Effective Retirement Programs: Model

Design Features and Financial Education

Thomas Buckner

MRS Program

I INTRODUCTION

“Effective Retirement Programs: Design Features and Financial Education” designing retirement/individual plans and providing financial education in the workplace for lower income households

These two elements are critically important considerations for plan providers.

Both must be carefully constructed to maximize the effectiveness of a retirement program in helping participants build adequate funds for when their working career ends.

Without a successful plan design, financial education will not be effective, and even a well-structured plan can fail to achieve retirement goals without financial education.

Can Employers Help?

The 2006 Pension Protection Act is mentioned as permitting employers to offer financial investment advice and automatic enrollment into a default investment fund.

Women appear particularly vulnerable to adverse events and a husband’s death can precipitate his widow’s entry into poverty [Weir and Willis (2000)].

Other studies report evidence of lack of preparation for retirement. The 2001 Employee Benefit Research Institute’s (EBRI) Retirement Confidence Survey (RCS) indicates that a large proportion of workers have done little or no planning for retirement.

Only 39 percent of workers in 2001 have tried to determine with some accuracy how much they need to save to fund their retirement.

Shift In Pension Plan Design shift from defined benefits to defined contribution plans and the many social and

economic changes that have occurred since World War II—changes that are likely to effect the retirement security of this population in many ways.

Major changes have occurred through several factors. First, for their portability across jobs, employees find DC plans attractive (Munnell and Sunden 2004).

Second, structural changes in the U.S. economy have occurred, namely a shift in the labor force in manufacturing sector and unionized jobs where DB plans are more offered, toward services sector and nonunionized jobs where DC plans tend to be offered (Wiatrowski 2004).

Third, changes in the law since the 1974 Employee Retirement Income Security Act (ERISA), with respect to funding requirements for DB plans or the introduction of 401(k) plans, have decreased incentives for employers to offer DB plans. Schieber (1999) documents a shift in focus of the federal regulation from limiting the loss of federal revenues through excessive deductions associated with employer-sponsored retirement plans prior to ERISA to increasing short-term federal tax collections in the 1980s and 1990s.

Fourth, pension accounting standards used for calculating long-term pension obligations of DB plans have changed, which has slowed the funding of pension plans for the baby-boom generation during the early part of their career.

As a result, increases in unfunded liabilities with subsequent Financial Accounting and Standards Board (FASB) rules.

Does Shift from DB to DC Reduce Pension Wealth?

As a result, if the shift from DB to DC plans reduces the pension wealth of workers at the bottom of the income distribution, these workers may be the least inclined to adjust by increasing other forms of savings.

Moreover, it is conceivable that, even if pension wealth is unaffected by the shift to DC plans, the degree of pension offsetting may be altered by the shift to DC plans. Another important concern with the shift to DC plans is that many workers will choose not to annuitize their balances at retirement.

Consequently, the shift to DC plans increases the chance that workers outlive their resources. Another important question that remains is how this shift from annuitized benefits to lump sums affects the distribution of pension wealth. As noted by Brown (2003), a shift away from uniformly priced annuities will financially benefit workers with shorter than average life expectancies (less educated black men, for example). Nevertheless, the increased risk of outliving their resources may leave a risk-averse worker worse off even though expected retirement income would be higher without annuities.

Why Financial Literacy?

increase retirement savings and reduce debt burdens and provide retirement security for lower income households.

lower income households encompass either low and moderate-income households, or households with incomes below 80 percent of area median income.

Families with incomes of $10,000 - $25,000 heavy debt burdens classify many of them as high-risk borrowers, limiting their access to credit and increasing the price of any loans they can obtain.

Can Lower-Income Net Worth be Measured?

Almost half of the families with incomes between $10,000 and $25,000 were not home owners.

The 1998 Survey of Consumer Finances found, for example, that 32 percent of families with incomes under $10,000 devoted more than 40 percent of their incomes to debt service .

According to this study, almost 30 percent of families with incomes under $10,000 had no financial assets, not even a bank account .

Even among the 70 percent with financial assets, median holdings totaled only $1100. In the case of families with 1998 incomes between $10,000 and $25,000, about 10 percent had no financial assets. Among those with assets, median holdings totaled less than $5000.

PLAN DESIGN

With regard to optimal plan design, strong evidence suggests that inertia or inactivity lowers participation rates substantially in simple, opt-in savings programs. Some plans remedy this by establishing participation as the default (with the ability to opt-out), but research shows that many of these plans have default funds and contribution rates that are problematic for retirement savings. Some research suggests moving away from the opt-in and opt-out framework altogether and focusing on an active-decision model. The idea is to develop mechanisms that require a worker to make a formal decision about the savings program by a certain date. In addition, plan design often seeks to reduce the complexity associated with saving for retirement by simplifying investment choices. Phased Retirement

Plan Design Suggestions

The most basic feature of a retirement for low income program, and one that plays a significant role in determining participation rates, is the enrollment approach used in the plan. Retirement programs are generally designed using either an opt-in or automatic enrollment strategy. In an opt-in plan, the default is nonparticipation for employees who are required to indicate their desire to be involved in the program, most often by submitting an enrollment form.

