Carpe Diem: How to seize better retirement outcomes

Steve Utkus, Principal and director of the Vanguard Center for Investor Research


In ancient times, the Roman poet Horace coined the phrase, “carpe diem,” which translates to “seize the day.” Little did he know that his wise advice would help 21st century plan participants successfully prepare for retirement.

History shows us that the most important ingredient for long-term investing is to save as much as you can today. It is plan contributions that have the largest impact on outcomes. Contribution decisions–in particular, the use of automatic enrollment and automatic escalation for employee deferrals, the size of employer contributions, and the total produced by both–are in the end more influential in driving retirement security.

Of course, in thinking about improving participant outcomes, investment committees rightly spend a great deal of time on the construction of a defined contribution (DC) investment lineup. This includes the structure of the investment menu, the types of strategies and managers offered, the selection of a default investment (when relevant), and fees paid. As we noted in our paper, Constructing a defined contribution investment lineup: Four best practices, the paradigm for making such choices has changed in DC plans. Sponsors have emerged as “choice architects,” balancing the need for a well-designed default fund affecting many participants, against the expanded menu options for a minority of participants wanting to make active investment choices. But while investment evaluation and menu design remain critical plan sponsor duties, their ability to increase participant savings rates is essential.

To illustrate this point, consider four different hypothetical scenarios involving a young participant saving over a working career, with standard demographic and plan design assumptions.¹

In the first scenario, the participant is automatically enrolled at 3% of pay, earns an employer match of 1.5% of pay, for a total contribution rate of 4.5% per year. Real investment returns net of fees are 4%. Our participant is projected to retire with a little more than $140,000.

In the second scenario, all details are the same—except real net returns are higher, at 5% per year after costs. That gives a meaningful boost to retirement savings, which reach close to $172,000. But to take on those returns, the participant must assume higher risk—a fact not captured in this simple illustration.

But in the third and fourth scenarios, the participant earns a net real return of 4%, but contribution rates are much higher. In scenario three, the participant’s total contribution is double, at 9% of pay (assuming auto enrollment at 6% with a 3% employer match). And, in scenario four, the total contribution rate is 13% (assuming an escalation feature of 1% from 6% to 10% in the early years). In these latter cases, savings at retirement is now either $280,000 or $392,000. That’s double or nearly triple the savings from the first scenario.

Higher contribution rates lead to better outcomes

These results underscore how important contribution rates, not relative investment returns, are in determining retirement outcomes. On the investment side of the equation, the sponsor can control asset allocation (of the overall menu and the default fund) and investment fees, but not the equity risk premium. Contributions are directly under sponsors’ control, particularly with the growing use of automatic enrollment and automatic escalation, and the important influence of inertia in participant decision-making.

Can an employer-sponsored DC plan be certain to provide retirement security? No, not in a world of uncertain market returns. But can employers substantially improve the odds of great retirement outcomes through a well-designed policy on plan contributions? As the data shows, the answer is a definite yes. Make sure that your employees seize the day now to achieve a better tomorrow.

I’d like to thank my colleague Frank Chism in Vanguard’s Investment Strategy Group for his contributions to this piece.

¹ The key demographic assumptions: The participant has a starting salary of $35,000, earns 1% real wage increases per year, joins his or her DC retirement plan at age 32, and contributes for 35 years until age 67. The employer offers a $0.50 on the dollar match up to 6% of pay. These hypothetical examples do not represent the return on any particular investment and the rate is not guaranteed. The final account balance does not reflect any taxes or penalties that may be due upon distribution. Withdrawals from a tax-deferred plan before age 59½ are subject to a 10% federal penalty tax unless an exception applies.

Note: All investing is subject to risk, including the possible loss of the money you invest.

About Steve Utkus

Mr. Utkus is principal and director of the Vanguard Center for Investor Research. The Center conducts and sponsors research on investor behavior and decision-making. It also works to apply behavioral insights to real-world settings. The Center’s scope includes individual investors (whether direct, advised, or in defined contribution plans) and institutional investors. The Center’s work will be of interest to investors, advisors, consultants, employers, media, the research community, and policymakers. Mr. Utkus’s personal research interests include retirement economics, behavioral finance, and the role of psychology in household financial decisions. He earned a B.S. from the Massachusetts Institute of Technology and an M.B.A. from The Wharton School of the University of Pennsylvania. He is a member of the advisory board of the Wharton Pension Research Council, is currently a visiting scholar at Wharton, and is a member of the board of trustees of the Employee Benefit Research Institute in Washington, D.C.

How America Saves 2017 small business edition

The How America Saves 2017 small business edition is now available. This supplement to the annual benchmarking report, How America Saves 2017, is dedicated to Vanguard Retirement Plan Access clients.

Hardship distribution documentation update

As an employer with a 401(k) or 403(b) plan, you have made a commitment to help your employees to save for retirement. Perhaps the last thing you want is for them to take money out of the plan before that point. But a lot of employers have chosen a plan provision that lets employees get to their savings if they experience a “hardship.” This common option can actually increase plan participation by giving employees access to their money if they have such a hardship.

