An increasing number of businesses with 401(k) plans are automatically enrolling their employees. According to the Plan Sponsor Council of America (PSCA), about 62% of such companies used auto-enrollment in 2020, up from 60% in 2019 and just 46% in 2010. With auto-enrollment, workers have to opt out of the retirement plan if they don’t want to participate rather than having to opt in, as used to be common practice.
Automation has been very effective at increasing retirement plan participation and retention. As reported by CNBC, a Vanguard study found that 92% of retirement plan participants who had been opted into their employer’s plan were still participating three years later.
Automated enrollment in a workplace retirement plan is a good thing. It can help overcome the very powerful forces of inertia and the preference to spend rather than save. However, there are some potential downsides.
The limits of automation
As more and more decisions are made for us, whether financial or otherwise, there can be a tendency to take too little ownership over those decisions, to assume that the decisions being made on our behalf are the right decisions.
How much to save. For example, a common automation feature being used in many workplace retirement plans is setting what percentage of a participant’s salary is contributed to the plan. In many cases, the default “deferral” rate has been just 3% of salary. While a growing number of plans have now doubled that rate, 6% is still too low for most people to be able to build a sufficient retirement nest egg.
The good news is that nearly 80% of employers using auto-enrollment now also use auto-escalation, which gradually and automatically increases the deferral rate, usually up to a maximum of 10%. While employees can choose to increase their contribution rate at any time and up to the maximum amount legally allowable, very few typically step outside the automated process. Far better if more people were encouraged to run some numbers with a retirement calculator, determine their optimal savings rate, and choose to save at that rate.
What to invest in. With the majority of automated retirement plans, participant contributions are automatically invested in target-date funds (TDFs). To be sure, target-date funds have a lot going for them. They simplify what can be a confusing process: choosing an appropriate asset allocation. And they automatically make that allocation more conservative over time, which is very helpful.
Still, TDFs are far from perfect. Without understanding how they work, it can be easy to assume that all such funds with the same target date are designed the same, when the reality is that asset allocations vary widely among different fund families. And, there may be other strategies that are better suited to a person’s goals and risk tolerance.
Whether to borrow. A few years ago, the Wall Street Journal highlighted another problem with automated retirement plans. It cited several examples where workers who never made a conscious choice to participate in their workplace plan or at what level eventually were shocked to discover that they had quite a bit of money built up in their accounts. Without appreciating the importance of leaving the money alone so it could grow and be available to them in their later years, they wanted the money now! And after finding out how easy it would be to “borrow” they money, they did.
The best of both worlds
As plan sponsors work to bring new levels of automation to 401(k) plans, it would be ideal if they (or someone!) would bring added focus to teaching participants how to get the most from such plans. Nudges are tremendously helpful in overcoming inertia. However, just as a tug boat can get a big ship moving, there still needs to be a captain at the wheel who knows where the ship is going, understands what it’s going to take to get there, and takes responsibility for the journey.