Every time it seems there’s nothing new to say about auto features, new questions arise. Most of them spring from fallacies that continue to be perpetuated throughout the 401(k) industry.
Some oft-repeated misunderstandings in the retirement plan industry are:
- A default contribution rate of 3% is standard.
- Capping auto-escalation lower than 15% is a good idea.
- Auto-sweeping non-participants into the plan is risky.
- Employees won’t appreciate full use of auto features.
Let’s dig into these misunderstandings and why they each may be inaccurate.
Why a 3% default contribution rate might be a mistake
One of the more confounding norms in plan design is the 3% auto-enrollment rate. No one is (or at least very few people are) retiring on 3% savings, yet many participants assume that the default rate is sufficient and are unlikely to increase it on their own. I’m sure you know this on some level, but when was the last time you actually looked at the numbers?
Median weekly earnings for full-time wage and salary workers in the United States were $1,037 in the first quarter of 2022.* If we extrapolate that to $53,924 annually, a 3% contribution rate would be just $1,618. Obviously, that amount would grow with time and raises (one would hope), and investments would mature. But let’s run this through a retirement calculator. We’ll set the age at 40, giving this hypothetical individual at least 25 years to save. According to American Funds’ retirement planning calculator, someone looking for 80% of their final annual salary during a 20-year retirement, starting at $53,924, could need to save $1,074,032. With a 3% contribution rate, they’re projected to come out of 27 years’ worth of saving with $152,640.†
Chart 1: Hypothetical growth of investments over 27 years until retirement
Chart is for illustrative purposes only, based on the hypothetical projections from American Funds’ retirement planning calculator, using 3% contribution of the median weekly earnings for full-time wage and salary workers in the United States. The calculator assumes that the growth rate of your investments is 8% per year before retirement and 6% per year after retirement. Many financial professionals suggest planning for a lower growth rate in retirement because you may want to switch to a more conservative investing style as you grow older. The calculator does not account for post-retirement income taxes, which may apply to certain investments. The calculator assumes an annual inflation rate of 4%. Over the past 50 years, the Consumer Price Index, a common measure of inflation, averaged about 4% a year. The calculator assumes a salary increase of 3% per year until retirement. The 3% increase is applied to the previous year’s salary. Hypothetical growth rates are not intended to reflect actual results; your results may vary.
For most financial professionals, it’s obvious that 3% is not enough to retire on. So then, why did it become the standard default contribution rate? By the power of suggestion. When auto-enrollment was introduced, several influential sources, including leading behavioral finance experts, used 3% as a hypothetical contribution rate. Pretty quickly, a norm was born. Employers routinely used 3% as their base auto-enrollment rate, despite its insufficiency.
Fortunately, that tide is starting to turn. Six percent is gaining traction as a starting enrollment rate. This is definitely an improvement. But consider the hypothetical 40-year-old saver. Even if they raise their contribution to 6%, nearly doubling their savings projection to $305,186, this number is still significantly shy of the goal.†
Encourage plan sponsors to consider setting the default enrollment rate to at least 6% and to couple that with sufficient auto-escalation.
Embrace auto-escalation and raise the cap
Too many plan sponsors are afraid of auto-escalation and set their contribution caps too low. One objection that frequently arises: “I don’t want to upset employees.” The fear is that an imagined employee will discover that a higher percentage of their paycheck is being channeled into their retirement account than they expected.
Anecdotally, employees are rarely upset about auto-escalation, and they may be surprised when they hit the cap. Of course, most people are pleased when they discover a higher-than-expected balance in their 401ks, and the “problem” of an upset employee can be solved with a few clicks of a button. If they want to reduce their contribution, that is an easy fix.
A much greater risk is to your plan participants’ savings goals. People are often inclined toward inertia and underinformed about retirement savings needs. Left to their own devices, they’re likely to assume that their current contribution rate, whether it’s 3%, 6% or something else, will help them reach their goals. Fortunately, you have tools to leverage this inertia and help them overcome their own misinformed confidence. Auto-escalation provides this power, yet some sponsors are reluctant to use it to its full extent. This is particularly true when it comes to capping the escalation rate. I’ve seen sponsors set caps as low as 6%.
