In a recent survey of 1,000 adults, only 26% could currently identify that there are three branches of the U.S. federal government. Everyone I raised this with was surprised about this ignorance of civic institutions, but we all may have mistakenly assumed adults have a common set of knowledge. For example, while I do know the branches of government, many people have expressed absolute bewilderment that I can’t change a flat tire on my car. And my inability to distinguish between a flat head and Phillips head screwdriver has drawn more than a few laughs as well.
I have also seen this false assumption about common knowledge in my work as a retirement consultant. During the initial period that defined contribution programs were becoming the primary workplace retirement plan among private sector workers (1982—2006), organizations designed plans assuming employees could successfully manage their own retirement savings, if just empowered to do so. All sponsors had to do was offer a matching contribution with a wide array of investment fund choices and participants would take things from there. What we finally learned was that most people had neither the knowledge nor interest to actively engage in saving and investing for retirement, frequently making poor decisions, or ignoring the issue entirely. So, spurred by the Pension Protection Act of 2006, sponsors have spent the last 10 years designing plans that stress default decisions, knowing the average employee welcomes cues from the employer on how best to save and invest for retirement.
Despite this track record, a number of recently published surveys and articles indicate sponsors may be falling into the “assumption” trap again, this time around Roth deferrals. This is a wonderful idea—Roth deferrals allow participants to contribute on an after-tax basis, enjoy tax-free growth and make tax-free withdrawals at retirement. But employers are, on balance, doing a poor job of communicating their value. If you review a sampling of employer plan communications on Roth deferrals, you find that many of them advocate comparing marginal income tax rates at the time of deferral and retirement to determine whether pre-tax or Roth deferrals are more beneficial. Frankly, I don’t know my marginal tax rate now and couldn’t speculate on what it would be at retirement. And I suspect I am not alone in this regard. So the likely outcome for many employees—particularly those less familiar with concepts such as marginal tax rates—will be to ignore the opportunity to contribute using Roth deferrals, even if they could really benefit.
A recent study supports the idea that many employees aren’t knowledgeable about Roth benefits. A survey of 1,000 defined contribution plan participants by Cerulli Associates showed only one-third could correctly identify the benefits of Roth contributions. What’s more, generally accepted Roth wisdom says that younger, lower-paid workers are the most likely to benefit from a Roth deferrals because they’ll pay taxes at their lower tax rate now instead of the higher tax rate they may have later when they advance in their careers and start earning more money. So you might expect Roth usage to be highest at lower-income levels. But that frequently isn’t the case. An analysis of our individual client plans showed that Roth usage increases as incomes rise from $30,000–$90,000, tailing off from that point. What this suggests is that financial literacy, which has been shown to be correlated with income levels, might also be an important factor in driving Roth usage.
Given that educating employees about Roth is a struggle, and the track record of engaging employees through education alone is mixed, why not mirror other plan provisions and default employees who may likely benefit to Roth instead of pre-tax deferrals? Sponsors could split the default based on compensation levels—some employees would be defaulted to Roth deferrals while others would be defaulted to pre-tax deferrals. Or, a sponsor could set the general plan to default all participants to Roth deferrals for a plan covering primarily lower-paid employees.
These may seem like radical ideas, but so did the concept of automatic enrollment 25 years ago. Considering how well employees have adapted to the automatic election concept, why not give it a try?