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Not automatically increasing employee contributions could be short-sighted
Left to their own devices, many workers contribute just enough to their 401(k) plans to qualify for any matching funds from their employer—and employers most commonly match only up to 6 percent of an employee’s pay. But workers should aim to save at least 10 percent or more of their pretax earnings over their working lives to ensure an adequate retirement nest egg, many financial planners recommend.
An automatic escalation feature within 401(k) and similar defined contribution plans can help employees increase their savings and achieve their retirement goals. Typically at the start of each year, the plan automatically raises the percentage of pay that plan participants contribute by one percent or more, until they achieve a set deferral rate, such as 10 percent of their paycheck. Participants may affirmatively opt out of the annual increase.
Testimony before a U.S. Senate Finance Committee hearing on helping Americans prepare for retirement, held on Jan. 28, highlighted the value of auto escalation.
“Given the enormity of the retirement savings crisis … we need bolder steps,” advised Alicia H. Munnell, director of the Center for Retirement Research at Boston College, in her testimony. “The most important policy change would be requiring all 401(k)s to be fully automatic, while continuing to allow workers to opt out if they choose. Plans should automatically enroll all of their workers—not just new hires—and the default employee contribution rate should be set at a meaningful level and then increased until the combined employee contribution and employer match reach 12 percent of wages.”
John J. Kalamarides, head of Institutional Investment Solutions at financial services firm Prudential Retirement, testified that based on his firm’s research, a model template for 401(k) plans would include:
• Automatic enrollment of employees at a rate equal to 6 percent of pay, with an option for eligible employees to opt out or select an alternative contribution rate.
• Automatic escalation of employee contributions to 10 percent of pay, in annual 1 percent increments, with employee opportunity to opt out.
“We believe that use of a model plan [would] increase retirement savings for plan participants,” Kalamarides said.
A good reason why automatic enrollment should be paired with auto escalation is that when employees are automatically enrolled at a set salary deferral rate, they are less likely to revise their contributions upward over time as their earnings increase, a January 2016 research report by J.P. Morgan Asset Management found. The result is that automatic enrollment, by itself, increases the percentage of employees who participate in the plan but results in a lower overall savings rate among participants.
But while 62 percent of employers with large plans (over $200 million in assets) automatically enroll new employees into their plan, far fewer (48 percent) have adopted automatic escalation, according to a 2015 survey report by the Defined Contribution Institutional Investment Association (DCIIA), a Washington, D.C.-based nonprofit organization that represents retirement plan stakeholders.
The top three reasons that employers gave for not offering automatic escalation were:
• Too paternalistic toward employees (21 percent of respondents).
• Employees would complain (14 percent).
• Too costly from a company matching perspective (13 percent).
Significantly, among plans that offered automatic escalation, almost one-third of respondents reported actual savings rates greater than 10 percent, while for plans without automatic escalation, only one-fifth of participants had savings rates over 10 percent, DCIIA found.
“Automatic enrollment helps bring younger workers into the plan, but even when they become participants, the level of their contributions is low. Auto escalation can help,” said Joe DeSilva, senior vice president and general manager of ADP Retirement Services, based in Florham Park, N.J., in an interview with SHRM Online.
While many plan sponsors know about automatic enrollment, far fewer are aware of the value of auto escalation, DeSilva noted, even though “the data suggests when you do auto escalate, employees end up at retirement with larger nest eggs.”
As to employee opposition, one answer is better communications, which should include stressing that participants always have the ability to opt out of the automatic increase, DeSilva said.
“At the end of the day, you combat that with overall education,” he noted. Employers should do a better job “driving awareness to participants about the power of saving early in their career, during those low-income, low-wage years when employees are first entering the workforce. Pointing out the power of asset growth over time is critical. Employers often aren’t doing a good job of telling that story.”
Regarding employers that haven’t put automatic escalation in place because they don’t want to pay out more in matching contributions, “I think it’s completely short-sighted,” said DeSilva. “I would hope that employers are smarter than that. If they’ve been educated on the benefit of offering a 401(k) or other retirement plan, they know that their employer contributions are tax-deductible, that retirement plan assets can grow tax-free, and that if you’re starting a plan, there are tax credits available. It’s not only a benefit for their employees but a benefit for them.”
Consider ‘Stretch Matches,’ Too
“Inadequate saving levels could potentially be improved if plan sponsors altered auto-escalation features to help reach deferral rates of 10 percent or more,” noted Lorie Latham, director at Towers Watson Investment Services in Chicago.
As for the match formula itself, “participants take cues from their employers,” Latham said. That’s why more are stretching their match. “A 100 percent match formula on 5 percent [of deferred salary] may signal that a 5 percent savings rate is the appropriate level of savings,” Latham said. “However, a match formula of 50 percent on the first 10 percent will still cost the employer the same amount of maximum match dollars and would also require participants to save more to get their ‘free’ money from the plan sponsor. This could help ensure a successful outcome.”
And plan sponsors needn’t limit auto-enrollment to new hires. Instead, they should weigh the merits of annually auto-enrolling current employees who don’t participate in the plan into a suitable default investment, such as an age-appropriate target-date fund, Latham advised.
Stephen Miller, CEBS, is an online editor/manager for SHRM.
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