Plan Design
Automatic enrollment has helped bring millions of American workers into retirement plans. But participants still don’t save enough. In fact, according to the National Institute on Retirement Security, more than 75% of American workers fall short of conservative retirement savings targets.1 Plan sponsors may wish to improve this situation by making fuller use of auto-features.
Here are some action steps sponsors can take to boost the power of their retirement plans:
- Up the auto-escalation percentage
- Automatically enroll existing employees — not just new hires
- Re-enroll participants into more appropriate options
- Encourage rollovers from workers’ previous plans
Ramp up auto-escalation to boost savings rates
Most employers auto-enroll new employees at a default contribution rate and then automatically increase that rate over time (a practice called auto-escalation). If the initial default rate is around 4%, however, it would take 6–11 years of 1% annual increases to bring the contribution rate to the 10%–15% minimal levels most experts say2 are needed to meet income replacement levels at retirement.
To address this problem, employers should consider ratcheting up their initial default contribution rates to between 6% and 12% and bumping up the annual increase to 2% or more.
Won’t higher rates provoke an employee backlash? Surprisingly, research shows many participants appear willing to clear that hurdle with their employer’s help. About half of investors tend to accept the initial default rate of 6%, with some accepting as much as 12%.3
Auto-escalation: How high can we go?
At what percentage should you stop auto-escalating employees? Look at it this way: If you have two employees, with one of them auto-escalated to 15% and the other remaining at a 6% contribution rate, the employee that gets auto-escalated will have $1.3 million more at retirement, based on an 8% annual return assumption.
A simple scenario shows the power of auto-escalation
Source: Capital Group. For illustrative purposes only. Not an actual investment. Assumptions: A hypothetical employee enrolls in the employer’s retirement plan at age 25, at which time she is earning $40,000 a year, and then retires at age 65. The salary is assumed to grow 3% annually. Both scenarios assume participant contributes 6% in the first year and that the portfolio will grow by a flat rate of 8% each year. In the 3% auto-escalation scenario, we assume the plan has an automatic default escalation rate of 3% each year until year four, at which time the salary deferral rate continues at 15% until retirement. Monthly retirement income projections assume a withdrawal rate of 4% each year over 30 years of retirement. The scenario assumes the portfolio grows 2.5% annually after retirement, and an average of $3,462 in extra spending each month.
Re-enrollment to align participant allocations with retirement objectives
The advent of the qualified default investment alternative (QDIA), typically target date funds, has greatly improved the average participant’s investment allocation. According to Aon Hewitt, the median 5-year annualized rates of return for DC participants across all age groups fully invested in target date funds is on average 2.9% higher than the return for investors not invested in target date funds.4
Higher historic returns in target date vs. non-target date
Source: Aon Hewitt, “Target-Date Funds: Who Is Using Them and How Are They Being Used?” 2016.
Often overlooked with the success of target date funds is the fact that about 81% of DC assets still are invested elsewhere.5 Sponsors may want to give some thought to defaulting their participants to more thoughtful age-appropriate allocations through an investment re-enrollment into target date. Surprisingly, only 14% of plans have taken this step despite its potential ability to improve outcomes.6
Auto-sweep to cover more workers
Nearly three-quarters of employers automatically enroll new employees. Why not take it a step further by auto-enrolling employees who aren’t already in the plan? According to the Bureau of Labor Statistics, only about 40% of workers nationwide participate in a retirement savings plan like a 401(k). Yet only a minority of plans currently take the time to auto-enroll existing workers, even though it could, in some cases, dramatically increase participation.7
Put savings from old plans back to work
A crisis point can occur when employees switch jobs and either abandon assets or cash out their retirement accounts. From 2004 to 2013, separated employees left more than 16 million accounts, with an aggregate value of $8.5 billion, in workplace plans.8 Plan sponsors can help mitigate plan leakage by providing necessary roll-in paperwork and guidance to new employees.
Looking ahead
Because the road to retirement is a long one, employers may wish to shift their plans out of manual mode and into automatic with tools such as auto-enrollment and auto-escalation, which can nudge their employees along and help them pursue a successful journey to retirement and beyond.
1National Institute on Retirement Security, “Retirement in America: Out of Reach for Working Americans?” September 2018.
2Morningstar, “Save More Today: Improving Retirement Savings Rates with Carrots, Sticks, and Nudges,” April 5, 2017.
3Morningstar, “Save More Today: Improving Retirement Savings Rates with Carrots, Sticks, and Nudges,” April 5, 2017.
4Aon Hewitt, “Target Date Funds: Who Is Using Them and How Are They Being Used?” November 2016.
5BrightScope and Investment Company Institute, “The BrightScope/ICI Defined Contribution Plan Profile: A Close Look at 401(k) Plans, 2015,” March 2018.
6Callan Institute, “2018 Defined Contribution Trends,” 2018.
7Defined Contribution Institutional Investment Association, “Design Matters: The Influence of DC Plan Design on Retirement Outcomes,” July 2017.
8U.S. Government Accountability Office, “401(k) Plans: Greater Protections Needed for Forced Transfers and Inactive Accounts,” November 2014.
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