legal security. Furthermore, some employers were uncertain about their exposure to potential lawsuits from employees who joined savings programs later in their tenure or those who shifted savings from one retirement account to the sponsored fund. The GAO suggested the Labor Department could expand the safe harbor regulations to specify whether firms are also protected from lawsuits by these workers.

Clarifying Labor Department safe harbor regulations associated with auto-enrollment retirement plans, as the GAO suggested, will not alone rescue the United States from a significant savings deficit. But if the Labor Department works to address some of the confusion firms expressed to the GAO, this may help at least chip away at the larger problem.