Is This $136,852 Gift Hidden in Your 401(k)?

I have news for you: Your 401(k) might have an enormous benefit buried in the fine print. And no, it's not your company match. (But if one is available to you, please take advantage -- it's free money for retirement!)

This $136,582 gift has a boring name -- auto-escalation -- but gives you a tremendous opportunity to compound your retirement wealth, given enough time.

The psychology of saving

One of the key advantages of the 401(k) is that it encourages you to forget that the money exists. Oh, sure, you get a quarterly statement, but the money isn't in your checking account (where it might get spent) or your brokerage account (where you might fret over volatility and start trying to time the market). You get used to a slightly smaller paycheck than you'd otherwise have, and the saving is effortless from there.

That's a good thing, as it takes status quo bias -- our inherent tendency to do nothing -- and turns it into a savings advantage. After all, reducing your 401(k) deferral percentage requires effort -- effort that could be spent on the million-and-one other things currently jockeying for your attention. Consequently, many people defer a percentage of their salary into their 401(k) and forget it.

Here's where auto-escalation comes in. It usually works something like this: You start your 401(k) plan by withholding 6% of your paycheck in the first year. The plan then automatically bumps you up to 7% in the next year. And 8% the year after. And it continues on until you hit, say, 10% of each paycheck. It's a minor difference each year, the sort of thing that's easily missed as you get a cost-of-living adjustment.

Auto-escalation, then, gives you an excellent opportunity to take no action and yet save more. It's increasingly common -- 60% of 401(k) plans now offer auto-escalation, according to a Willis Towers Watson study conducted in 2018.

Let's work the math

Let's pretend that you earn the median household income in the United States -- that's $61,372 as of 2017 (the most recent year with full data), according to the U.S. Census Bureau. Visualize that you never receive any raises, that your 401(k) doesn't have a match, and that you save 6% of your salary in it every year for 30 years at a 7% annual return (pretty standard for the stock market, historically speaking). At the end of 30 years, your nest egg is worth $372,183. Not a bad chunk of change!

Now, let's compare that to the same scenario -- except you're lucky enough to have auto-escalation built into your 401(k), so the 6% savings in year one becomes 7% in year two and grows by a percentage point each year until hitting 10% in year five and staying flat from then on. Now your savings are worth $576,545 -- or more than the $500,000 that the median worker thinks he or she will need in retirement. (I think that number is far too low – but that's its own conversation for another day.)

Now, when you look at those two numbers ($372,183 and $576,545), you notice that there's more than $200,000 separating them. Part of that is the additional contributions from saving more each year toward your 401(k) (10% vs. 6% in year six, for example). But the larger part is thanks to the compounding of those extra savings.

Total change in account value $204,362
Minus additional contributions ($67,509)
Total difference in returns due to compounding $136,853

The gift of auto-enrollment could be worth an extra $136,853 in returns. Of course, your mileage may vary -- it's impossible to predict stock market returns in the future (as we'd all love to). And you'd likely make a different amount than the median American household (hopefully more!). Also keep in mind that this exercise assumed our mythical worker never received a raise.

And here's the best part

Your employer may not offer an auto-escalation feature, but you can create your own auto-escalation plan. Simply put a date in your calendar and leave yourself a reminder to increase your 401(k) contribution by a percentage point that day. Block off 20 minutes to talk to HR and fill out the paperwork -- usually it's pretty simple -- and then you can go back to forgetting about your 401(k) for the next year.

(What's more, you can eventually increase beyond 10% if you're so inclined. That's where things get really interesting.)

Given the size of the benefit, if you can afford to increase your deferral every year, or even every other year, it's a huge opportunity to grow your retirement nest egg. That, plus a long runway, helps you leverage a retirement saver's best allies: time and compounding.

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