Watson Wyatt’s Survey on Default Investments and the DOL’s Proposed Regulations

Automatic enrollment arrangements and the corresponding default investment provisions in defined contribution (DC) plans have been gaining popularity as a way to help more workers save for retirement.

The Pension Protection Act of 2006 eliminates some of the barriers that have discouraged many employers from adopting these arrangements. Watson Wyatt Worldwide recently surveyed Insider subscribers about automatic enrollment, default investments, and loans and other withdrawals from DC plans. The web-based survey also asked respondents about their reactions to the U.S. Department of Labor’s (DOL’s) proposed regulations for qualified default investment funds (see Watson Wyatt Insider, November 2006).

The DOL’s proposal would protect plan fiduciaries who invest plan assets on behalf of participants who fail to choose their own investments, as long as the fiduciary invests the assets in a qualified default investment fund, and meets certain notice and other conditions. The DOL-approved default funds would include the lifecycle or targeted-retirement-date (TRD) funds, balanced funds and professionally managed account funds.

Plan fiduciaries would still have to prudently select and monitor the default fund under their plans.

The survey uncovered several interesting surprises. Probably the biggest surprise concerns the DOL’s proposed regulations. Almost half of respondents would have to change their default investment fund to receive protection, because most have a stable-value or money-market fund as their default investment fund.

One-third of the respondents already have automatic enrollment, and more than half of those who don’t are thinking about it. The survey respondents cite the high cost of the employer match and legal liability as the two main barriers to adopting automatic enrollment.

A majority believe that plan loans and other withdrawals from their DC plans are significantly affecting participants’ asset accumulations and the cost of plan administration.

Lastly, most respondents (94 percent) have a default investment fund, primarily for participants who fail to select a fund and for automatic enrollment.

Respondents’ DC Plans and Other Pension Benefits

The number of fund options in these primary DC plans varies widely; the median number of offerings is 15 and the average 23. The first and third quartiles of the number of available funds are 10 and 20, respectively. The investment options most commonly offered in respondents’ DC plans from among choices listed in the questionnaire are stable-value funds, balanced funds and lifecycle or TRD funds (see Table 1).

Table 1 | Percentage of Respondents Offering Each Fund Type in DC Plan

Roughly 60 percent of responding firms offer active defined benefit (DB) plans along with their DC plans.

Significance of Withdrawals From DC Plans

We looked into whether these firms believed that withdrawals and cash-outs from their DC plans were significantly affecting either plan administration or asset accumulation (Table 2). Most withdrawals are in the form of loans to employees or withdrawals when employees terminate before retirement.

Table 2 | Percentage of Firms Reporting Outflows as Moderately or Very Significant for Plan Administration and Asset Accumulation

Automatic Enrollment

One-third of responding companies have automatic enrollment in their DC plan either for all employees or for new hires only. However, 57 percent of the remaining respondents say they are considering automatic enrollment arrangements. Of the firms that offer an active DB plan, 5 percent have automatic enrollment for all employees and 25 percent have automatic enrollment for new hires only in the primary DC plan.

Survey respondents cited two primary reasons for not having automatic enrollment: the cost of the employer match (26 percent) and legal liability (21 percent). Various other reasons and the accompanying percentages are listed in Table 3.

Table 3 | Reasons for Not Having Automatic Enrollment

Many respondents wrote explanations of other reasons for not having automatic enrollment, including high turnover, resistance from unions, system limitations, safe-harbor contributions, already high participation rates and lack of buy-in from senior management.

Default Investment Funds

Ninety-four percent of responding companies have a default investment fund for their DC plan. The main reasons for having default investment funds are for employee non-selections, followed by automatic enrollment and rollovers (see Table 4).

Table 4 | Reasons for Having Default Investment Funds

The three top default funds are the lifecycle fund, the stable-value fund and the money- market fund, with the lifecycle the most popular choice at 38 percent (see Table 5).

Table 5 | Default Investment Funds

We investigated whether certain default funds were more likely to be used for certain purposes. We specifically looked for a link between the stated reason for having a default fund and the use of an equity-based fund. We found that firms that use default investments for automatic enrollment are much more likely to offer an equity-based fund — the lifecycle and balanced funds — than those that use default investments for other purposes. Table 6 shows the correspondence between the reason companies use default investments and their use of equity-based funds.

Table 6 | Percentage of Firms With Equity-Based Funds and Reason for Using Default Investments

We also asked respondents whose companies have a risk-based or age-based asset allocation whether they use a prepackaged mutual fund or create their own fund from the current core lineup. Of the approximately half of responding firms with an asset-allocation fund, 75 percent have a prepackaged mutual fund and 25 percent have a core lineup.

Views on Proposed DOL Regulations

Under the DOL’s proposal, lifecycle or TRD funds, balanced funds and professionally managed account funds would be qualified default investment alternatives (QDIAs). By contrast, stable-value and money-market funds would not be given relief from legal liability by the proposed regulation. Roughly 53 percent of respondents are considering changes to their default fund option because of the DOL’s proposed regulations. In their current form, the rules would cause almost half (48 percent) of surveyed firms to change their default fund.

