Tuesday, June 16, 2015

Filling The Gap: 401(k) / 403(b) Architecture to Enhance Savings

Early in a career, an employee can often be laissez-faire about the benefits that a company offers. The various add-ons are not really noted. These benefits are wide ranging, ands provide both extra compensation and protection for the employee. The top line number on the salary is easy to focus on, but health insurance, paid leave, long-term and short term disability, and life insurance are all part of a comprehensive benefit plan. These are not entirely benefits for the employee. The employer benefits by having a present and healthy workforce. The various benefits aid in that manner. They also can be used as positives. In their textbook “Human Resources Management,” Robert Mathis and John Jackson point out that these benefits are not just costs, but that they can help keep an organization competitive in recruitment and as a competitive advantage in competition, as employees with better benefits have been found to have higher job satisfaction and thus better outcomes (p. 427). As strong and varied benefit package also help the organization by keeping the best employees around, even if they do not necessarily use them. The authors further note that benefits have the advantage of often being untaxed as income to employees (p. 429). So that the marginal return in terms of utility is enjoyed more on a dollar spent on more salary.  
Problem Statement - What Challenges in Organizational Design Exist in This Business
Politicians from both sides of the aisle have been raising alarm bells about the coming insolvency crisis of the Social Security trust fund for a long time. The last major changes in the program came thirty years ago, and it has been a political football ever since. The Social Security Administration estimates that at current rates, the trust fund will be depleted by 2037. At that point the funds for social security will no longer be paid out of the trust fund, but will come from incoming taxation. The inflows are expected to be lower than the outflows, so this means that payments after that date will be at 76% of the expected amount. Thus the SSA is calling for either slightly lower benefits now or a raise in taxes to plug that shortfall (Future financial status). If this doomsday scenario happens or not, Social Security was not fully formulated to replace all of a household’s income. The exact amount of income social security replaces varies, but for the median family, it is just a little over a half of the last year’s income (income replacement). The good news is that there are costs associated with with work that can be avoided by being retired. A worker has added food and transportation costs. In retirement many people after long careers should have reduced housing costs as well. When all the costs are considered, only eighty percent of the previous income is calculated as necessary for retirement. Eighty percent needed with fifty percent filled by Social Security creates a gap of thirty percent of the former take home pay. The question then becomes how do you fill that gap.
Traditionally, one way to fill that gap has been through private pensions. At their height, thirty-five percent of private sector Americans were working under a defined benefit pension plan. For better or worse, that number has almost halved in the last two decades, where now only eighteen percent of private workers have some defined benefit coverage. Because of traditional working patterns where one spouse worked outside of the home in the workforce, while another stayed home in domestic toil, there are still thirty one percent of households that are covered by pensions (pension coverage). There are still sectors where pensions are still extant, but they face pressures of their own. Currently pensions are found amongst government workers at a much higher rate with seventy-eight percent of government workers covered. This has created  a disconnect between government workers who are funded by the taxpayers. The taxpayers see the government workers enjoying a benefit that the private workers do not get to enjoy, so the easy response is that they government workers should not continue to enjoy those benefits. The reasons that the private sector scaled back on pensions is complicated and has political and social correlates with the decline of unions and the rise of globalization, but the bottom line is that from a business perspective pensions are long term, open-ended liabilities. For a business to be competitive currently, it needs to operate leaner, and that means having long term, open-ended liabilities on the books is not optimal. Though proper benefit design is a competitive advantage in attracting and retaining talented staff, there are other competitive pressures that predominate, and the general trend is to do away with private defined benefit pensions.
