Many 401(k) experts were upset by a recent article that suggested enrolled individuals automatically faced a decrease instead of an increase in retirement savings rates. The author wrote this was because most participants do not change their contribution rate from the default level, and the default is lower than the rate most people choose with active enrollment.
This raises an important question: what should 401(k) sponsors do when they start offering plans that feature a default contribution percentage for automatic enrollment? Although most people accept the importance of enrolling, it is clear workers need to save more for retirement.
Escalation Rates
A common criticism of plan design is that default contribution rates are too low. A Vanguard survey showed the most popular default for automatic enrollment plans was 3% of pay, with nearly 58% of plans surveyed using that rate out of more than 2,000 plans.
The same study found that 73% of plans use a 3% default while only 27% chose a default rate of 4% or higher. Jean Young, a senior research analyst at Vanguard's Center for Retirement, noted most plans use a default between 1% and 3%, which suggests many plans would benefit from a higher default.
Further contribution rate issues
To address low defaults, many employers add an automatic escalation feature that increases contribution rates annually until a cap is reached. For example, a plan may increase contributions by up to two percentage points per year until contributors reach a cap percentage of pay.
However, Vanguard's research indicates employees need total contributions of roughly 12% to 15% of pay each year. In summary, employers often set default contribution rates too low and provide escalation schedules that are insufficient, so many participants may not save enough by retirement.
Continuing education
Fixing defaults and escalation schedules is important, but ongoing communication and education are also essential. Continued training helps sponsors understand why a 3% default will not work and how to analyze savings gaps over time so they can make future improvements.
For more information on retirement-plan design and education, see Understanding Workplace Retirement and Health Savings Plans.
Matching contributions
Matching is one of the most important ways sponsors can help employees save. During economic downturns many sponsors reduced or eliminated matches, which lowered both savings rates and overall participation.
Smaller employers were more likely to avoid automatic plan features such as escalation and automatic enrollment, often relying on a personalized benefits approach; for related small-business resources see Small Business Administration Bonds.
For plan design and insurance considerations that affect retirement plans, see 401(k) vs 403(b) and Related Insurance Considerations.
For information about participant coverage options, see Participants Accident Coverage (Motorsports).
To put this information in perspective, sponsors should recognize the issues, obtain the training needed to correct them, and understand participant engagement and behavior for both defaulted and actively enrolled employees. Sponsors who need help implementing plan changes or communication strategies can talk to an agent.
Frequently Asked Questions
What is a default contribution rate for automatic enrollment?
A default contribution rate is the percentage of pay that employees are automatically enrolled to contribute to a retirement plan unless they opt out or change it.
Why is a 3% default often considered too low?
Most research finds 3% is insufficient to meet retirement income targets; combined employer and employee contributions closer to 12% are often recommended for adequate retirement savings.
How does automatic escalation help participants?
Automatic escalation gradually raises contribution rates, typically by one to two percentage points per year, which can increase savings without requiring active decisions from participants.
Should small employers use automatic enrollment and escalation?
Small employers may rely on personalized communication instead of automatic features, but automatic enrollment and sensible escalation can still boost savings and participation when implemented thoughtfully.
What can sponsors do to improve participant outcomes?
Sponsors can raise default and escalation rates, maintain employer matches, and provide ongoing education so participants understand and stay engaged with their retirement savings.