Under automatic enrollment, employees are, by default, account holders in the retirement plan. They can opt-out of the plan but usually must fill out paperwork to do so. Madrian and Shea (2000) find in their study of a large U.S. company that switching from an opt-in to an automatic enrollment plan increases participation substantially and lowers discrepancies in 401(k) participation among different demographic groups. Similar results are demonstrated in a report by Holden and VanDerhei (2005), which finds, for all eligible employees in the study, that automatic enrollment increased 401(k) participation by 26 percentage points. Automatic enrollment allows employees to avoid deciding whether to participate in the plan by making participation the default. This factor is particularly important because inertia and the desire to avoid making a complicated decision can have a significant impact on participation.

Phased Retirement

A phased retirement program that provides access to a guaranteed income stream, available predominantly through a pension plan, can offer the security needed to transition from full time employment to ultimate retirement.

Phased retirement programs must be easy to design, implement and administer. They must also not be subject to nondiscrimination tests that they would fail because of who actually uses or is allowed to use them.

And they must be structured to allow a requirement of supervisor/management approval for each employee to work reduced hours.

Social Security May Actually Benefit Lower-Income Retirement?

Subsequently, minorities are more likely than whites to have lower lifetime earnings, they are advantaged by Social Security's progressive benefit formula that provides larger relative benefits for lower-paid workers. Moreover, blacks in particular are more likely to receive other important Social Security benefits, such as disability, that help protect against lost earnings.

Certain reforms that would reduce benefits to help restore solvency could have a disproportionate effect on low-wage earners, including African Americans and Hispanics, depending on how they are structured.

For example, raising the age of retirement would lower the average lifetime benefits of blacks relative to whites because of blacks' lower life expectancy.

The Effectiveness of Financial Education On Lower Incomes

In designing a retirement program that counts the adequacy of long-term retirement savings among participants as a goal.

Financial education can be especially helpful to certain subgroups of the population, including minorities, women, and those with low income and education levels

The core aspects of financial education are controlled by employers: the topics covered, the delivery methods used, the frequency with which it is offered, and its general availability.

Financial Education for Second-Generation Parents Further, older low-income second-generation

parents were more likely to reside in skipped vs. three-generation families, as were those outside the South. The author argues that low-income coresident grandmothers may be adversely affected by time limits associated with the Personal Responsibility and Work Opportunities Act of 1996.

Wealth Accumulation

Subsequently, regardless of any possible shortcomings in data, the net wealth position of black families is noticeably lower of whites with similar characteristics. Interestingly, the reason does not appear to be savings, since a large amount of consumption research suggest that blacks save more at any given level of income; but rather to past lower average income than whites of that income level.

Consequently, current economic status of blacks income data alone which generally shows roughly three-fifths as much income are very misleading for they did not address the relative poor net wealth position of black families. These stark findings on wealth accumulation will continue as this study depicts for the legacy of past economic deprivation remains.

The Effect of Lower Wages on Social Programs Expenses As the study depicts low wages have not only

have immediate implications for low wage employees and their families but also affect the expenditures of government security programs. Employers are able to pay low wages because government programs exist to help low-income families meet their needs. The burden of providing income supports and services to low-wage workers is passed on to the public through programs supported by taxes.

Who Are the Non-Participants

According to SCF data, 10 percent of respondents do not save or invest at all, and certain demographic groups are particularly at risk. the less-educated, non-Hispanic blacks, Hispanics/Latinos, and those with low total family income are all more likely to report that they are not saving or investing.

The largest discrepancy is between those with no high school diploma (25 percent do not save) and those with a college degree (less than 5 percent do not save) of their retirement savings.

Perhaps the most striking finding in this analysis concerns individuals between the ages of 50 and 59, who are quickly approaching their retirement years.

Of this group, roughly 25 percent believe that their retirement income will be totally inadequate. Importantly, as the study suggests having a quarter of the group so close to retirement feeling unprepared is a substantial concern.

The Unbanked

A familiarization of the unbanked population with the advantages and mechanisms of mainstream financial institutions and, eventually, saving for retirement for the unbanked is important especially if Social Security becomes privatized.

as the study denotes for this population Government-sponsored programs called individual development accounts (IDA), which are matched savings accounts similar in format to 401(k)s, have popped up around the country in such places as Pennsylvania, New Jersey, and Delaware as components of welfare-to-work programs

although some community banks offer them in order to attract customers. Employers currently do not offer IDAs, but they may be able to do so soon.

Focus On Retirement Lower Income Security

Focusing on Personal Financial Management will lead many individuals and organizations to promote financial education as a way to help lower income households build retirement and develop good credit records.

More importantly, every individual needs to recognize and understand that it is far more difficult for lower income households to save and meet payment obligations than for middle- and high-income households.

