Building Toward a Better Retirement: Choice Architecture and Plan Participants

Overwhelming. That’s normally the first response plan participants give as to why they didn’t start saving for retirement. HR professionals and retirement consultants have heard it before, “Too many options; too many decisions; I wasn’t sure what these words even meant.” Effectively helping plan participants prepare for retirement takes designing the message in a different way.

Choice architecture is a term used to describe how decisions can be influenced by the layout, order, and variety of the choices presented. This concept can be used to help steer retirement plan participants into better decision-making. Plan sponsors can use choice architecture to their advantage by improving how participants’ choices are presented and by using smart default options.

An important first step is to consider what obstacles often prevent employees from joining a plan or increasing their savings. A white paper from Wells Fargo, Driving Plan Health says, “Knowing which plan features, communications, and digital tools are designed to address these various psychological barriers is an important first step and can help guide the selection of which features and tools to use.”[1] The plans that have solved for these types of problems, leveraging design elements, usually produce the best retirement outcomes for their employees.

Make their first choice automatic

Automatic enrollment and annual re-enrollment can be used to overcome inertia of participants by automatically putting them into the plan when they first become eligible. The participants must take action to opt out if they do not want to participate; this often results in much higher 401(k) participation rates than plans which don’t use automatic enrollment.

Retirement outcomes for participants can be further improved by implementing automatic deferral increases. This helps those participants who do not take initiative in managing their savings.

Finally, qualified default investment alternatives (QDIA) can be tailored to meet the needs and investment styles of different workforces. Offering QDIAs allows participants to accumulate far greater savings in the form of investment earnings than if they left their funds in cash or a stable return fund. In the article, Choice Architecture and Participant Investment Decisions, Vanguard notes, “Sponsors seeking to change behaviors of longer-tenured participants may wish to consider reenrollment into a low-cost default option, as that is one way to counteract the profound inertia influencing longer-tenured participants’ investment holdings.”[2]

Incentivize their saving goals

Once enrolled, there are many choices participants must make. How those choices are presented to them can make a huge difference in long-term savings. For example, the Save More Tomorrow program gives participants a nudge to save more by having them establish their own future defaults today. The defaults selected happen automatically in the future when a raise occurs, so the participant never has a decrease in take-home pay.[3]

Another common way to incentivize participants to save more is to offer employer matching or profit sharing contributions that are tied to their 401(k) deferral rates—the more they defer, the more the employer gives them.

There are always some participants who select their investments when they first enroll and never touch them again. Auto-rebalancing can be used to return the accounts to their intended asset allocation, often increasing returns and keeping risk in check.

Smart design leads to smart decisions

An article by Voya suggests using a Reflective Index to help apply choice architecture to the plan. It is possible to automate the determination of a participant’s decision-making style. The Reflection Index evaluates participants on three decision-making style indicators: attention, information gathering, and making tradeoffs. The assessment gives insight into how participants in different plans are making decisions. Voya states, “By leveraging the insights of behavioral science and the data of the digital world, we can tailor our suggested ‘course corrections’.”[4] Plan sponsors can use the index to help them make plan design decisions. For instance, plans where more participants are characterized by a reflective decision-making process should encourage their participants to re-evaluate their elections based on additional personalized information; whereas re-enrollment might be a better solution for plans if most participants are characterized by an instinctive decision-making process. “By making it easier for their participants to make the right decision, we can offer them another chance at a successful retirement.”[5]

Something we may not think of as affecting a participant’s retirement plan choices is the website design. Participants’ interactions on websites can be tracked; then small changes can be made to lead participants to better choices. Simple changes to implement might include locating relevant plan information where the participant is being prompted to make a choice, making the language of enrollment options as simple as possible, or using a “traffic light” color design to guide choices.

One size doesn’t fit all when it comes to participant communication. Tailor the plan’s communications to have language and information designed for your workforce. This will help grab the participant’s interest and improve the communication’s overall effectiveness.

Saving to and through retirement

Choice architecture can be used not only to optimize auto features but also to help eliminate the loss of funds. Retirement Clearinghouse has recently developed a program which helps participants keep track of their retirement funds as they move from job to job. For smaller account balances, which might otherwise get cashed out or rolled to an IRA by default, this program captures and tracks these assets by moving terminated participants’ account balances with them to their new employer’s plan—all by default.[6]

Another way savings can be preserved is by limiting opportunities to withdraw from the plan through loans, hardship withdrawals, in-service or termination cash outs.

