Stagnant wages, job insecurity and a steady decline in pension plan and retiree medical benefits have jeopardized the retirement security of many workers—but to different degrees.
A new analysis by Aon Hewitt, the global human resource consulting and outsourcing business of Aon Corporation, reveals that Generation Y workers (those ages 18 to 30) may be most at risk from these trends despite having the most amount of time to save.
Due to lack of participation in defined contribution plans, low savings rates and high rates of cashouts, eight in ten Generation Y workers will not meet all of their financial needs in retirement unless they significantly improve their saving and investing behaviors.
After factoring in inflation and postretirement medical costs, Aon Hewitt projects Generation Y workers will need to save 18.7 times their final pay in retirement resources—including Social Security, employer-provided defined benefit and defined contribution plans and employee savings—to maintain their current standard of living in retirement (this assumes retiring at age 65; more will be needed to retire earlier). Yet Aon Hewitt's research shows that employees of this generation who work a full career are on track to accumulate just 12.4 times their final pay, leaving a shortfall of 6.3 times pay—a third of their total needs. The situation is even bleaker for workers without a pension plan, who have a shortfall of 8.0 times pay. This also assumes no future leakage from withdrawals or cashouts, and that Social Security benefits are not reduced, rendering these scenarios optimistic at best.
According to Aon Hewitt, there are many reasons for these shortfalls, including rising health care costs, increased life expectancy and the emergence of defined contribution plans as the primary retirement savings vehicle for most Americans. However, one factor in particular plays a significant role for this Generation—employees' saving and investing habits. Aon Hewitt's analysis shows that only half of Generation Y workers who are eligible to participate in a defined contribution plan do so, meaning they have accumulated very little savings, if anything, in their plan. Among those who do save, the average before-tax contribution rate is only 5.3 percent of pay, with 41 percent of workers not saving enough to receive the entire employer-provided match.
Even if workers begin saving early, Aon Hewitt's research shows that most cash out their savings well before retirement. Nearly 60 percent of Generation Y workers cash out their retirement savings when changing jobs, which means they are missing out on the opportunity for decades-worth of tax-deferred growth on their investments. For example, a 25 year-old employee who cashes out $5,000 from his or her retirement plan may potentially be sacrificing $56,000 at retirement(1) in exchange for a small amount—perhaps only $3,500 after taxes and penalties—from the cashout.
"Younger workers will have fewer future benefits from their employers and potentially the government. They need to save a third more in their defined contribution plans than workers who are nearing retirement today, but there's clearly a lack of urgency to proactively save," said Pamela Hess, director of Retirement Research at Aon Hewitt. "Employers can play a critical role in helping this generation of workers by being thoughtful about offering participants the help they need to get on the right track. Automated tools with more robust defaults, innovative matches, investment advice and personalized messaging leveraging innovative technology are effective ways to start and keep these younger workers on the right path."
Impact of Automation on Saving and Investing Behaviors
According to Aon Hewitt's analysis, automation is playing a strong role in helping employees save across all demographics, but especially with younger generations. Participation rates of Generation Y workers who were automatically enrolled were 85 percent in 2009 compared to just 42 percent under traditional enrollment. Generation Y workers were also more likely to use contribution escalation features, which enable participants to increase their contribution levels over time. For example, nearly a quarter of Generation Y workers elected or were defaulted into contribution escalation when available in their employer's defined contribution plan, compared to just 10 percent of Younger Baby Boomers.
Additionally, Aon Hewitt's data shows that Generation Y participants use simplified investment solutions more often and are more likely to use them correctly. This is primarily because of the growing popularity of premixed portfolios as the default investment under automatic enrollment. More than two-thirds (69 percent) of Generation Y investors used a premixed portfolio (mainly target-date funds) in 2009, compared to 54 percent for Generation X investors and 45 percent of Younger Boomers. Further, nearly 60 percent of Generation Y workers holding a premixed portfolio used it as a turnkey solution—meaning they invested 100 percent of their assets in the fund—compared to 40 percent of Generation X workers. This is a vast improvement from past years prior to automation, when younger generations tended to over-use conservative investments such as stable value funds.
"Generation Y workers now have more diversified portfolios than other generations largely because of default behavior," noted Hess. "An increasing number of younger workers are automatically enrolled in their defined contribution plans and defaulted into a target-date portfolio. These funds are improving diversification and rebalancing, which have greatly helped defined contribution investors in recent years."
According to Aon Hewitt's analysis, while Generation Y workers saw losses in their defined contribution plans similar to other generations during the 2008 market crash, their portfolios rebounded well when the markets recovered given better diversification and the embedded rebalancing. Generation Y workers experienced a -28 percent median rate of return in 2008 and a 29 percent median rate of return in 2009. This is compared to -28 percent and 23 percent, respectively, for Younger Boomers.
Creating a Generation of Savers
Generation Y employees face many challenges when saving for retirement, including lack of interest, procrastination, competing financial needs and little investment knowledge. But employers can take steps to urge employees to save more and make retirement saving easier. Some ideas includ
• Adopting and/or enhancing automated tools and defaults. Automatic enrollment, coupled with solid defaults, can have a dramatic impact on all savers, and particularly on Generation Y workers. More than half of employers offer automatic enrollment in their defined contribution plans, and more are adopting this feature each year. In addition, while most employers continue to use a 3 percent default contribution rate, the percentage of companies using a 6 percent default contribution rate has increased from 3 percent in 2001 to 11 percent in 2009. The number of companies coupling automatic contribution escalation with automatic enrollment has also increased, from 28 percent in 2007 to 40 percent in 2009.
• Acknowledging differences in learning styles and needs across generations. For Generation Y workers, communications need to be quick, easy to understand and require minimal effort on the part of the employee. Asking younger workers to "check the box" will be much more effective than asking them to read a 30-page brochure on their investment options. Technology—including the use of smart phones and BlackBerry devices—plays a key role when communicating with this generation.
• Designing innovative employer matching contributions. Aon Hewitt's data shows that 37 percent Generation Y workers only contribute enough to receive the full employer match. Employers should consider re-designing their employer matches to encourage better behavior. For example, instead of offering a three percent dollar-to-dollar matching contribution, companies can offer a match of 50 cents for every $1 dollar up to 6 percent, encouraging twice the employee savings level.
• Offering more robust investment help and advice. According to a recent study conducted by Aon Hewitt and Financial Engines, a 25-year-old who uses professional investment help when investing $10,000 could have $105,800 by age 65—more than double the $52,100 had he or she not used help, assuming the higher median annual return is maintained over the entire period. While investment help is becoming increasingly standard with defined contribution plans, many companies still do not offer employees financial advice. According to Aon Hewitt, about half (50 percent) of companies offered their employees some type of investment advice in 2009.
• Adopt a Roth. Saving through a Roth feature can provide significant benefits to younger workers by covering (lower) tax consequences now versus at retirement. According to Aon Hewitt, one-third of plans currently offer Roth, and when available, Generation Y participants are the heaviest users.
"Employers are taking the right steps to design their defined contribution plans in a way that encourages saving, but more needs to be done to move the needle in the right direction," said Hess. "We're working with legislators, regulators, and plan sponsors to encourage them to make changes to their retirement programs that will eliminate existing barriers to improving plan utilization, and add opportunities for increased savings."