December 5, 2013—Welcome to the Alliant Best Practices Series for 401(k) Plan Sponsors, in which we offer 10 best-practice essentials for helping plan participants achieve retirement plan success. Here’s the fourth best practice in our series.
“Never put off till tomorrow what you can do today.”
— Thomas Jefferson
In our last post, Financial Education for Your Plan Participants, we discussed providing your plan participants with the education needed to understand financial essentials. Before that, we covered the benefits of offering individual consultation to speed their way. Auto-enrollment and escalation form a third and vital leg in a tripod of retirement plan best practices.
Increase Participating by Harnessing Our Best, Worst Habits
Thomas Jefferson’s advice aside, it’s human nature to put things off, especially when it comes to unpleasant chores. So, even though most of us want to save for retirement, we have a way of procrastinating when left to our own devices.
By understanding our own worst habits, we can turn them around, so they work for rather than against us. That’s the premise behind auto-enrollment and escalation features in plan design. In both cases, these auto-pilot programs require employees to opt OUT of recommended saving habits if they don’t wish to participate, rather than requiring them to opt IN to participate. This dramatically increases the odds that employees will participate fully in their retirement plan programs.
Auto-Enrollment Benefits Employees
In an auto-enrollment plan, when employees take no action:
- They are automatically enrolled.
- A predetermined percentage of their salary is withheld.
- Their withholdings are invested in a Qualified Default Investment Alternative (QDIA).
Auto-enrollment benefits employees by taking advantage of the tendency to drag one’s feet on decision-making. It ensures that no decision still generates a desirable outcome.
Auto-enrollment has been well-received. For example, an October 2011 industry survey found that 70 percent of employees said they favor the use of automatic enrollment. On the flip side, according to a Boston College report cited in this Wall Street Journal MarketWatch post: “Just 67% workers with a 401(k) plan that don’t have automatic enrollment contribute to their plan.”
Auto-Enrollment Protects Employers
Auto-enrollment and QDIAs also serve as a safe harbor for you, the plan sponsor, to protect you from liability when the participants have not been proactive on their own. As described by a Department of Labor/Employee Benefits Security Administration fact sheet, “The Pension Protection Act (PPA) President Bush signed into law in 2006 removed impediments to employers adopting automatic enrollment, including employer fears about legal liability for market fluctuations and the applicability of state wage withholding laws.”
Auto-Escalation for Improved Savings Rates
So far, so good. Unfortunately, ongoing analysis revealed an unpleasant, unintended consequence inherent to early auto-enrollment programs: Participant savings rates decreased.
What was at play? In this case, momentum was playing against indecisive employees. When auto-enrolled at an initially modest savings rate of 2–3 percent of their salary, they were less likely to select a higher amount or increase that amount over time, because it required a conscious act to do so.
This is where automatic escalation comes in to save the retirement day. If a participant takes no action, auto-escalation increases his or her savings rates each year until a desired level is reached. As always, the participant can opt out any time, but he or she must choose to do so.
Again, the program seems well-received. A Principal Financial Group analysis found that when auto escalation is an opt-in program, only 6 percent of participants take advantage of it. When the plan design incorporates automatic escalation, almost 80 percent of employees stay with it.
To optimize the odds that participants achieve their desired retirement, we would suggest the following goals for a well-managed 401(k) plan with auto-enrollment and auto-escalation:
- Encourage higher participation and utilization rates through through plan design.
- Establish initial auto-enrollment at a deferral rate of 6% of salary.
- Establish automatic escalation of the deferral rate at 2% per year.
- Ultimately move participants into a deferral rate of 10%.
Next Up: Investment Policy Statements: Putting it in Writing
Once employees are participating and saving at a meaningful rate, you want to ensure they have sensible investment portfolios to choose from – or be auto-enrolled into. In our next post, we’ll cover how to generate a prudent Investment Policy Statement to guide Fiduciary investment selections, enhance investment outcomes and shield you from liabilities.
Do you like what you’ve read so far in our Alliant Wealth Advisors 401(k) Solution Best Practice Series? We also offer a complimentary presentation to further explore these best practices with you and other key retirement-plan decision-makers at your company. Please contact us to learn more.