The Business Case for 401(k) Automatic Enrollment
By David C. John
Despite the recession, evidence shows that automatic enrollment—where employees participate in a 401(k) plan unless they opt out—is a very effective way to increase both participation and savings. Employers are discovering that automatic features are very popular with employees, making employers that have adopted them more attractive, thus increasing the ability of these employers to recruit and retain employees. Simple mechanisms like automatic enrollment and escalation enable employees to build the retirement security that they will eventually need, while feeling more secure now because they have savings. Companies using automatic 401(k)s have seen employee participation rates soar—often to well above 90 percent—especially among the lower-income and minority workers who are too often left behind.
Is automatic enrollment worth the cost of additional employer matching contributions plus any cost of implementation or ongoing administration? While this is a question that every company has to answer for itself, more and more employers are concluding that sound business reasons justify adopting automatic enrollment. The top three reasons generally cited for using automatic enrollment are:
- providing better benefits to improve employee morale, retain talent and improve recruitment;
- enabling senior executives to save more for retirement by improving your company’s 401(k) non-discrimination test results; and
- reducing the effects of replacing a defined benefit (“DB”) pension.
Companies Benefit from Happier and Better Employees
Employees like automatic enrollment and automatic escalation. Studies show that support among those who remained in the plan is close to universal, while large majorities of employees who opted out of automatic enrollment also approve of automatic enrollment.1 In addition, one survey found that 85 percent of workers said that automatic enrollment helped them to start saving earlier than they would have otherwise done.2
This strong support for automatic enrollment and escalation makes including those features in a 401(k) plan more effective both for retaining valued employees and for recruiting new talent.
In addition, Americans are increasingly anxious about being financially underprepared for retirement. A combination of automatic enrollment and other automatic features can help to ensure that 401(k) plans are more effective at generating the larger account balances necessary to replace a meaningful portion of employees’ preretirement wages.3
Employees Who Are Helped the Most
Automatic enrollment and escalation have a special value to your minority and moderate income employees. In general, these groups tend to be much less likely to participate in a 401(k) plan. However, studies show that automatic enrollment can dramatically increase participation by the four groups—women, minorities, younger workers and moderate-income employees—most likely to under-save. Automatic enrollment can increase participation in these four groups from about 1 out of 5 to 4 out of 5 and above.4 As described more fully in the next section below, the participation of moderate- and lower-income workers is a key factor in allowing your higher paid managers to save more.
A further encouragement for moderate-income workers to participate in your 401(k) can come from the federal saver’s tax credit. In addition to the normal 401(k) tax benefits, workers whose family income in 2011 is below about $56,500 for a married couple (and half that for a single person) are entitled to receive a special tax credit equal to as much as 50 percent of their 401(k) contribution. While your employees can take advantage of the savers credit without any company involvement, providing those employees who qualify for it with information about the tax credit will serve as an additional incentive for them to accept automatic enrollment into your 401(k) plan.5
Companies Benefit When Senior Executives Can Save More
Automatic enrollment and automatic escalation enable senior executives and more highly paid employees to save more for retirement by improving the company’s performance under the 401(k) non-discrimination tests. Non-discrimination tests seek to ensure that tax preferred retirement savings plans benefit all employees, regardless of their income level, rather than just highly compensated executives.
Automatic enrollment and escalation improve non-discrimination performance by increasing participation and/or contribution rates among moderate- and lower-income workers. When these workers don’t participate or don’t contribute enough, they depress the non-highly paid group’s average contribution level.
If a company does not perform satisfactorily on the non-discrimination (“ADP” or “ACP”) tests, it is required to either reduce the amount of executives’ tax-favored contributions or make special employer contributions for non-highly paid employees. In some cases, failure to meet non-discrimination tests even requires companies to return some of the contributions that executives have already made. Taking any of these measures is likely to cause pain and friction within a company. But the use of automatic enrollment and escalation has allowed many HR and benefits professionals to inform senior management that these unpleasant steps are unnecessary because the company meets the anti-discrimination tests.
One way to improve a company’s performance on non-discrimination tests is to either begin automatic enrollment at a higher rate (5 or 6 percent, for example), steadily escalate the automatic contribution level (typically 1 percent a year), or both.