Auto-escalation has no generally applicable IRS limit, though guidance on the niche case of auto-enrollment safe harbor plans has affected perception. Thanks to the SECURE Act of 2019, plan sponsors with an automatic enrollment safe harbor plan can increase the auto-escalation cap up to 15%. It’s promising to see in the Callan Institute’s 2022 Defined Contribution Trends Survey that 27% of safe harbor sponsors intend to increase their cap to the maximum. Conversely, it is disappointing to see that 31% intend to make no increases whatsoever.
Have or will increase automatic escalation cap in qualified automatic contribution arrangements (QACAs)
For a prominent recent example of an escalation cap increase, look to Charles Schwab. According to Ignites, the company raised the cap for its own employees’ 401k plan from 10% to 15% in 2021 and increased the default deferral rate from 5% to 6%. Each year, contributions are automatically increased 1%. Hopefully, this plan design by a major financial firm will serve as a model to plan sponsors across industries.
Encourage sponsors to consider setting escalation caps to 15% and let employees decide for themselves if they want to opt-out.
Make non-participants opt out every year
If there’s a bogeyman of auto features, it’s the auto-sweep. “What if my employees get mad that I put them back in the plan when they already opted out?” But what if they reach age 65 and realize they haven’t saved for retirement? It may be better to make employees opt out each year than to see someone forget they opted out once upon a time. The risk is far greater to the employee in the second scenario — years of potential saving wasted.
Encourage plan sponsors to embrace the auto-sweep feature and include the opt-out opportunity as part of their annual open enrollment, right alongside health insurance decisions.
Defaulting to a retirement income strategy comes with risks
As for the new trend toward guaranteed retirement income features in qualified default investment alternatives (QDIAs), proceed with caution. Target date investments are designed to meet the needs of the majority of participants in that most individuals will want a greater share of more conservative investments as they near retirement. That said, the closer a person is to retirement, the more nuanced their needs will be — and the less room they will have for error. Income in retirement can involve many unique factors for an individual, which means it may require more attention than your average mid-career accumulation portfolio. Many guaranteed solutions add cost and/or reduce liquidity, which may not be right for the majority at that point in their timeline.
If QDIAs are designed to help people who aren’t necessarily thinking about their retirement investments, then those that include either a guaranteed or a non-guaranteed income element should be prepared to flip that script. Make sure participants are paying attention. Alert them to the income element(s) of the QDIA and what that could mean for them. This may involve much more disclosure, more education and more opportunities for the participant to make different choices.
I understand that including income-generating investments in a QDIA is designed to prevent people from reaching retirement without a plan, but people cannot afford to sleepwalk into distribution, either. If you choose to expand the retirement income aspect of your plan, here are my suggestions:
- Understand the retirement income aspect of your current QDIA.
- Offer multiple options that can help meet the diverse retirement income needs of participants.
- Offer both guaranteed (protected) and non-guaranteed options.
- Consider allowing participants to “opt-in” to guaranteed options based on their needs and preferences.
A final point to consider
Professionals in the retirement industry have a duty to keep their sights on the long term, but for some reason, plan sponsors often fixate on the short-term feelings of employees over their long-term retirement readiness. When it comes to plan design, financial professionals have a responsibility to encourage plan sponsors to use the tools available to help participants work toward their retirement goals. That sometimes means making decisions they wouldn’t necessarily make for themselves, like higher default enrollment rates, higher caps on auto-escalation rates, and auto-sweeping employees back into the plan. It also sometimes means approaching trends with caution, as one should with retirement income.
To close, remember how infrequently plan sponsors report problems from raising default contribution rates or auto-escalation caps—or even from auto-sweeping. While some of these features may feel like an overreach, encourage your clients to make full use of them.
This article first appeared here.
John Doyle is SVP, senior defined contribution strategist at Capital Group with over 35 years of experience. He holds an MBA from the F.W. Olin Graduate School of Business at Babson College and a bachelor’s degree in economics from Georgetown University.
Nice article John. There are 2 steps to retirement with dignity: (1) save, and (2) don’t lose your savings. Sponsors encourage the 1st step with auto enrollment and auto escalation, but they fail miserably at the 2nd critical step because they’ve chosen very risky TDFs that are 85% risky at the target date — 50%+ in equities plus 35%+ in risky long-term bonds. You’ve described this concern John & suggest that defaulted beneficiaries take back control as their near .retirement but history (especially 2008) suggests they won’t hear your advice, but good try.