An Introduction to 401k Auto-Features: Breaking Down Barriers

In all areas of life, examples can be found of things that influence a person’s behavior; small levers that, when pulled, create huge actions and translate into gratifying results.

In workplace retirement plans, such as a 401k or a 403(b), these levers are presented in the form of auto-features. Auto-features are mechanisms that can be woven into the way a retirement plan is designed. They are a proven game-changer when it comes to encouraging retirement plan participants to start saving more for their financial futures.

Workplace plans: A critical factor in savings success

The monumental role that a workplace retirement plan plays in helping working Americans save for retirement can’t be understated. Eye-opening research from the Investment Company Institute indicates that 56% of those who participate in a defined contribution plan through their job say they probably wouldn’t save for retirement if they didn’t have a plan at work.

Nine out of 10 account owners agreed that their workplace plan helped them think about the long term and made it easier to save. And while having access to a retirement plan is a great starting point, it’s simply the gateway to helping them achieve retirement readiness. That is where auto-features come in.

What gets in the way of saving for retirement?

In order to understand the plight that retirement savers face when urged to improve a standard of living that they won’t be able to enjoy for several years to come, it’s important to recognize the psychological forces that are at play. The most prominent of those forces is willpower (or, a lack of it). Willpower can be thought of as a basic ability to delay gratification, and most people are not good at it.

When it comes to saving for retirement, individuals struggle when posed with the choice of something that will make them happy today or something that will make them happy in the future.

An example of how willpower correlates to the saving-versus-spending dilemma can be found in an experiment conducted by Dr. Nava Ashraf, a Harvard Business School economist. Dr. Ashraf offered bank customers a chance to open individual savings accounts, but only if the customers agreed they would withdraw their funds after they reached a target date or target savings amount they had chosen.

After a year, the customers who enrolled in the accounts saved 82% more than customers in a control group who had not opened the special accounts. Eliminating the decision of whether to spend or save helped the customers fortify their willpower and choose an action that would lead to a positive future outcome.

Retirement plan auto-features can help plan participants achieve the same results by:

• Making it easier for participants to save for their future instead of overspending to fulfill more immediate, but often empty, gratifications
• Lowering psychological barriers that might prevent participants from enrolling in their company’s retirement plan and getting them to save earlier in their work life cycles
• Helping them overcome the inertia that often keeps savings rates static, thrusting their savings momentum forward
• Providing opportunities to invest in funds that offer more appropriate asset allocations

Retirement plan auto-features come in three main forms: auto-enrollment, auto-deferral escalation, and re-enrollment. Although all three work slightly differently, they open the doors to improving outcomes for retirement savers. Let’s look at how each of these auto-features works, the benefits for plan participants and retirement plan sponsors, why the manner in which they are implemented matters, and how financial advisors who consult with corporate retirement plan clients can make a difference.

Automatic enrollment

Although auto-enrollment was introduced long ago, its continued popularity is an attestation to its effectiveness—with 69% of retirement plans offering an auto-enrollment feature compared with 51% in 2015, according to the 2020 Defined Contribution Institutional Investment Association (DCIIA) Plan Sponsor Survey.

How it works. With auto-enrollment, eligible employees are automatically set up to contribute to their retirement plan at a specific percentage of pay. The most common default percentage is 3%, according to research from Deloitte. There’s an opt-out feature, but—good news—only 10% of employees choose not to enroll (sound familiar?). And, according to research conducted by Vanguard, 92% of participants hired under auto-enrollment still participated in their plan, compared with just 29% of participants under voluntary enrollment. Auto-enrollment doesn’t just lower the barrier for entry, it kicks it down.

It’s important for retirement plan sponsors to understand thatafter implementing an auto-enrollment feature, the vast majority of plan participants stay enrolled in the plan compared with a 44% participation rate for plans with voluntary enrollment (which requires employees to opt-in). For plan sponsors who are skittish about implementing auto-enrollment in their plan due to fear that they will get pushback from their employees, those concerns should be put to rest.

Indeed, employers who have implemented an automatic enrollment feature say employee resistance has been less than anticipated, according to the Plan Sponsor Council of America’s 62nd Annual Survey of Profit-Sharing and 401k Plans.

