Auto Enrollment Makes 401(k)s Easy, but Experts Say it’s Not Enough

Automatic enrollment in 401(k) plans makes saving for retirement a breeze by automatically diverting a small portion of new employees' salaries to the plan. But if you think by placing your retirement planning in the hands of your employer will prepare you for your golden years, experts said you'll probably come up short. 

Since the enactment of the Pension Protection Act [PPA] in 2006, the number of large employers offering automatic 401(k) enrollment has increased about 19% since 2005, to about 34% in 2007, according to Hewitt Associates, a human resources consulting firm based outside of Chicago.  That's a clear step in the right direction; few would argue that an increase in the number of employees contributing to their 401(k) plans is bad thing.  The average contribution rate employees are automatically enrolled in is about 4.5% of their salary, and while that is certainly better than nothing, it might not be enough.

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“Four-and-a half percent in total is not going to give you a good retirement," said Anthony Webb, a research economist at the Center for Retirement Research at Boston College. "I guess that 4.5% is better than nothing, but it’s certainly not going to get you where you want to be.”

This prompts the question of why employers are automatically enrolling their employees at such a low rate, especially since studies show employees are unlikely to drop out of automatic enrollment plans when their contributions are automatically increased.

Michael Doshier, vice president of marketing for Fidelity Retirement Services said the number of employees who drop out of automatically enrolled 401(k) plans is between 1% and 9%.  Of all the starting deferral rates, more people increase their deferral rates as a next step when 6% is selected as the default  compared to a 3% default. 

Since increasing contribution rates seems to have a positive impact on the amount of employee participation, it’s unclear why employers would be reluctant to raise default contribution rates.

One hypothesis has to do with the fact that before the Pension Protection Act or PPA was signed into law, many employers feared that automatically enrolling employees in a savings program could violate some state laws, or that they might be exposed to liability if the stock market were to go down and employee contributions lost value. There was also some concern that employees would demand automatically contributed funds be returned to them, which would be difficult for employers to do because of 401(k) withdrawal restrictions. Now that those issues have been dealt with, more employers are offering automatic enrollment, although there is still some hesitation to automatically enroll employees at a high contribution rate.

"The original ruling that defined and approved automatic enrollment back in 1998 used 3% as an illustration of how automatic enrollment works,” said Mark Iwry, who directed the issuance of the ruling when he was serving as an official at the Treasury Department.

“There were subsequent rulings that made clear that 3% was not a requirement, only an example, but much of the corporate community tended to stick relatively close to the terms of that [original] ruling, ” said Iwry who is now  the  nonresident senior fellow at the Brookings Institution and managing director of the Retirement Security Project.

The nonprofit Retirement Security Project and many others have since recommended the default contribution rate be automatically increased over time; thus, the employee who was automatically contributing 3% in the first year of employment would be contributing 4% in the second year, 5% in the third, and so on until the contribution rate reached a level designated by the plan.

That idea is beginning to catch on.

A study done by the Center for Retirement Research in 2006 showed 39% percent of the companies that had already used automatic enrollment had also added automatic escalation features. But that data was collected before the PPA, and there is reason to believe the number of employers offering automatic escalation will be much higher now.

Another reason some companies have been slow to automatically enroll employees at high contribution rates is because it adds a significant amount of cost.

“They have to think about match dollars,” Doshier of Fidelity said. “If you go from 70% 401(k) participation to 90%, then that’s a big jump.  Most plan sponsors would rather ease into this with a multi-year strategy.  They’d rather go in with the 3% and then slowly do the automatic increase.”

Sixty percent of Vanguard plan sponsors are either already offering automatic escalation, or they automatically enroll employees at a rate of 6% with a 4% company match, said Steve Utkus, director of the Vanguard Center for Retirement Research. He thinks the bigger issue is getting more firms to adopt auto enrollment and to get the firms that have adopted it to auto-enroll existing employees, not just new hires.

Regardless, employees currently enrolled at a low default contribution rate should consider upping the amount. Experts said contributing between 9% and 12% of your total salary is a much more realistic way to get your retirement savings on track.

“We guide employers to go to 10%,” Doshier said. “If you save 10% over time, that’s a number that will substantially contribute to retirement.”

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