Defined Contribution Plans and the Challenge of Financial Illiteracy

The Harvard Law School Forum on Corporate Governance and Financial Regulation 2019-06-14

Posted by Jill E. Fisch (University of Pennsylvania Law School), Annamaria Lusardi (George Washington University), and Andrea Hasler (George Washington University), on Friday, June 14, 2019
Editor's Note: 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 The classic defined-benefit (DB) plan has largely been replaced by the defined-contribution (DC) plan.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.