Benefits. Beyond the obvious benefits to participants, an automatic enrollment program has many benefits for retirement plan sponsors, including:

• Increased participation and higher contribution rates, which may favorably affect a sponsor’s nondiscrimination testing results, allowing owners and highly compensated employees to contribute more to their retirement savings plan.
• Simplified selection of appropriate investments, particularly target-date fund investments. This often fulfills Qualified Default Investment Alternative (QDIA) objectives, providing safe harbor protections for plan fiduciaries.
• Encouragement for employees on the path to retirement. This can help stave off the drag on a business’s financial resources when employees can’t afford to retire, as well as foster a culture of loyalty, morale, and productivity.
• Potential to qualify for a tax credit of up to $500 for three years, courtesy of a provision in the SECURE Act. (Note: impending legislation, coined SECURE Act 2.0, would require employers to auto-enroll employees at 3% of their pretax pay, increasing annually by 1% up to at least 10% but not exceeding 15% of the employee’s pay).

Automatic deferral escalation

A logical next step to keep participants’ savings momentum moving forward is to implement the auto-deferral escalation feature. This tried-and-true mechanism helps participants incrementally bump their contribution rates until they meet a predetermined level. The minimum recommended ceiling has traditionally been 10%, although as auto-deferral popularity rises, experts have recommended raising the ceiling to 15%.

How it works. Auto-deferral escalation features allow plan sponsors to set the percentage by which a participant’s elective deferral will increase each year until it reaches a predetermined ceiling (the most common annual increment is 1%).

Benefits. Notably, auto-deferral escalation combats the inertia retirement savers regularly grapple with, causing them to leave their savings rates static—a fatal retirement saving flaw. Again, the effect of opt-out versus opt-in when it comes to auto-deferral escalation cannot be underestimated.

According to T. Rowe Price, participants presented with an option to opt out of auto-deferral escalation adopt at a rate of 65%, compared with an adoption rate of just 12% for those presented with a choice to opt in. Furthermore, increasing deferral percentages encourages participants to realize the full extent of their employer-matching contribution possibilities. So, auto-increase not only represents steady progress, but it could mean a double win for some participants.

Re-enrollment

The re-enrollment feature essentially gives participants a valuable chance at a 401k investment do-over by allowing them to modify their existing (and, in many cases, unsuitable) 401k investment choices into the plan’s QDIA, which is typically a target-date fund. Unlike auto-enrollment and auto-increase, which have experienced enthusiastic and widespread adoption, re-enrollment has only seen a 9% adoption rate by plan sponsors. This is despite only 34% of plan participants being highly confident in selecting plan investments and more than 60% who welcome investment help!

How it works. Participants receive a notification that their existing assets, as well as future contributions, will be directed to the QDIA on a specified date, unless they choose to opt-out. As you may have guessed, re-enrollment opt-out rates are surprisingly low.

Benefits. It has been established how crucial a retirement plan is when it comes to saving for the future. But saving is only part of the equation. Participants aren’t being given the chance to see their full possibilities come to fruition because they are asked to do something that is not inherently natural.

For retirement investors who aren’t confident enough to choose investments or lack the time and discipline to stay on top of their investments, re-enrollment offers a great way to combat those irrational investment tendencies and to ensure that they’re re-positioned to meet their retirement goals.

There are benefits for plan sponsors, too. When implemented correctly, re-enrollment allows them to strengthen their fiduciary standing by gaining favorable QDIA safe-harbor protections.

Advisors play a critical part

Financial advisors and consultants who coach business owners and retirement plan clients can take three easy steps to help clients pull the right levers to take full advantage of the benefits of auto features.

1). Start by reviewing your book of business to identify plans that aren’t currently adopting auto-features. All employers could benefit from auto-features in their company’s retirement plan, but to begin, pay particular attention to those that display the following warning signs:

• Low or historically declining participation rates, counting eligible versus participating employees with an account balance
• Low or historically declining savings rates (The average participant savings rate is 7%, according to Vanguard research.)
• Low average account balances for participants (The average balance is $106,478, also per Vanguard research.)
• Plans that have had corrective distributions
• Companies with multiple locations, which typically have enrollment and engagement challenges
• Lack of QDIA or target-date funds in the plan offering

Present the various retirement plan auto-features to plan sponsors who display the warning signs. Remind them how a retirement plan benefit can be a key factor when trying to attract and retain talented employees, and discuss how these features can help both them and their employees.

2). Then, be sure to discuss auto-features with the plan sponsor’s service providers, such as their recordkeeper and third-party administrator, to determine whether the features are feasible and what effect they might have on the employer’s annual nondiscrimination testing, matching contribution budgets, and business taxation.

Of course, there is no universal solution to foster retirement plan engagement, but as evidenced by research, giving retirement savers a nudge to act for their financial futures by leveraging auto-features is well worth the effort. Proactively offering simple auto-feature solutions that can optimize retirement plan offerings will have a meaningful influence on employees and employers alike.

Dan Collins, AIF®, Retirement Marketing Program Manager, Commonwealth Financial Network, Member FINRA/SIPC.