Finally, choice architecture can even influence the age at which a participant might begin to draw down their savings. Using a “consider the future first” checklist of eight reasons to claim benefits later, The TIAA Institute encourages some participants to delay claiming their benefits for up to 18 months.[7]

In perspective

Whether a participant logs in once and makes a single choice or is making a lifetime of choices, there are many ways employers can use choice architecture to assist all types of decision-makers when they do engage. Understanding your employees and tailoring the approach can help them make the best decision–ultimately improving retirement readiness.

Questions? Contact the Findley consultant you normally work with or Laura Hohwald at Laura.Howald@findley.com or 615.665.5349.


[1] “2018 Driving Plan Health.” Wells Fargo, 2018. Accessed January 2019.

[2] Pagliaro, Cynthia, and Stephen Utkus. “Choice Architecture and Participant Investment Decisions.” The Vanguard Group, May 2018. Accessed January 2019. www.oecd.org/els/health-systems/Obesity-Update-2017.pdf.

[3] Thaler, Richard, and Shlomo Benartzi. “Save More Tomorrow™: Using Behavioral Economics to Increase Employee Saving.” American Journal of Education, Feb. 2004. Accessed January 2019. www.journals.uchicago.edu/doi/abs/10.1086/380085?journalCode=jp.

[4] Benartzi, Shlomo. “Using Decision Styles to Improve Financial Outcomes.” Voya. 2019. Accessed January 2019. www.voya.com/behavioralfinance.  

[5] Ibid.

[6] “Moving Retirement Forward.” Retirement Clearinghouse. January 2019. Accessed January 2019. https://rch1.com/.

[7] Johnson, Eric, Kirstin Appelt, Melissa Knoll, and Jon Westfall. “Preference Checklists: Selective and Effective Choice Architecture for Retirement Decisions.” TIAA Institute. June 2016. Accessed January 2019. https://www.tiaainstitute.org/sites/default/files/presentations/2017-02/ti_selective_effective_choice_architecture_for_retirement_decisions.pdf.

Posted on March 13, 2019

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Tax Reform and Retirement Savings

In the fourth quarter of 2017, as the Republican Congress and the Trump Administration resolutely pushed forward with tax reform legislation proposals, many people associated with the 401(k) and retirement industry were justifiably concerned. Oftentimes in the past when Congress has moved to “reform” the Internal Revenue Code the result has negatively affected retirement savings programs. In particular, 401(k) plans have often been used as a means to offset tax cuts that benefited taxpayers in other sections of the Code, and it seemed that this might be happening again. Indeed, during the 2017 tax reform discussion, concepts such as reducing the 401(k) deferral limit, freezing the annual cost-of-living adjustments, and something called Rothification were advanced as revenue-raising ideas. Rothification is an all-inclusive term that covered a number of proposals that would have compelled the conversion of some or all defined contribution plan contributions to Roth-type arrangements, thereby accelerating the taxation of those contributions.

Ultimately the Tax Cuts and Jobs Act of 2017 (TCJA) left retirement savings policy pretty much unchanged, but this is not to say that the recent tax bill will not affect retirement savings. While there are a few minor direct changes to retirement plan rules, the most significant impact this bill is likely to have will be the indirect effect of corporate and individual tax rate reductions on retirement savings and investment earnings.

Direct Changes in the Code

The only change made by TCJA that directly affects corporate retirement plans is an amendment to extend the rollover period for participants with loan proceeds that were reported as a taxable distribution due to (1) the participant’s separation from service or (2) the plan’s termination. Previously participants had only the standard 60-day rollover period from the date of the loan default to complete a rollover and avoid immediate taxation and penalties; this change gives participants until the due date of their tax return (including extensions) to complete a rollover. Plan sponsors will likely want to review all plan communications and the special tax notice as it pertains to this change.

