A July 2011 article in the Wall Street Journal stirred up a tempest among 401(k) plan experts by suggesting that enrolling participants in these plans automatically depresses rather than increases retirement savings rates.
That's because, the article suggested, most participants leave their contribution rate at the default level—which tends to be lower than the contribution rate most participants choose when they enroll actively in the plan. Not surprisingly, several experts took issue with the article’s findings.
However, the situation highlighted an important question: What do 401(k) plan sponsors need to do once they begin offering plans with automatic enrollment and a default contribution percentage?
Few would argue with the importance of getting individuals enrolled in a retirement plan. “It is vitally important that people begin saving for retirement, especially younger workers, and automatic enrollment gets that done,” said David Wray, president of the Profit Sharing 401(k) Council of America in Chicago. However, once participants are in the plan, workers need to save adequate amounts for retirement.
Are Plans Escalating Enough?
Some observers suggest that the problem with low participant contributions following automatic enrollment lies with the design of these features. A Vanguard Investments survey of more than 2,000 U.S. defined contribution plans managed by Vanguard in 2010 found that the most popular default contribution rate for plans with automatic enrollment is 3 percent of pay, with 58 percent of plans using this percentage. Looking more broadly, the survey found that:
• 73 percent of plans use default contribution levels of 3 percent or less.
• Only 27 percent set the default rate at 4 percent or more.
Interestingly, the popularity of the 3 percent default contribution seems to stem from the fact that the example the IRS included in its regulations governing these plans uses a default contribution rate of 3 percent. But whatever its origin, financial planners tend to agree that a 3 percent savings rate is not enough to secure the average person’s retirement. “The fact that three-quarters of our plans use a default contribution rate ranging from 1 percent to 3 percent of salary, with 3 percent being the most common, shows that there are a number of plans that would benefit from higher default contribution rates,” said Jean Young, senior research analyst with Vanguard's Center for Retirement Research in Valley Forge, Pa.
For that reason, many employers implement an automatic escalation feature, which increases the percentage each participant contributes automatically to the plan at specific intervals, usually once a year. The Vanguard survey, which focused on large companies, found that 75 percent of plan sponsors have automatic escalation. For example, a plan that enrolls workers in a 401(k) plan automatically with a default contribution rate of 3 percent of pay can increase that contribution rate automatically by 1 or 2 percentage points per year until total participant contributions reach a specific cap as a percent of pay or a dollar amount. The Vanguard study found that a 1 percentage point escalation is favored by 74 percent of plans.
Yet there is evidence that the default design choices plan sponsors make, even when they include an automatic escalation provision, are not enough to ensure a secure retirement. Research by Vanguard suggests that employees need contributions (theirs plus employer matching or discretionary contributions) that total 12 to 15 percent or more of pay annually. As this survey data shows, employers not only set their default employee contributions too low but also include automatic escalation rates that are not high enough to allow employees to catch up in a reasonable amount of time.
Inadequate Conribution Rates
In a separate research project, Vanguard analyzed overall plan contribution levels to determine if they were adequate for employees’ retirement needs. That research indicated that 40 percent of plans with auto enrollment had inadequate contributions rates. After five years, participants in these plans had overall contributions (employee and employer contributions) representing less than 9 percent of pay.
To achieve a contribution rate that is closer to what individuals will require in retirement, Young suggested, plan sponsors should aim higher. “If you start with a default contribution rate of 6 percent of salary and add in the typical employer match of 50 cents for each $1 employees contribute up to 6 percent of pay (which translates into 3 percent of pay), that brings total contributions up to 9 percent of pay,” said Young. Employers can push that up even further by including an automatic escalation of 2 percentage points per year, which would bring the savings rate above 12 percent within three years:
• Year 1: Automatic contribution (6 percent) + Employer match (3 percent) = 9 percent.
• Year 2: Automatic contribution (6 percent + 2 percent escalation = 8 percent) + Employer match (3 percent) = 11 percent.
• Year 3: Automatic contribution (8 percent + 2 percent escalation = 10 percent) + Employer match (3 percent) = 13 percent.
Continuing Education and Matching
Automatic design features can go a long way toward helping employees save for retirement by getting them enrolled in a tax-deferred retirement plan and increasing contributions steadily over time. However, even with these automatic features, 401(k) plan sponsors need to continue their education and communication programs.
For example, retirement education materials and tools can emphasize the fact that it requires a contribution of more than the 3 percent default contribution to take full advantage of available matching contributions and to save enough for a secure retirement. Providing planning tools and investment advice can help reinforce these messages. “These tools can provide a gap analysis to help participants recognize the consequences of keeping contributions at the default 3 percent,” said Wray.
Perhaps the most important role plan sponsors can play in employee retirement saving is by matching participant contributions. When plan sponsors reduced or eliminated matching contributions during the recession, that move had an adverse impact not only on participant savings rates but also on overall participation levels. “Our data definitely shows (that) where companies suspended or reduced the matches there was a decline in participation,” said Wray.
Interestingly, small companies consistently have avoided automatic 401(k) plan features, such as automatic enrollment and contribution escalation. Experts suggest that small companies, with their more personalized approach to benefits and one-on-one interaction between HR and employees, do not need automatic features.
“The average deferral rates in small companies have historically been higher than the rates at large companies,” said Wray. Large companies can emulate small ones and provide personalized help with retirement planning questions.
Joanne Sammer is a N.J.-based business and financial writer.
Self-Enrolled Participants Have Significantly Higher Overall Contribution Rates
Automatic plan features help passively enrolled participants, but actively engaged employees save more for retirement, according to 2011 research by Mercer, a provider of benefits administration outsourcing.
Overall, participants who were automatically enrolled in their defined contribution plan and participated in an automatic salary deferral increase program had a 25 percent higher contribution rate than those who were automatically enrolled in the plan but did not receive automatic deferral increases.
Conversely, however, those who self-enrolled in the plan and did not receive automatic deferral increases saved at a higher rate than those who self-enrolled and did receive automatic deferral increaes.
Mercer’s analysis is based on the behavior of 1.2 million participants for whom Mercer administers DC plans as of Dec. 31, 2010.
Automatic salary deferral increases equate to higher average contribution rates for those automatically enrolled but still lag behind those who self-enrolled
Average contribution rates for participants automatically enrolled in the plan*:
Average contribution rates for participants self-enrolled in the plan:
Participants not receiving automatic deferral increase
Participants receiving automatic deferral increase
* The most common default participant contribution rate for Mercer’s clients who use automatic enrollment is 3%.
“Clearly, it is important for plan sponsors to understand the difference in behavior and engagement between self-enrolled and automatically enrolled participants,” said Dave Tolve, U.S. retirement business leader for Mercer’s outsourcing business. “Those who self-enroll and set their own contribution rate are contributing nearly two and half times those who are automatically enrolled. While automatic enrollment obviously increases overall plan participation, it does little to overcome the inertia of unengaged employees.”
While further enhancing defined contribution plans with automatic increase features does drive increased savings, Tolve pointed out, “there is no comparison to the contribution and account values of actively engaged participants who consciously make retirement savings decisions.”
Auto Enrollment Boosts 401(k) Participation Among Minorities, SHRM Online Benefits Discipline, October 2011
401(k) Plans Add Features to Drive Participation and Savings, SHRM Online Benefits Discipline, September 2011
401(k) Automatic Enrollment: Does It Help or Hurt Savings?, SHRM Online Benefits Discipline, July 2011
The Business Case for 401(k) Automatic Enrollment, SHRM Online Benefits Discipline, July 2008
SHRM Online Benefits Discipline
SHRM Online Retirement Plans Resource Page