One Less Thing To Worry About
The typical American is short on time. Their day-to-day activities are occupied with their bills, job, home, spouse, kids, parents, politics, health, and (if they are very lucky) planning some leisure time. Planning for a retirement, decades in the future, is not a priority given the short term worries they have to contend with. The irony is that those decades can provide enormous long term benefits to future retirees through the magic of compounding interest, if only they could spare the minimal amount of attention towards retirement planning.
Lawmakers were aware of this deficiency and tried to find a way to encourage greater participation in employer-sponsored retirement plans, without direct engagement from the employees. To this end, the Pension Protection Act of 2006 popularized and codified several automatic features for retirement savings plans. Now, it was easier for employers to use these automatic features and get employees into the plan, saving for their retirement at an acceptable rate, and investing in a properly diversified investment. Employees, already short on time, have one less thing to worry about and generally benefit from being guided into the plan without direct action on their part.
Although they are growing in popularity, these features haven’t been universally adopted by every plan sponsor. In this article, we would like to describe automatic features and to discuss their advantages and disadvantages.
To help us, we enlisted an advocate for automatic features, Director at Fidelity Investments, Meghan Murphy. By the end of this article, we hope that plan sponsors will know a little bit more about automated features and seriously consider implementing them.
What are automatic features?
There are three classic automated features you might find in a defined contribution plan, like a 401(k): auto-enrollment, auto-increase, and auto-investment defaults.
Auto-enrollment is just what it sounds like. Meghan Murphy explains, “There are several auto-services which allow employers to automatically enroll employees into the retirement plan at a predetermined savings rate. 3% is the default deferral rate, although we do recommend 6%.”
Similarly, auto-increase allows employers to automatically increase their employees’ savings rates annually. They can set a predetermined amount, normally adding 1% each year, to their savings rate. For example, it is very common for a plan to begin enrolling employees into the retirement plan, setting aside 6% per year, and increasing that rate 1% per year until they hit 10% or 12%.
Finally, there are auto investment defaults – qualified investment default alternatives (QDIAs). When employers automatically enroll employees into the retirement plan, they also automatically default them into a plan-specific investment option. Meghan points out that, for Fidelity, “the majority of our sponsors, roughly 80%, use a target date fund: a fund that allows a person to be invested appropriately according to their age.” We’ve seen similar research which suggests Target Date Funds are the overwhelmingly popular choice for QDIAs.
Why use automatic features?
For participants – the employees – the benefits of automatic features are simple: it is one less thing to worry about. If participants want to opt-out of automatic arrangements, it’s not particularly difficult, but for the majority of employees, automatic enrollment and retirement planning is a net benefit. Automatic features can increase the number of employees engaged in the retirement plan and increase the average level of preparedness. Automatic features can also simplify retirement planning by adjusting retirement savings increases to coincide with bonuses or salary raises. As Meghan points out, “It makes retirement planning a bit easier and it takes the thinking out of it. When you use automatic increases with salary increases, employees never miss the money because it never hit their paycheck to begin with.”
The advantage is clear for participants, but what about for the employer? A retirement plan exists primarily to attract and retain talent, and there is evidence that employees will even accept lower compensation if they receive better benefits, including higher company match to their retirement plan.
In our experience employers and plan fiduciaries are deeply committed to their employees and providing them a path to a secure retirement. To this end, automatic features have a measurable positive impact to retirement readiness. Using the data of the largest recordkeeper, Meghan points out the benefits of auto-enroll: “in plans that use auto-enrollment, participation rate is about 84%. In plans that don’t use auto-enrollment, participation rate is 52%: clearly a huge impact.” Going beyond enrollment, automatic increases also advances aggregate savings rates. In Meghan’s words, “auto-enrollment gets them in the door and then you need auto increase to get them to save at the rate they’ll need to fund their retirement.”
Finally, there are also strong financial incentives for a company to provide solid retirement options. Specifically, employers want their employees to retire well. Why? Productivity and cost effectiveness benefit from workforce planning. “In the long run, if you have a workforce that is prepared for retirement, there is a bigger benefit. People who aren’t prepared for retirement will work longer and they may not necessarily want to. So, now they’re coming to work and they don’t have the best attitude about it. Older employees have higher health care costs to the company. You’ll bring in newer employees with fresh ideas who are motivated to be there.”
Why not use automatic features?
No action is without costs, and there are some downsides to using automatic features. For the employer, there are clear direct costs involved when adding more employees into a retirement plan with a company match. Plan sponsors may be hesitant to increase the amount of dollars needed dedicate to company matching funds. Furthermore, the plan committees and named fiduciaries can potentially open themselves to additional liability, depending on the decisions being made.
For the participants, automatic enrollment rates are generally too low for long term retirement security, and may create a false sense of security. “Many employees don’t have the financial background to make the proper decisions about their retirement. So when their employer automatically enrolls the employee at the default 3% deferral rate, they think it’s the right amount.”
I’ve decided to use automatic features. What now?
If you do decide to implement automatic features, it can now be accomplished quite painlessly. Most experienced recordkeepers and service providers should be able to turn the feature on with minimal input from the employer, but there are some features to consider first. For example, we recommend having a dialogue with key vendors, including the payroll vendor to discuss which IT changes may be necessary to implement the service.
Implementing auto-enroll features for new and existing employees might spur your plan committee to reconsider your retirement plan design prior to the switch. For example, company match amounts are typically set to match 100% of the employee’s salary deferrals, up to 3% of their salary. Instead of that matching structure, a plan could easily encourage increased savings by switching to a 50% company match for the first 6% of company salary. Participant retirement outcomes can be promoted with some savvy plan design without changing the cost to the employer.
Finally, employers should consider is an education campaign for new and existing employees about the new options. Many companies only turn on automatic features for new employees – fresh hires, but this is a good opportunity to look at existing employees who aren’t participating or those that aren’t participating at a significant level. Anecdotally, Fidelity notes that employers who automatically enroll employees who are saving less than 4% into a 6% default experience very low opt-out rates. In other words, employees are generally ok with increasing their deferral rate to 6%, but they have limited attention to make active changes to their retirement planning.
Our retirement plan now uses automatic features. What’s next?
The goal of implementing these features is increased participation in the retirement plan and increase retirement readiness for employees. Any vendor with the ability to implement this should also be able to demonstrate its impact in a short time frame. In as little as 6 months, vendors should be able to benchmark the change in employee participate rates and provide measurable progress reports towards the company’s goals.
So, when implementing these features, set the expectation with current service providers. Get an answer to your questions: based on my previous plan structure, how ready were my employees for retirement? How has that changed with the new features? Is there anything else we can do to help?
In the end, automatic features are a relatively simple way to promote healthy retirement habits. To give Meghan the last word on the subject: “It’s really important for people to save early and save often. Auto-services are a huge step in that direction. People who starting saving for retirement with their first job, it just becomes second nature to them. It’s just what you should do. Anything an employer can do to get them there, where saving feels natural, is what we would encourage.”
... For participants – the employees – the benefits of automatic features are simple: it is one less thing to worry about. If participants want to opt-out of automatic arrangements, it’s not particularly difficult, but for the majority of employees, automatic enrollment and retirement planning is a net benefit.”
... The advantage is clear for participants, but what about for the employer? A retirement plan exists primarily to attract and retain talent, and there is evidence that employees will even accept lower compensation if they receive better benefits, including higher company match to their retirement plan.”