Defined Contribution Plans and the Challenge of Financial Illiteracy
63 Pages Posted: 15 May 2019 Last revised: 2 Sep 2020
Date Written: 2020
Retirement investing 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 The classic defined-benefit (DB) plan has largely been replaced by the defined contribution (DC) plan.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 upon retirement.
We analyze data from the 2015 National Financial Capability Study to show that people whose only exposure to investment decisions is by virtue of their participation in an employer-sponsored 401(k) plan are poorly equipped to make sound investment decisions. Specifically, they suffer from higher levels of financial illiteracy than other investors. This lack of financial literacy is critical both because of the financial consequences of poor financial decisions and because of a legal structure that relies on participant choice to limit the fiduciary obligations of the employer with respect to the structure and options provided by the retirement plan.
In response to this concern, we propose mandated employer-provided financial education to address limited employee financial literacy. We identify and discuss three requirements that a financial education program should incorporate – a self-assessment, minimum substantive components, and timing. Formalizing the employer role in evaluating and increasing financial literacy among plan participants is a key step in providing retirement plan participants with the resources necessary to manage important decisions regarding retirement planning and, ultimately, for enhancing the financial security of American workers.
Keywords: retirement planning, defined benefit, defined contribution, fiduciary liability for 401(k) plans, implications of financial illiteracy, employer responsibility as substitute, formalizing employer role in evaluating & remediating financial illiteracy, employer-provided financial education components
JEL Classification: A29, D83, J32, K29
Suggested Citation: Suggested Citation