But absent policies that would raise the incomes of lower income households, education on budgeting may be the best alternative to help these households obtain the benefits that flow from retirement and clean credit records

Methodology The Health Retirement Study (HRS) offers a unique set of information that

overcomes many of the shortcomings of previous research on retirement and financial education.

This survey, covering a nationally representative sample of U.S. households born between 1931 and 1941 provides detailed information on wealth and the retirement process with a focus on health, labor markets, and economic and psycho-social factors.

also utilized is the 2004 Survey of Consumer Finances (SCF) to document the need for well-designed retirement programs and financial education. The SCF is a triennial survey on wealth and saving that is undertaken by the Federal Reserve Board in conjunction with the Statistics of Income (SOI) Division of the Internal Revenue Service (Kennickell 2006).

The SCF data are intended to represent the financial characteristics of a subset of the household unit called a “primary economic unit.” This unit consists of an economically dominant single individual or couple (married or living as partners) in a household and all other individuals in the household who are financially interdependent with that individual or couple. In a primary economic unit with a mixed-sex couple, the male is considered the head of household; for same-sex couples, the older individual is deemed the head of household.

Data in the MINT model are largely based on the Survey of Income Program Participation for 1990–1993 and 1996. Characteristics, including saving behavior, account balances, and sources of investment advice.

Why is Important To Measure?

Moreover, the HRS provides information on several past negative and positive shocks, including past unemployment, episodes of distress, inheritances, insurance settlements, and money received from relatives and friends.

Most importantly, it provides information about anticipated future resources and future events. This is critically important since decisions to save are intrinsically related to the future.

In the HRS, respondents were asked to report how likely it is that future home prices will increase more than the general price level, and how likely it is that Social Security will become less generous in the future.

Types of Behavior

Five types of HRS information are critically important to understanding retirement behavior:

information about planning,

past economic circumstances,

expectations about the future,

individual preferences,

and pension and Social Security wealth.

As the above SCF data has shown, a majority of people are not saving for retirement, exhibit short-sightedness in retirement planning, and do not feel satisfied with their expected retirement income.

Financial Education Increases Awareness of Present Conditions

In a typical budget-education course, for example, clients write down all of their household expenditures over the course of a month or longer.

This practice forces clients to summarize their households’ expenditures over the course of a month in various categories, providing both clients and counselors their cumulative share of a monthly or annual budget.

Financial-management education can also teach behavioral habits that people can use to help themselves adhere to personal spending limits and retirement plans.

The reason for such large percentage changes is that households at the bottom of the wealth distribution and those with low education have little financial net worth and increases of U.S. $2000 — the average change in wealth for those with low education that attend a retirement seminar — represent very large percentage increases.

Results for net worth show a similar pattern

Importance of Budgeting on Lower Income Retirement Security

These studies looked for changes in “good” budgeting behavior, such as maintaining a written spending plan, saving money for emergencies, or paying bills on time.

Two of the studies, one by Gladys Shelton and Octavia Hill and one by Sharon DeVaney and others, found a statistically significant increase in such behavior after participants completed a financial management course.

These estimates imply that retirement seminars can influence the accumulation of both net worth and broader measures of wealth.

Both financial and net worth can increase by 20 percent and a lot more across sub-groups of low education when workers attend retirement seminars

Ways to Retirement Security for Lower Income Households In addition, these individuals lack this information for such

expenditures are made in small daily or weekly increments, and is easy to overlook.

For example, a course might include a comparison of relative prices of a group of goods and services on which lower income households may commonly save money. It could also include information on understanding credit reports and on addressing past credit-service problems. Financial-management education frequently emphasizes that some retirement can be built by making only small sacrifices

financial literacy effect on lower income households

The results of the studies suggest that the need for financial-management education may be effective, for lower income individuals who live without retirement commonly speak of the extreme personal stress this creates.

Subsequently, with lower-income households a lower level of retirement and the corresponding heavy debt burdens of many lower income households have created a number of concerns with researchers for financial literacy of lower-income households.

Financial Literacy and Credit Concerns

Education can provide information that enables these households to achieve retirement, address past credit problems, and avoid costly mistakes.

Consequently, with a concise portrait of ways in which households allocate their incomes. Without this exercise, most people have little idea of the fraction of their incomes that goes to such purchases as gasoline, newspapers, and outside meals.

Such habits might include withdrawing only a fixed amount of cash at the beginning of each week to pay for recurrent minor expenses.

They could also include immediately depositing a part of each paycheck in a retirement account that is not used for transaction purposes (the “pay yourself first” rule) or

using automatic payroll deductions to fund retirement plans and other retirement goals

Effectiveness of Seminars on Lower-Income Households Estimated effects are sizable,

particularly for the least wealthy.

Overall, attending seminars increases financial wealth (panel a) by approximately 18 percent.

This effect derives mainly from the bottom of the distribution, where wealth increased by more than 70 percent.

The effect is also large for those with low education with increases in financial wealth close to 100 percent.