It is also worth mentioning that although the original House tax bill included a number of changes to 401(k) hardship withdrawal rules that did not make it into the final version of TCJA signed by President Trump, some of those provisions did enter the Code as part of the Bi-Partisan Budget Act of 2018. These changes to the hardship withdrawal rules include the following three items:

  • Effective for plan years beginning after December 31, 2018, the IRS requirement that participants be precluded from making salary deferral contributions for six months following the receipt of a hardship withdrawal is eliminated.
  • Effective for plan years beginning after December 31, 2017, the requirement that plan participants take advantage of available plan loans before qualifying for a hardship withdrawal has been eliminated.
  • Effective for plan years beginning after December 31, 2017, the types of benefit accruals eligible for a hardship withdrawal have been expanded to include qualified nonelective contributions (QNECs), qualified matching contributions (QMACs), and earnings on these contributions.

Impact of Tax Rates on Savings and Investments

As mentioned above, the biggest impact that the TCJA is likely to have on retirement savings is the effect of the reduction in individual and corporate tax rates. Whether this is a good thing or a bad thing depends on the individual taxpayer’s situation.

It is also worth mentioning that although it was discussed, the TCJA did not ultimately change the tax rate on investment income. A change in the tax rate on investment income and the value of saving in a retirement plan move in tandem. Simply stated, if the capital gains tax rates increases, then the value of saving within a retirement plan increases as a means of avoiding that additional tax. Conversely, if the tax on investment income decreases, then the value of saving within a retirement plan also decreases.

Impact of individual tax reduction

Tax-qualified retirement savings plans, except for Roth-type arrangements, are primarily tax-deferral vehicles. This means that any change in ordinary tax rates will affect the value of the tax deferral; however, the effect will not be the same for every 401(k) saver. Contributions made by or on behalf of an individual taxpayer to a tax-qualified retirement savings plan (except for Roth contributions) are excluded from taxable income when they are made. These contributions also accumulate earnings on a tax-free basis, but the earnings are taxed as ordinary income when distributed.

There are a few things that can be gleaned from this tax treatment if you want to think about your own 401(k) participation. If your tax rate decreases, then

  • the value of pretax contributions to your 401(k) plan decreases
  • the value of the tax deferral on earnings within the tax-qualified plan decreases
  • a Roth contribution may be more attractive as the up-front taxation is at a lower rate

A big part of the evaluation of how tax rates affect savings within a tax-qualified plan is dependent on what your tax rate will be when you take a distribution. Hint—you want your tax rate to be lower when you take the money out unless you had chosen the Roth contribution option, which is not taxed when distributed.

Impact of corporate tax rate reduction

While the corporate tax rate deduction under TCJA is significant for many corporate entities, its impact on retirement savings plans is not something that can be clearly substantiated. In theory, when the top end corporate income tax rate drops from 35 percent to 21 percent, the affected corporations should become more valuable, stock prices should increase, the value of mutual funds holding those shares should increase, and all of this should be reflected in the future investment earnings of retirement savings plans. But of course, anticipating investment earnings is more complicated than that.

Another aspect of lower corporate income tax rates is that they may encourage more businesses to incorporate. The possible implication is that business owners may decide that it is more beneficial to invest in their businesses rather than their retirement savings plan.

Impact of 20 percent pass-through deduction for qualified business income

One thing that the TCJA does to attempt to even out the competitive impact of the deep cuts to corporate income tax rates (as compared to the more modest individual tax rate reductions) is to provide a new type of tax deduction for pass-through qualified business income to sole-proprietors, partnerships, and S-Corporations. The deduction can be as high as 20 percent of a business’s pass-through income; however, the details can make the actual deduction calculation extremely complicated. While the details are beyond the scope of this article, generally the amount of the deduction will vary based on factors such as the nature of the business’s activity, whether it pays wages, and the total income of its owner. In some cases, this pass-through deduction may create a disincentive for a small business to fund a tax-qualified retirement savings plan. Business owners who can take advantage of this pass-through deduction may choose not to put money into a retirement plan because they do not get the 20 percent deduction on plan contributions. Additionally, any plan distributions are taxed at ordinary rates with no 20 percent deduction.

Conclusion

Although many changes were discussed in the buildup to passing the Tax Cuts and Jobs Act of 2017, in the end, retirement savings plans are basically left unchanged. Because tax-qualified retirement savings plans are, at their core, nothing more than income tax deferral vehicles, any change in tax rates will affect how these plans are used. It will be interesting to see how businesses respond to the new rules of the tax game.

Questions? Contact the Findley consultant you normally work with or contact John Lucas at john.lucas@findley.com, 615.665.5329.

Posted July 24, 2018

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