Roughly 94 percent of respondents feel somewhat or very positive about the lifecycle or TRD fund as an appropriate default investment fund. However, only 60 percent are somewhat or very positive about a balanced fund as an appropriate default investment fund, and only 39 percent think a professionally managed account is appropriate.

When asked to rank the attractiveness of the three default funds, most respondents ranked the lifecycle or TRD fund first, the balanced fund second and the professionally managed fund third.

Respondents expressed a range of opinions about the appropriateness of stable-value and money-market funds as default investments. More than one-third of respondents are moderately or very interested in a stable-value fund as a default investment. Eighteen percent of respondents are moderately or very interested in having a money-market fund as a default investment. Of respondents that currently use a stable-value fund as a default investment, 64 percent are moderately or very interested in keeping it. Similarly, of respondents that currently have a money-market fund as a default investment fund, 53 percent are moderately or very interested in a money-market fund as a default investment.

Interestingly, among responding firms whose primary DC plans have significant asset outflows, 38 percent are moderately or very interested in the stable-value fund as an additional QDIA, compared with 30 percent of companies with little or no asset outflows. Similarly, 20 percent of firms that have significant asset outflows from their primary DC plan are moderately or very interested in money-market funds as an additional QDIA, compared with 16 percent of firms that have little or no significant outflows.

We also asked respondents what they would do with their current default fund if the DOL regulations are passed as proposed. Almost half of them said they would keep the money in the current default fund. However, 27 percent would make changes as necessary to comply with the guidance.

Survey respondents expect these proposed changes to be good for their workforce overall. A majority of respondents think the effects would be positive for lower-paid (58 percent) and moderately paid (54 percent) employees, but only 27 percent of respondents believe the proposed regulations would have a somewhat positive or very positive effect on highly paid employees. This may be because most higher-paid employees tend to make their own investment choices and so won’t be much affected by default investments.

Many survey respondents remain concerned about costs and administrative burdens.

Most respondents believe that the proposed regulations would affect men and women similarly. Roughly 46 percent believe that the DOL’s proposal would be somewhat or very beneficial to employees with short tenure. However, a larger percentage — 68 percent of respondents — think the effects on long-term employees would be neutral. Only 19 percent expect the proposed regulations to have a somewhat or very positive effect on long-tenured employees. This may be because long-term workers have received more performance reports and so tend to be more aware of investment performance.

Survey Implications

This survey has several interesting implications. First, although many survey respondents are considering automatic enrollments for their DC plans, they remain concerned about costs and administrative burdens.

Second, DC plans with automatic enrollment mainly use equity-based funds for their default investments. DC plans that do not use equity-based default investment funds generally use stable-value and money-market funds as default funds for purposes such as employee non- selections and rollovers.

Third, a majority of plan sponsors would have to change their default funds in their DC plans to comply with the proposed regulations; and of the funds favored by the DOL, most respondents prefer the lifecycle funds. A significant minority would consider keeping stable-value and money-market funds as their default fund if allowed by the rules.

Sponsors considering automatic 401(k) plans with equity-based default investments might want to think about eliminating loans and in-service distributions.

Finally, because asset outflows are significant in many DC plans, sponsors that are considering truly “automatic” 401(k) plans with equity-based default investments might want to think about eliminating loans and in-service distributions. These features would no longer be needed to encourage enrollment among lower-paid employees, and removing them would lighten administrative burdens on plan sponsors and keep asset accumulations intact.

About the Survey

There were 95 survey responses, all from either benefits managers or benefits directors. Respondents are not necessarily representative of all sponsors of DC plans, but rather tend to be those with a strong interest in automatic enrollment, default investment funds and the DOL’s proposed regulations.

Of the 95 responding organizations, 89 percent sponsor a 401(k) plan and 5 percent sponsor a 403(b) plan. The rest offer combinations of different plan types, such as a 401(k) plan with an employee stock ownership plan (ESOP) feature.

Most of the responding firms are in the manufacturing or mining industry, followed by the services industry, and then the finance, insurance and real estate (FIRE) industry. Table 7 shows the industry breakdown among respondents.

Table 7 | Percentage of Firms in Industry Categories

Firm size and plan assets vary widely. Survey respondents employ roughly 1.5 million full-time employees, with the average number of full-time workers about 16,000. The smallest firm employs 50 full-time workers, and the largest firm employs 200,000 full-time workers. Assets in these primary DC plans total approximately $96 billion, with the average asset value roughly $1 billion.

Roughly 1.2 million employees are eligible for the primary DC plans sponsored by respondents, and the average number of eligible workers per responding firm is about 14,000.

Participation in the primary DC plan varies widely among respondents’ companies. The survey represents approximately 900,000 participants, and the average number of participants per plan is roughly 10,000. On average, 75 percent of eligible workers participate in the DC plan. The first- and third-quartile percentages of eligible participating workers are 67 percent and 88 percent, respectively.