With Social Security perhaps dropping what it pays the average retiree along with the diminishing of defined benefit pensions, what has to replace the thirty percent gap between what Social Security replaces and what is needed to live a comfortable life then has to come from the employee's own savings. Thankfully, the federal government has created ways so that employees can save money and be incentivized with tax favors. 401(k)’s and related plans for nonprofits were set up so that savings could be put into various funds and then grow tax free until they were pulled out of the funds for use in retirement. This means that taxes can be deferred, and taxes will be paid at a lower rate as it is assumed that the tax rate when the monies are pulled out will be lower than the rate that exists when the employee is working. There is a secondary benefit in adding money to a 401(k) in that employee contributions lower taxable income, so the employee has lower taxes. There are limits to how much can be contributed. In 2015, the limit is $18,000, which is almost a third of the median household income (Tax Information). 401(k)’s as of right now are the most efficient vehicle for employees to use to save their money to make up that gap. There exist other retirement plans, such as a Roth IRA which uses taxed funds and are allowed to grow untaxed. These are also subject to limits, and are not an option at upper income levels. For the majority of the middle class, the 401(k) is where it is at.
The problem is that not enough people are saving enough money to fill that gap in retirement. If a saver took that $18,000 limit and put that much away every year for a thirty-year career, they would have put away a nominal $540,000, which would appreciate nicely barring some untimely rift in the global economy and markets. If that was just put in a money market fund with no growth, it would allow an income stream of $21,600 a year if withdrawn at the commonly accepted rule of thumb to withdraw only four percent of your savings a year. This is more than the gap, and an employee who saved along these lines would be in line for a comfortable retirement
The problem is that most people are not saving for retirement at anywhere the rate that would allow a comfortable retirement. Younger workers see retirement as far off, and there are always bills that need to be paid first, from student loans to housing costs to bringing children into the world and all of those associated cost. What young are missing out on is the potential for great growth in whatever money is out aside. To retire with half a million dollars which will be needed to make up the gap between what is needed and what Social Security can provide, it is much cheaper in dollars to start early than it is when older. Using the shorthand of the rule of 72, where you divide 72 by the assumed fixed growth to see how fast it will take for the money to double, any saving done by the time a worker hits thirty will double three times before their retirement using the long term trend in the S&P index of 6.5% growth (real returns). The reality is that very few people are making contributions to their retirement plans that will allow them to take advantage of the seeming magic of compounding growth. The reality is much more grim. Social Security will be around in some form, but with the decline of pensions, personal savings is what will support people in their retirement, a period of life that is increasing with every generation with better medical care to enhance longevity. The General Accounting Office (GAO) of the federal government did a recent survey that shows just how unprepared most people are for retirement. The GAO looked specifically at people who are close to retirement and how ready they were for the coming life change. They found that 29 percent of people in the cohort of people from 55 to 65 had exactly no retirement savings. For those that did, the median amount was just $104,000 (Retirement Crisis). As seen earlier, this will not be enough to fill the gap between social security and the amount needed. That is why the GAO also looked at other studies about future retirement insecurity, and determined that somewhere between a third and two thirds of retirees will not have the resources to live a comfortable life (Retirement Crisis). Many people further infer that that they will be able to work past the traditional retirement age to shield themselves from this crisis on a personal level, but these plans are often thwarted because people end up having to drop out of the workforce for a myriad of issues that were not foreseen.