The Concern

Congress created hardship distributions to help eligible individuals use plan savings to satisfy certain financial needs. The policy made sense: if people are afraid to save for retirement because they may face an emergency, let’s remove that barrier. But the rules for properly administering hardship distributions may create some of their own barriers—barriers that employers should carefully consider before approving hardship distributions. These rules are complex, so we’ll try to make them more straightforward by focusing only on what you need for proper documentation of hardship distributions.

As you might expect, some employees might request hardship distributions for situations that don’t qualify. To avoid this possibility, the hardship regulations require employers make sure that an employee truly has an “immediate and heavy financial need” before paying funds out of the plan. The rules list these “safe harbor” events that satisfy the financial need requirement.

1. Certain unreimbursed medical expenses
2. Costs directly related to the purchase of a principal residence
3. Payment of post-secondary education expenses
4. Payments necessary to prevent the employee’s eviction from or foreclosure on a principal residence
5. Certain burial or funeral expenses
6. Repair expenses for damages to the employee’s principal residence caused by qualifying events (e.g., natural disasters)

The IRS requires reasonable employer diligence in confirming whether hardship distribution requests are legitimate. Rather than taking an employee’s word for it, employers must obtain proof that a qualifying event has happened. The regulations (which, again, are complex) allow for employee self-certification in one context, but not when using the safe harbor hardship reasons above. Over the years, many employers began assuming that all that was required for a hardship payment was an employee’s certification that it was needed. This relaxed approach led the IRS to act.

The Options
To clarify the regulations, the IRS issued internal memos to its field staff early in 2017. These memos apply to audits of both 401(k) and 403(b) plans and outline the approval procedures and accompanying documentation for self-certifying hardship distributions. Employers now have two methods to document their reliance on an employee’s self-certification that an immediate and heavy financial need exists.

1. You can rely on the employee’s original source documents, including estimates, contracts, bills, and statements.
2. You can rely on a summary of source documents.

In either case, you must be prepared to provide the IRS sufficient detail to support the need for a hardship distribution. If you use the original (or “source”) documents methods, you must retain these documents to prove compliance with IRS hardship distribution rules. This would include such documents as medical, educational, or funeral home invoices, foreclosure or eviction notices, and formal estimates for home repair following a casualty loss.

If you allow your employee to provide a summary in order to obtain a hardship distribution, the summary must contain

• the employee’s name,
• the total cost of the hardship event,
• the distribution amount requested, and
• a certification by the employee that the information is accurate.

The employee must also provide specific information about the deemed hardship distribution. This information includes, for example (for medical care), who incurred the medical expense, how are they related to the employee, the general category of medical expense (e.g., diagnosis, treatment), who provided the medical service, and the amount of expense not covered by insurance.

Additionally, when you allow an employee to summarize source documents, you must give the employee a notice explaining that

1. hardship distributions are taxable and additional taxes may apply,
2. distribution amounts cannot exceed the immediate and heavy financial need,
3. hardship distributions cannot include earnings on elective contributions or from qualified non-elective contributions or qualified matching contributions, and, perhaps most important,
4. the employee “agrees to preserve source documents and to make them available at any time, upon request, to the employer or administrator.”

This last point may nudge employers away from using the summary method altogether. If you use the “summary” method and you haven’t adequately documented an employee’s financial need, the IRS will request more detailed source documents—from the employer or third-party administrator. When deciding which method to use, employers should ask themselves, “How likely is it that I will get these original documents from my employees several years after the hardship distribution?”

The Decision

The recent IRS guidance reminds us that employers are still ultimately responsible for proving that they have properly made any hardship distributions. The summary method may require you to gather proof of the hardship long after the payment; the source document method requires you to obtain the employee’s proof of hardship before you authorize a distribution. Many employers are now deciding that they are more likely to obtain the needed hardship proof if they require it from the employee up front. Most employees view hardship distribution provisions favorably—especially when they need them. Allowing such distributions may encourage some employees to contribute to their plans without worrying that they cannot get to plan assets in an emergency. Just make sure that you don’t gather the hardship documentation from your employees in a way that could create problems for you down the road.

Annual whitelisting reminder

Just because you received this email, it doesn’t mean you’re receiving all essential emails from us. We’ve updated our whitelisting document. Please share it with your IT department or email service provider so that our IP addresses and domains are “whitelisted” by your organization’s security tools to ensure successful delivery.

Reminder: Use your forfeiture account

Have you checked your forfeiture account lately? Generally, forfeitures should be used for the plan year in which they arise. Depending on your plan’s provisions, money in the forfeiture account can:

• Be used to pay certain administrative expenses
• Reduce the amount required to fund an employer contribution
• Be allocated to participant accounts

Ensure your contact info is current

Keep personal contact information current so we can keep you informed of important plan events.

1. Log on to your employer website.
2. Go to Plan Overview and then View/Edit Plan Information.
3. Enter your phone number and email address.
4. Click Save to finish updating your information.