How adding automatic features can improve your defined contributions pension plan’s design
New guidance issued last November by Ontario’s Financial Services Regulatory Authority (FSRA) clarified the regulator’s interpretation concerning automatic features in defined contribution pension plans. According to FSRA, neither the Pension Benefits Act (PBA) nor its regulations prohibit the use of automatic features. As far as pension plans registered in Quebec go, automatic features are not formally prohibited. However, Quebec legislation does apply certain restrictions in terms of the design of these features. It is therefore preferable to validate with Retraite Québec that any such feature is acceptable to the regulator before it is implemented.
Why make use of automatic mechanisms?
Though we might like to think that people will act rationally and make appropriate decisions concerning their savings, in reality this isn’t always the case. People exhibit several behavioural biases that affect their decisions regarding consumption and, in turn, their savings. This reality, coupled with low financial knowledge in certain sectors, has demonstrated that a large proportion of workers cannot make the necessary decisions over time that allow them to accumulate sufficient retirement savings. In order to counter these biases and low financial knowledge, automatic mechanisms can supplement other available means, such as financial incentives and the simplification of decisions to encourage people to enhance their retirement savings. The combination of these mechanisms aims to boost a defined contribution pension plan’s performance and improve the savings for members of the plan.
What is an automatic feature in a defined contribution pension plan?
In a defined contribution pension plan, several decisions can be left up to plan members. Automatic features attempt to counter plan members’ natural inertia by acting automatically in the members’ best interests, making a positive default choice on the member’s behalf. The ultimate decision remains up each member to make and a member can, after the fact, re-establish the status that applied before the automatic feature kicked in. The most well-known automatic features include auto-enrollment, automatic contribution increases and the default choice of investment options.
Auto-enrolment is frequently used in certain countries such as the U.K. and U.S. when plan participation is voluntary and mandatory participation is not allowed. In the U.S., studies show an increase of 35% to 67% in participation rates in pension plans that use auto-enrolment relative to entirely voluntary opt-in arrangements1. This is true despite the application of various enrolment criteria, such as a minimum and maximum age or a minimum salary rate that can limit the impact of an auto-enrolment feature. Auto-enrolment can apply only once a member fulfills set eligibility criteria or, possibly, apply a second time after a set period of time following an eligible member’s withdrawal from plan participation. This second enrolment allows potential members to reconsider their decision in light of the evolution of their financial situation.
Even when members have the ability to withdraw from a pension plan, their natural inertia makes the vast majority of them remain enrolled in the pan. Incentives can also be put in place to counter the available withdrawal option. Financial incentives such as low levels of required contributions in the first few years of participation and matching employer contributions help support participation rates. Not only does auto-enrolment increase plan participation, but several international experiments demonstrate that very few voluntary withdrawals follow auto-enrolment. In New Zealand, 16% of all employees enrolled automatically in the state-sponsored « KiwiSaver» plan2 had opted out and remained out as of June 2018 and, in the United Kingdom, around 10% of people currently opt out of their workplace pension plan.
An automatic increase to contribution rates is also an effective means to help workers enhance their retirement savings. Whether enrolment to a pension plan is fully voluntary or auto-enrolment is in place, setting initial contribution rates too high can increase the chance that certain workers opt out altogether or withdraw from participation during the grace period following automatic enrolment. A lower initial rate, together with gradual automatic increases, can help achieve adequate levels of savings even though contributions are lower in the first few years. In order to limit the impact on available income, such automatic increases can be made to coincide with members’ scheduled salary increases. Just like for auto-enrolment, a pension plan can allow a member to maintain the present level of contribution and cancel the automatic increase if desired. It would also be possible to set out two options right at enrolment time: one where the member begins contributions at the highest rate allowed under the terms of the plan, and another that starts at a lower rate but schedules automatic increases, without allowing the choice for contributions to remain at the lower rate.
The most broadly used automatic feature is the choice of a default investment option. Many defined contribution pension plans have modified their default investment option, going from a (very conservative) money market fund to a lifecycle-type fund, precisely because experience has shown that members often remain invested in the fund they were assigned by default. The nature of lifecycle funds, which automatically modifies asset allocation over time, is itself a good example of a benevolent automatic feature.
Finally, when a pension plan adopts automatic mechanisms, they can be useful to capitalize on « triggering » events to communicate more effectively with plan members - for example, during a second enrolment period or when an automatic contribution increase occurs, more targeted and personalized information has a better chance of achieving its objective than more general annual communications.
Simplifying the process
The more complex the process from the workers’ point of view, or the larger the number of decisions required, the more they tend to postpone or avoid having to make these decisions. In light of this, not only should the information communicated to plan members be simplified as much as possible, but it’s important to simplify the process itself and minimize the number of decisions it requires the members to make. The choice of a default investment, automatic contribution increases, and auto-enrolment are all successful because they require no decision or action from plan members.
Conclusion
Automatic features are tools that allow better designs for defined contribution pension plans, particularly when participation is voluntary. In any pension plan, periodically reviewing its design is necessary to ensure the plan remains well tailored to the characteristics of the targeted membership and still achieves the savings objectives it originally targeted. The addition of automatic features can not only enhance plan performance but also simplify the exercise for plan members and improve their appreciation of the plan itself.
1 Inclusiveness and finance, OECD 2019 p.10
2 Inclusiveness and finance, OECD 2019 p.16
