Defined Contribution Plans and the Challenge of Financial Illiteracy

Jill Fisch is the Saul A. Fox Distinguished Professor of Business Law and Co-Director, Institute for Law and Economics at the University of Pennsylvania Law School; Andrea Hasler is Assistant Research Professor in Financial Literacy at the George Washington University School of Business; and Annamaria Lusardi is the Endowed Chair of Economics and Accountancy at the George Washington University School of Business. This post is based on their recent article, forthcoming in the Cornell Law Review.

Retirement saving in the United States has changed dramatically. The classic defined-benefit (DB) plan has largely been replaced by the defined-contribution (DC) plan. With the latter, individual employees’ decisions about how much to save for retirement and how to invest those savings determine the benefits available to them upon retirement.

This system relies on employees to save and invest their money for retirement, decisions that they are poorly equipped to make. A variety of studies document low levels of financial literacy in the general population. People with low financial literacy are susceptible to a number of investment mistakes, including choosing products that do not meet their needs and paying excessive fees. They are also vulnerable to fraud. Moreover, investment decision-making is complicated. The typical 401(k) plan offers participants products that many of them do not understand. Effective retirement savings also requires people to begin saving early, to reallocate their portfolios periodically as they age and, when they retire, to determine how to manage the balance in their accounts to provide income for the rest of their lives.

Although financial illiteracy is a widespread problem, the evolution of workplace pensions exacerbates the problem by imposing responsibility for financial well-being in retirement on a group of people who are particularly ill-suited to the task. We term these people “workplace-only investors,” which we define as people whose only exposure to investment decisions is by virtue of their participation in an employer-sponsored 401(k) plan or equivalent DC plan; they do not have other retirement accounts or financial investments. We view workplace-only investors as forced or involuntary investors in that their participation in the financial markets is a product of their employment and unlikely the result of informed choice. They are a sizeable share of participants in DC pension plans.

In our article, Defined Contribution Plans and the Challenge of Financial Illiteracy, forthcoming in the Cornell Law Review, we present the first research to focus specially on the characteristics of workplace-only investors. We analyze data from the 2015 National Financial Capability Study to show that workplace-only investors suffer from higher levels of financial illiteracy than other, more active, investors, making them particularly poorly equipped to make sound financial decisions. The financial literacy of workplace-only investors is particularly low and alarming when looking at concepts specifically connected with investment decisions. In addition, we find that workplace-only investors differ from other investors, not just in financial decisions with respect to their retirement accounts, but also in other financial decisions, such as debt management. In short, workplace-only investors are particularly vulnerable.

This problem of financial illiteracy is compounded by the fact that the existing regulatory treatment of DC plans relies heavily on participant choice to limit the responsibility of employers in connection with retirement investing. So long as employers offer their employees some reasonable investment options, they have limited responsibility for their employees’ financial well-being.

We consider the implications of our findings for the viability of participant-directed retirement savings and identify two potential responses. One possibility is that ERISA could be modified to impose greater responsibility on employers who sponsor participant-directed retirement plans. We identify several limitations in the viability of this option. We also note the risk that greater liability exposure could decrease employer willingness to provide retirement plans for their workers. Alternatively, employer-sponsors of participant-directed retirement plans could be required to evaluate and remediate the financial literacy of plan participants, thereby enhancing the effectiveness of participant choice. We argue that this second option is more promising and that ERISA or the Department of Labor should mandate financial education as a component of employer-provided DC plans.

We conclude by offering preliminary reflections on how employers could do so effectively. We identify three components of an effective employer-provided financial education program that could be implemented by all employers: (1) a self-assessment enabling employees to measure their financial literacy, (2) minimum information about both the employer-provided plan and the process of saving and investing for retirement, and (3) timing the provision of financial education so that it occurs at critical moments when employees make financial decisions. Importantly, we reason that financial education should not be limited to the time an employee enrolls in a plan but should continue to provide that employee with information relating to rebalancing, changes in employment, and managing plan assets at and after retirement.

There are several reasons why a mandate is necessary in light of the market-based trend toward providing workplace-based financial education. First, it would ensure that all employees, not only those working in big firms or firms providing generous pension benefits, have access to financial education in the workplace. Second, our proposal leaves room for firm-specific decisions about the details of employee financial education; a mandate only sets a floor with respect to minimum standards. Third, a regulatory mandate encourages market-based innovation and bolsters the exchange of information and experience across firms, improving the supply and quality of programs over time. Finally, a requirement that applies to all firms is necessary to address worker mobility. Many workers change jobs during their working career.

In the same way in which DB plans were not an adequate pension system in a dynamic labor market, DC plans that do not take into consideration and address the different needs of workers are not adequate for the current labor force. The minimum financial education requirements that we propose in this article are necessary for DC plans to be viable and for workplace-only investors to save and plan effectively for their retirement.

The complete article is available for download here.

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