Benefits and Challenges: DC Plans Evolve, Part 2

August 2024

The landscape of retirement saving in the United States has changed significantly over the past several decades. Defined contribution (DC) plans are now the primary mechanism for workplace savings. While these plans are not perfect, they offer a good savings opportunity to the millions who participate in them. In this second installment of this two-part article, we will cover how these plans have evolved to better serve U.S. workers.

DC plans, like defined benefit (DB) plans, have their limitations. Critics rightly argue that DC plans shift investment risk and longevity risk from employers to individuals, which can lead to inadequate retirement savings if people make poor investment choices. It is true that DC plans place more responsibility on individuals. That said, LIMRA research found the majority of people believe that workers have a responsibility to save for their own retirement.

Pros and Cons

With greater responsibility comes greater control. Participants can choose from a range of investment options, allowing them to tailor their portfolios to their risk tolerance and retirement goals. While research suggests that people value this ability, many participants are not equipped to manage their funds. In response, many retirement plan providers added investment guidance or advice to their plans. About a third of retirement plans currently offer their participants investment advice. Almost all offer investment education and/or some type of guidance.

Plan design and defaults can also help manage volatility and investment strategy. For example, life cycle funds, which automatically adjust asset allocation, can help mitigate the impact of market volatility. Managed accounts or customized portfolios, in which investments are professionally selected, monitored and adjusted, are another option. About 49 percent of DC plans offer managed accounts to their participants.

Efforts to enhance financial literacy and offer good, scalable investment guidance and advice have been areas of focus for the industry. DC plans are also portable, so workers can take their retirement savings with them when they change jobs.

Another argument leveled against DC plans is that they may exacerbate income inequality because higher-income individuals can afford to contribute more and receive larger tax benefits. While income disparities exist, plan and policy adjustments like improved employer match programs and targeted tax incentives for low-income earners can help make retirement savings more equitable.

Evolution and Innovations

DC plans were never intended to be the main or only vehicle to save for retirement. Since their inception, these plans have continued to evolve, incorporating innovations designed to facilitate saving and expand access to plans. The majority of U.S. workers have favorable views of DC plans, appreciating the control and flexibility these plans offer for their retirement savings.

Facilitating Savings

Employers and legislators are working hard to encourage employees and citizens to build their retirement savings. Recent actions include:

Automatic enrollment and escalation. Many employers have implemented automatic enrollment and automatic escalation features in their 401(k) plans. These features help increase savings rates.

Catch-up contributions. These were introduced as part of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001. This legislation was designed to enhance the retirement savings opportunities for American workers, particularly those approaching retirement age who needed to save more aggressively to prepare for their post-working years.

Targeted tax incentives. The Saver’s Credit is a federal tax credit designed to encourage low- and moderate-income individuals to save for retirement. Eligible individuals can receive a tax credit for contributions to their retirement accounts, effectively reducing their tax burden.

Addressing Investment Risk

When employers swapped DB plans for DC plans, they shifted the investment risk to employees, many of whom don’t understand or have the knowledge to implement or manage investment strategies. To help them do that, employers are fine-tuning their DC plans in various ways:

Participant education and access to advice. The majority of DC plans offer assistance to participants, including access to financial advisors, educational workshops, online resources and automated investment advice services.

Target date funds. These funds automatically adjust the asset allocation of a participant’s portfolio based on their expected retirement date, becoming more conservative as retirement approaches. This simplifies investment decisions for participants and helps manage risk over time.

Financial wellness programs. Employers increasingly offer financial education and wellness programs to help employees make informed decisions about issues beyond saving. Many include debt management and emergency savings strategies. Many of these programs also address physical and mental well-being.

Tackling Longevity Risk

Employees worry about outliving their retirement savings. Service providers, employers and legislators are devising various solutions, among them:

Lifetime income solutions. In response to concerns about outliving retirement savings, some DC plans now offer annuities and other lifetime income products as investment options. These solutions aim to provide retirees with a steady stream of income throughout retirement.

Expanding Access. Various states have enacted legislation to create state-sponsored retirement plans for private-sector workers who do not have access to employer-sponsored plans. Some examples include California's CalSavers, OregonSaves and Illinois Secure Choice.

The SECURE Act of 2019 introduced pooled employer plans (PEPs), which allow unrelated employers to participate in a single, collective plan managed by a pooled plan provider. They simplify the administration and reduce the fiduciary burden for employers, making it easier for small and midsized businesses to offer retirement plans. Other innovations include multiemployer plans (MEPs), in which two or more unrelated employers join efforts to offer a single retirement plan.

Continued Evolution

At the end of 2023, 401(k) plans held approximately $7.4 trillion in assets and served some 60 million active participants. While the DC system is not without its flaws, it remains a valuable tool for many workers to build their retirement savings. In fact, the expansion of DC plans is a global trend. Beyond Australia, the U.K. and the U.S., China and India are introducing DC plans as part of their pension reform. Despite its imperfections, the DC system continues to provide significant benefits and financial security for a large portion of the workforce. Continued evolution will only make them more effective in the future.