Auto-Enrollment and Auto-Escalation: Right for Your Retirement Plan?
Auto-Enrollment and Auto-Escalation: Right for Your Retirement Plan?
Updated June 2021
When it comes to saving for retirement, getting started can be the hardest part for many employees. This challenge, however, is being solved for many American workers by the dramatic increase over the past decade in the percentage of 401(k) plans that use automatic enrollment and automatic escalation features to encourage participation.
More than 60 percent of plan sponsors automatically enroll workers in their defined contribution plans today, according to the Plan Sponsor Council of America’s 63rd Annual Survey of Profit Sharing and 401(k) Plans (which analyzed 2019 plan experience). That is up from 46 percent in 2011. Nearly 75 percent of plans with automatic enrollment also automatically increase deferral rates, and 60 percent of employers use a default deferral rate of more than 3 percent. PSCA also reports that 90 percent of eligible workers participate in a company defined contribution plan.
Despite the growing popularity of automatic enrollment and escalation features, determining whether to adopt them is far from being a decision that plan sponsors can put on cruise control. While automatic enrollment and escalation offer many benefits to employees as well as plan sponsors, sponsors need to consider and manage them effectively to ensure a successful program.
Background and Latest Data on Automatic Enrollment
The Pension Protection Act of 2006 (PPA) created a safe harbor for plan sponsors to automatically enroll workers into 401(k) plans. Instead of requiring employees to choose to join a plan, automatic enrollment flips the decision to start saving and requires them to opt-out if they don’t want to participate. With automatic enrollment, employers elect a default contribution rate and can use a Qualified Default Investment Alternative (QDIA), such as a target date or lifestyle fund, to relieve employers of any fiduciary liability for this initial investment choice. The PPA also allows plan sponsors to automatically increase employee contributions over time. Once in the plan, participants can reallocate the assets out of the QDIA to whatever investments they see fit within the plan’s eligible investment options.
The PPA has paved the way for workers’ inertia to work for them, not against them, when saving for retirement. Studies have shown that automatically enrolling workers into defined contribution plans and boosting their contribution rates on an annual basis have helped more people to save for retirement than if left on their own to do the work. In addition, Vanguard’s recent data showed that participation rates triple to 91 percent for new hires that have been automatically enrolled into plans; this is compared to 28 percent of new hires who have voluntarily enrolled.
In the PSCA study, automatic enrollment is most common in large plans (i.e., plans that have 5,000 or more employees); 73 percent of large plans use automatic enrollment. Industry-wise, 79 percent of non-durable goods manufacturing companies use the strategy, closely followed by 78 percent of insurance and real estate companies. Industries with lower usage rates include wholesale distribution and retail trade (50 percent) and financial companies (51 percent).
So why are nearly 40 percent of plans not following suit and using automatic enrollment? And why aren’t nearly a quarter of companies currently using auto enrollment not pairing it with annual contribution escalations? For those not using auto enrollment, 43 percent of the respondents to the PSCA survey said they were happy with their participation rates while 26 percent said auto features don’t line up with corporate thinking.
Understanding the Benefits
As with any element of plan design, there are important items to consider when - using automatic enrollment and escalation. Various types of automatic contribution arrangements can meet safe harbor provisions and exempt plans from certain non-discrimination testing requirements. Even though auto features are increasing in popularity, there is not a one-size-fits all program for every retirement plan. As companies consider whether to adopt these features—or amend their use of them—they need to evaluate the potential benefits and costs from both the employees’ perspective and the company’s perspective.
Benefits of Automatic Enrollment and EscalationFor Plan Sponsors:
- Defaults employees into an investment vehicle that is pre-approved by the Department of Labor
- May streamline and simplify the new employee on-boarding process
- May lead to lower administrative fees and/or the ability to offer additional tools and services to participants thanks to higher cumulative assets under management
- Puts employees on an automatic savings track, which may help improve employee retention and help them feel more secure about their financial futures
- Adds a benefit that can be used to attract and retain top talent
- Aids in non-discrimination testing
- Certain auto enrollment plans allow highly compensated employees to contribute the maximum amount and relieves the plan sponsor from anti-discrimination testing
- Reduces employer payroll taxes because funds are being contributed pre-tax
- Generates certain tax credits and deductions, such as matching contributions, for employers
- Increases plan participation among all incomes and age groups
- Allows many participants to save for retirement who might not do so if left on their own
- For traditional plans, participants defer paying income tax until they withdraw funds at retirement
- Allows participants to take advantage of company match or “free money”
Necessary Considerations for a Successful Automatic Enrollment and Escalation Program
For Plan Sponsors:
Requires administrative oversight, particularly in regard to ensuring all eligible participants are properly and timely enrolled and escalation amounts are properly aligned with payroll withholdings
Requires coordination and controls with record keepers and other third-party service providers
Requires amending plan documents
Certain auto enrollment plans need to start at the beginning of the plan year
May call for more robust communication campaigns with employees to help them understand new plan features
If mistakes are made, corrective measures can be costly and time consuming
May cause employer contribution amounts to rise as more employees participate in the plan
May result in more accounts with lower balances, especially for plans with lower default contribution rates and adds more burden on administrator to clean out balances when participants terminate
May give employees a false sense of security, especially if the default rate is set too low and no automatic escalation is paired with the enrollment
May increase the risk that employees end up with suboptimal asset allocations across their entire portfolios if they don’t fully understand the holdings in their target date or lifecycle funds
As Americans’ retirement savings rates continue to be lackluster and as companies become increasingly focused on their employees’ financial wellness, automatic enrollment and escalation features may be useful tools in managing your workforce and getting employees prepared for their financial futures. In addition to helping put employees on track for a successful retirement, implementing these features can have powerful benefits for employers, as well, by streamlining the enrollment process and serving as a tool to attract and retain talented workers.
Before adopting automatic enrollment or escalation, plan sponsors should work closely with their internal teams, as well as with their third-party service providers, to ensure that the proper controls and procedures will be put in place.
To better understand the benefits and administrative requirements of automatic enrollment and escalation and to assess how these features could be adopted in your plan, contact a member of BDO’s ERISA team.