The Pension Protection Act of 2006 included a non-discrimination safe harbor for companies that meet its employer contribution and other conditions. Companies that qualify can avoid non-discrimination (and “top heavy”) testing altogether.
Companies Benefit if They Must Replace a Defined Benefit (“DB”) Pension
One way to ease the loss of a traditional DB pension plan that has been closed, frozen or cut back is to include automatic features in your company’s 401(k) plan. When combined with an appropriate level of matching, automatic enrollment allows affected employees to seamlessly transfer to the new retirement plan. Automatic features simplify their decision-making by placing them in an appropriate automatic investment choice at a pre-selected contribution rate that can replicate the most important features of their old DB plan such as automatic coverage and professional investment management.
Automatic Features Are Worth Any Small Additional Cost
It is hard to justify any additional costs in difficult business conditions, but adding automatic features to your 401(k) plan may be an exception. For one thing, the actual cost may be much lower than expected, and since employees like both automatic enrollment and automatic escalation, the returns in the form of keeping valued employees may be high. Another is that an employer match is more flexible, and can be increased, decreased or even temporarily suspended depending on business conditions.
The fact is that the rise in the employer’s cost of matching contributions under automatic enrollment will ordinarily be modest—and less than proportional to the increase in participation. And, of course, employer matching contributions are tax-deductible, which further lowers the cost.
The following example illustrates why the cost of adding automatic enrollment might be lower than expected. For a fairly typical 401(k) plan in which 75 percent of the eligible employees already participate, the average employee contribution is between 6.5 and 7 percent of their pay, and the employer match is 50 cents on the dollar, up to 6 percent of pay. If adding automatic enrollment to the 401(k) plan increased participation to 90 percent of eligible employees, which is typical, participation would have increased by 20 percent. However, this 20 percent increase in participation might only increase the cost of the employer match by 10 percent or less, for these reasons:
- Lower Matched Contributions. In this example, the new automatically enrolled participants will be contributing at the initial automatic contribution level. If that level started at 3 percent of pay (instead of the full potentially matchable 6 percent contribution), the matching contribution might initially rise by only 10 percent, rather than 20 percent.
- Lower Pay. Second, most higher paid employees sign up for the plan on their own, which means that a larger proportion of existing employees who are automatically enrolled have lower earnings. This means that the additional cost of an employer match per employee should be lower than it is for those who were already participating in the 401(k) plan.
- Gradual Phase-In. Finally, another way to manage the costs of automatic enrollment is to first apply the technique to new hires only, then later expand it to existing employees who have not yet signed up to participate in the 401(k). This gradual approach spreads out the additional cost over a longer time, and gives management even more control over the process. Of course, firms are only in full compliance of their anti-discrimination tests (which determines when higher paid employees can make full use of their tax favored savings limits) when both new hires and existing employees are auto-enrolled, but phasing in the process is a way to stretch out costs.
- Flexibility to Reflect Business Conditions. Although it is best to keep the employer match constant, you can adjust your company’s match if necessary to reflect business conditions. In the recent recession, a number of companies were forced to temporarily eliminate the match in order to preserve jobs and remain in business. Some have already restored their matches, and others plan to do so when they can. When the economy improves, companies could reward employees by increasing the employer match.
Most importantly, the potential increased cost of matching higher amounts of employee contributions (unlike a DB plan contribution obligation) is relatively predictable and easy to take into account for planning and budgeting.
Employees overwhelmingly support both automatic enrollment and automatic escalation, and adding these features to a company 401(k) plan can ensure that executives can take full advantage of their tax-favored retirement contributions. For these reasons, companies sponsoring 401(k) plans are increasingly adopting automatic enrollment and other automatic features. Adding these features is a simple, cost-effective way to improve the happiness of almost all of your employees, while simultaneously making it easier for you to retain highly paid key executives.
Retirement Made Simpler is a coalition formed by AARP, the Financial Industry Regulatory Authority (FINRA) and the Retirement Security Project (RSP). The campaign was created specifically to inspire and support employers who want to help their employees save more for retirement. By providing companies with the tools and information they need to automate their 401(k) plans, more Americans will achieve a safe and secure retirement. For more information, visit www.RetirementMadeSimpler.org.
David C. John, Retirement Made Simpler Policy Advisor, is also also Senior Strategic Policy Advisor at the AARP Public Policy Institute and Deputy Director of the Retirement Security Project.