Literature Review
If the problem is that the average person will not have enough resources in retirement, then the answer is that more resources should be allocated to the worker in retirement. There are three possible sources. First is the government, which could allocate more resources to the retired, through raising the taxes for Social Security, or raising the cap on money that is taxable for Social Security purposes, currently at $118,500. With the gridlock in Washington, the SSA will advocate for some of these changes, but their implementation remains an unknown. The second source would be from the employer of the retiree, but as seen earlier, these defined benefit plans are receding from common use, not increasing. So that leaves the retiree as the source of the retiree’s resources that will fill in the gap.
The question is how do you get people to save money when it is clearly in their long term interest, but it is still something that does not happen. Here is where insights from behavioral economics can come into play. The field looks at how people interact economically in real world situations. This approach runs counter to a more traditional view of economics where the economic actor is a self-maximizing, rational character. Behavioral economics asks the question “What if people aren’t rational”. It is still contentious in some circles, but it has had some useful applications at the micro level. Richard Thaler is one of the founders of the field, and in his new book “Misbehaving,” he talks of the application of behavioral economics to making people save money. His view is that signing up is complicated, and most people will not sign up for something that is complicated. Evert friction put in place makes people less likely to do something, even if that thing is in their best interest (Thaler 312). So one of the big insight of behavioral economics is about setting the defaults so that people are forced into the choice that is best for them, this choice architecture has entered the language by the title of one of Thaler’s previously co-written books. It is a nudge. Through nudging, whoever is making the default can make it so that the default is the best option. As Thaler puts it: “Why not make joining the plan the default and tell people that if they do not opt out, they will be enrolled in the plan at some default savings rate and in some default investment product?” (312). The opt out is important because it still allows the employee choice in the matter. If they really do not want to save any money for retirement for whatever reason, they have the choice to do so. There are critics of nudging who say that nudging is paternalism and limits options, but the opt out clause leaves saving up to the individual.
The lack of savings is just not an issue to look at at the higher levels. Each organization in their human resource departments have to make choices about benefit design that will balance the available resources and what is necessary to attract and retain talent. Making sure that their people do what is best for them is in the long term interest of every organization. My organization is no different. We have health and life insurance and disability and worker’s comp, we have twelve holidays and more vacation and sick days than you can use accumulate. The problem is that as an organization, we are not saving enough. CSS provides services to the developmentally disabled in the western suburbs of Chicago. There are approximately 150 hourly staff who provide front-line services for the individuals we serve. We also have 56 benefits-eligible employees who work in our administrative offices and other full time workers.
There are two proximate causes to our own lack of savings. First of all, we work in the nonprofit sector, which offers fewer extrinsic rewards to employees in the sector, which are balanced in part by the intrinsic reward of doing well in the community. More bluntly, the pay is not what it is in the private sector. Paychecks are stretched The second cause is that we have to opt into the retirement plan, here a 403(b) because of our nonprofit status. The default is structured so that you have to fill in these forms and there are enough people who end up not putting anything aside in spite of the tax-sheltered nature of the plan, and also in spite of the matching, which is half of what the employee puts aside up to four percent. This default means that of the 56 eligible employees who could put their money aside, only 30 do so. Of that thirty, only 12 people save more than what they need to do to get full matching, which is four percent. That means that as a whole, we are not saving enough.
A couple of ways exist to improve the amount of money we save as individuals at the agency. First, there could be better outreach and education from the HR and Finance Departments to individual employees about the need for retirement savings and a recommended level of savings. This could work so that every employee would make an educated choice about their savings rate and their plans that they allocate their money too, which is a separate discussion to be had once you just get people putting money back for retirement. A related option would be to seperate the retirement discussion from where it is now. Currently, we now have to make decisions about all the various benefits that we have options for at one meeting in October. It is overwhelming, and when people have too much cognitive load they will reach for the safe and easy choice to make. Isolating the decisions so that they can be focused on would allow the individual decision to be the center of the employee’s attention, and thus would be able to benefit from deep concentrated thought from the employee. From an organizational perspective, however, doing everything all at once is more efficient in that you do not have to pull all the employees away from their productive duties for administrative tasks, no matter how important. The third option would be changing the defaults. If currently only about half of the employees are taking advantage of the retirement plan and two thirds of those people are sticking right at the default, then the defaults are off.
Recommendation - what are the solutions and state the benefit of this course of action
The current structure of the retirement benefit at CSS is that for eligible employees, the company will match fifty percent of your first four percent of savings if you opt-in. These defaults have resulted in under-saving by our employees, and they need to be changed. The easy thing to say is that there should be greater maching, so that it was dollar-for-dollar up the a set amount. Unfortunately, we operate in an industry that generates a lot of its funding from governmental bodies, and governmental bodies are at the point in the political cycle where they are not freeing up extra funds for their partner agencies. There is a marked constraint on the agency’s resources, but still the need exists to incentivize employee savings. The thing to do is change the defaults. First off, change the enrollment from an opt-in to an opt-out structure. That means that the half of the people who are not enrolled would now be part of the plan, barring disenrollment. Secondly, change the matching. It may sound less generous, but matching a smaller percentage of the employee contribution would mean that employees would have to contribute more to themselves in the future to ensure that they received the full match from the organization. A simple proposal would be to match only twenty five percent of the employee contribution up to eight percent of the employee’s salary. That means that in real terms the agency would not have to contribute any more to the employee than they already are, but instead of the sum of savings being six percent of the employees’s salary, it would be ten percent. Set that as the default and then you would help the employees have a more secure. There is also the added benefit that humans love nice round numbers. One final consideration exists in designing this nudge. People do not like seeing their take-home pay decreased, so to make sure the most people take this up as possible, it has to be phased in gradually. The increased withholding should be timed to pay increases, so that the employee will see their take home increase at the same time they are increasing their own contribution. Otherwise, people would see their pay decrease in the here and now, and might take the opt-out option to stiff their future selves.


Thaler, R. (2015). Misbehaving. New York, New York: Norton

Mathis, R., & Jackson, J. (2011). Human resource management (13th ed.). Mason, OH: Thomson/South-western.

People Have No Savings:

Fall of Defined Benefit Plans:

Income Replacement:

IRS Tax Information:


Equity returns: