Vol. 45, No. 9
Employees who are automatically enrolled in 401(k) plans tend not to take maximum advantage of the benefit.
Employers and employees can both benefit from automatic enrollment in 401(k) retirement plans, but the practice is not an automatic answer to the problem of people saving too little money for retirement.
Under automatic enrollment, employees who do not actively request to be excluded from a plan are enrolled and a default deferral amount is automatically deducted from their paycheck and contributed to their 401(k) plans. The money is invested in a default investment vehicle, usually something conservative such as a stable value fund. Employees who do not want to take part must actively submit their election not to participate in the retirement plan.
Used for several years for new hires (see HR Magazine, November 1997, p. 112), the Internal Revenue Service (IRS) this year issued two rulings approving automatic enrollment for employees already on payrolls and for participants in 403(b) retirement plans for nonprofit and educational workers and for 457 plans for government workers.
Noting that 75 million Americans do not participate in a retirement pension plan and have little or no other retirement savings, Treasury Secretary Lawrence Summers and Labor Secretary Alexis Herman issued a joint statement praising automatic enrollment as a "promising method of encouraging participation by those who disproportionately have been missing the benefits of a regular, disciplined approach to retirement savings. … We encourage employers to consider adopting automatic enrollment."
Besides a genuine desire to help employees save for retirement, companies have pragmatic reasons to offer automatic enrollment. It is a good way to increase the contribution level for non-highly compensated employees so that plans meet discrimination tests and highly compensated employees can maximize their contributions.
But the inertia that keeps employees from signing up for 401(k) plans to start with also keeps them from taking real advantage of the programs after they are automatically enrolled in them, say pension experts.
A study by Hewitt Associates released in July found that automatic enrollment virtually eliminated the participation gap between high- and low-wage employees, but that automatically enrolled participants tend to remain at conservative default elections, even after one year of participation in the 401(k) plan.
The Hewitt study looked at the participation and default behavior of more than 53,000 eligible employees hired before and after automatic enrollment was initiated at two U.S. companies over a one- to two-year period. More than half remained at the companies’ conservative default elections. Both companies automatically enrolled employees in conservative stable value funds at a 2 percent to 3 percent contribution rate.
After the automatic enrollment program was implemented, an average of 63 percent of participants hired under automatic enrollment at Company A contributed at the default rate; 57 percent invested in the default fund and 51 percent remained at both default elections. At Company B, an average of 62 percent of employees participating under automatic enrollment contributed at the default rate; 67 percent invested in the default fund and 58 percent remained at both default elections.
"Because a majority of automatic enrollees seem to assume that one size fits all in terms of the default contributions rate and fund, they are still at risk," says Lori Lucas, defined contribution consultant at Hewitt. "Younger participants in particular could be unnecessarily giving up a substantial part of their retirement nest egg by failing to raise their contribution rate or moving into a more aggressive investment portfolio."
Employees in focus groups have told Lucas that they are happy to be automatically enrolled, she says. "It’s not that they didn’t want to be in the plan; they just never had gotten around to it. But the consensus was that they were still somewhat overwhelmed by the choices they had to make."
Employees still had serious questions about what funds were appropriate to their needs, she says. "The strong message we were getting from people who were not in a plan prior to automatic enrollment was that they hardly know where to begin. They are prime candidates not only for automatic enrollment but for [investment] advice."
Of course, a company has a fiduciary responsibility to communicate to employees that they may opt out of the plan. And most plan sponsors recognize an obligation to provide some education about investing for retirement. Lucas says to tell employees: "We’re getting you in as a starting point, but this is not the end. Make sure where you are in the plan is tailored to your needs."
To further serve beneficiaries, companies sometimes bring in third-party experts to provide individualized investment advice. And Lucas recommends using the Internet, especially to reach younger employees who are not likely to be thinking much about retirement.
"It used to be that everybody had some kind of pension," says Lee Kliebert, president of Kliebert Pension Investment Counsel in Okemos, Mich. "Now very little of an individual’s retirement benefit is funded by the company and we’ve turned employees into their own portfolio managers. They have to figure out how to invest their dollars. We’ve put the burden on employees over last 20 years."
Many employees simply don’t take the initiative, according to Kliebert. "The law of physics says that something in motion tends to stay in motion. So people don’t enroll in 401(k) plans. When they are automatically enrolled, the same principle applies—they tend to stay with whatever they were enrolled in."
He sees automatic enrollment as a two-step process. "The first step is to implement it and duck." Then, after employees have become used to having money deducted from their paychecks, effective education efforts can persuade them to increase their participation.
The best way to educate employees is to show them how their retirement fund is growing, says Thomas Rossi, a Watson Wyatt Worldwide senior consultant in New York.
"Show them what it will grow into with just a little reduction in their take-home pay. Teach them first to be a saver, then to save enough," Rossi says. The more individualistic the message, the more likely it will be heard, he adds.
Rossi suggests that companies consider periodically bumping up an employee’s contribution on "a sliding scale," an approach he has not yet seen used.
Two experts who have studied automatic enrollment plans agree that companies need to find ways to encourage employees to contribute at higher rates. Brigitte C. Madrian, associate professor of economics at the University of Chicago Graduate School of Business, and Dennis F. Shea, vice president of total compensation for UnitedHealth Group in Minneapolis, also suggest enrolling employees at an initial low contribution rate, then automatically increasing the rate in small increments.
For example, they note in their paper for the National Bureau of Economic Research, "companies could start employees out at a 3 percent contribution rate, and then increase the contribution rate automatically by 1 percent each year unless the employees opt to change their contribution rate in some other way."
In their study, "The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior," Madrian and Shea found that 83 percent of employees who were automatically enrolled had some of their 401(k) contributions allocated to money market funds (five times the fraction of such allocations for non-automatic enrollees), and 80 percent had all of their contributions allocated to money market funds (16 times the similar fraction for non-automatic enrollees). Only a quarter had any of the contributions directed to the stock market.
Madrian and Shea suggest that companies choose less conservative default investment options, such as balanced or "lifestyle" funds. "While employers may be wary of choosing default fund allocations that are too aggressive because of the potential negative repercussions if returns fall or are negative, alternatives to very conservative investment choices should at least be considered."
Although there are good business reasons for companies to choose automatic enrollment, there also are good business reasons many companies decide against it.
The Profit Sharing/401(k) Council of America (PSCA) in Chicago, in its 43rd annual survey of profit sharing and 401(k) plans, found that only 4.2 percent of companies have automatic enrollment in 401(k) plans.
Richard Koski, a principal with Buck Consultants in Secaucus, N.J., says some companies see automatic enrollment as paternalistic. "I’ve probably talked to more that chose not to do it than do it. They say ‘if employees don’t want to join, they are adults.’ "
And some companies have backed away from automatic enrollment because of the cost, according to Koski. "They ask why give a gift to people who aren’t motivated enough" to act on their own? According to the PSCA survey, half of the companies that have automatic enrollment plans have a 50 cents on the dollar matching contribution. Twenty-nine percent reported that they offer no match at all.
Kliebert says he has never read or talked to anyone who was particularly concerned about the expense of automatic enrollment.
"It certainly is going to increase cost," he says, but "no matter how you slice it, the move from defined benefit to defined contribution saves corporation dollars."
Another issue for companies considering automatic enrollment is the employee turnover rate. High turnover rates mean more administrative work for the HR department. "If you have a fairly stable workforce, it makes a lot more sense," says Koski.
While industries such as fast food and retail have high turnover, they also have a need to increase the number of non-highly compensated employees in their retirement plans.
"Highly paid employees are such a small sliver of the population in these companies. They have tons of ‘zeros’ "—employees who aren’t participating at all, Koski says. "The zeros really hurt." In these industries automatic enrollment can be a real help to allowing highly compensated employees to contribute more toward their retirement.
A company might consider outsourcing the automatic enrollment plan to cut down on administrative headaches, but Koski warns that that may hurt participation because outsiders have fewer opportunities to talk to employees about the plan.
"People in the company can be more aggressive in going after people," he says, bringing up the subject when talking to employees about other issues. "HR people are a vital link in getting people to join the plan."
Yet another reason not to try automatic enrollment, according to Kliebert, is concern about state payroll withholding rules. "Nothing has come out yet that assures us that federal Employee Retirement and Income Security Act pre-emptions apply to this. This is going to make conservative people wait until that issue gets resolved by a court case or a Department of Labor ruling.
"There are issues that are still out there, but slowly those barriers are coming down. The current administration in Washington is supportive. Everything looks like it’s heading in the right direction," he says, "but very cautious people have reason to wait."
In the long run, "I think it’s going to take off," Kliebert believes. "The [IRS] rulings that have come out have got the process going and got people thinking. Most companies I consult with are not yet doing it. They need to see a little bit more that it’s going to work. Small companies are not doing it much so far, but I think it will happen."
That’s because "it’s good anytime you get people feeling better about the benefits that are being provided by the company. If they aren’t participating, they aren’t appreciating that particular benefit."
Koski also sees the idea taking off. "A year ago there was still a lot of controversy surrounding automatic enrollment," he says. Now "the fear is gone. There’s been pretty rapid development in this area. Some people say it’s going to become standard operating procedure, but that might be a stretch."
Stephenie Overman is a Chatham, N.J.-based freelance writer specializing in employee relations and health care issues.