Many 401(k) experts were upset by a recent article in the Wall Street Journal 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. The design of plan features is being blamed more frequently for low contributions after automatic enrollment. 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 also showed that 73% of plans use a 3% default, while only 27% chose a default rate of 4% or higher. One intriguing finding was that the 3% rate appears to be chosen simply because the IRS used it as an example in its regulations. Financial planners generally agree that 3% is inadequate for a secure retirement. Jean Young, a senior research analyst at Vanguard's Center for Retirement, said most plans use a default rate between 1% and 3%, which suggests many plans would benefit from a higher default.
To remedy this, many employers add an automatic escalation feature to increase the contribution rate for participants enrolled automatically. For example, a plan may increase contributions by up to two percentage points annually until contributors reach a cap percentage of pay.
However, there is significant evidence that default plans alone are not sufficient to secure retirement, even when they include escalation. 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.
Further Contribution Rate Issues. In another Vanguard study, at least 40% of plans had inadequate overall contribution levels, with combined participant and employer contributions under 9% of pay. Young suggests sponsors set higher default and escalation rates—she recommends a 6% default with a two-percentage-point annual escalation, which raises the savings rate above 12% within three years.
Continuing Education. Although fixing default and escalation rates is essential, it is also important for 401(k) plan sponsors to keep communication and education programs current. Ongoing training helps sponsors understand why a 3% default will not work and how to analyze 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 the recession 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 more personalized benefits approach; for related small-business resources see Small Business Administration Bonds.
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.