Automatic 401(k) Overview for Employers

By: Source: AARP.org Date Posted: 2006-05-19 15:35:05.083048-04:00

News reports and research studies continue to highlight that many American workers may not have enough money to live comfortably in retirement.

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  • " More than half of workers saving for retirement report total savings and investments (not including the value of their primary residence or any defined benefit plans) of less than $50,000 (52 percent). " (2006 Retirement Confidence Survey - Employee Benefit Research Institute & Mathew Greenwald & Associates)
  • " Nearly one-third (33%) of American employees work for employers who do not sponsor a retirement plan. " (EBRI Issue Brief No. 289, January 2006)

For the employers who do offer retirement plans, the most common type of plan offered today is the defined contribution plan. Millions of employees participate and make sensible investment and savings choices. But others save too little, invest too conservatively or don't participate at all. For these individuals, existing education methods in the workplace often aren't enough.

  • Employees often find investment information confusing or they lack interest.
  • Some employees feel they do not understand finance and are embarrassed to ask questions.
  • Too many decisions and lack of time, information or money paralyze employees. Rather than risk making what they think may be the wrong decision, many do nothing.
  • Other employees contribute too little or too late or both.

Putting Your 401(k) on Autopilot
Some employers have taken over the wheel and helped their employees put their retirement plans on "autopilot." The simple approach is an "automatic 401(k)" sometimes called an autopilot plan. Employers automatically enroll new employees in their 401(k) plan as soon as they become eligible while giving them the opportunity to opt out. Employers can also make default choices regarding the amount of money employees contribute to the 401(k) and where the funds will be invested. Employees retain the right to decide whether to withdraw from the plan and whether to decline the default choices.

The "Auto-Advantage" Recruits New Participants
Automatic enrollment boosts participation among lower-income employees, who are the least likely to participate in 401(k) plans. But keep in mind that if all you do is automatically enroll employees' contributions into a conservative fund, it does not move the dial for your employees' retirement security. It should be combined with sensible default funds other than conservative funds and if not a higher savings rate than 3%, then add an automatic escalation feature that will increase their savings on a periodic basis.

Pertinent Studies
EBRI's study indicates a majority of employed workers favor:

  • Automatic enrollment (69%)
  • Automatically increasing the percentage of salary contributed when an increase in pay is received (65%)
  • Automatically investing contributions for the employee (59%)

(The 2006 Retirement Confidence Survey, EBRI Issue Brief No. 292)

A study by Brigitte Madrian and Dennis Shea showed that using auto-enrollment boosted 401(k) participation rates among some plans as follows:

  • Women from 35% to 86%
  • Hispanics from 19% to 75%, and
  • Low income groups from 13% to 80%

(Madrian & Shea, 2001)

Some employers have taken a step further to automate other features of their 401(k) plans including automatic escalation, automatic investment defaults other than a conservative fund and rebalancing. These automatic features are essential to increasing savings given the fact that both men and women can expect to spend more years in retirement.

Other Potential Advantages
While the use of automatic enrollment is not sufficiently widespread among employers to produce definitive studies, retirement experts predict that other benefits from auto-enrollment will include:

  • Higher account balances for all because employees will have enrolled earlier in their careers
  • Higher account balances among higher-paid employees because employers will have met discrimination tests
  • Potentially lower employee turnover

While employers with high employee turnover may resist automatic enrollment because of cost/paperwork, they may be pleasantly surprised to find that turnover reduces when newly recruited 401(k) participants view their 401(k) account statements. What's more, since non-participants tend to be lower-paid, the practice of automatic enrollment could result in favorable discrimination testing* that allows the higher-paid to defer more. (Jane White, Retirement Solutions Foundation)

*nondiscrimination testing is testing to ensure that low-paid workers take advantage of tax-deferred retirement savings plans and that the tax benefits of such plans do not accrue solely to the highly paid

Primary Concerns of Employers
Some employers are reluctant to implement automatic 401(k)s due to:

  • Fiduciary concerns: fear of litigation from employees because their accounts lost money
  • State Anti-Garnishment Laws: laws that require employees to receive written notice from employers before money is taken out of their paychecks. ERISA generally is thought to pre-empt these rules though legal advice differs on the matter state by state
  • Costs: higher participation raises employer match costs (see article on costs)

Addressing Fiduciary Concerns
Unfortunately, many employers have resisted adopting automatic enrollment—or have adopted it but chose a "default" investment allocation that is 100% invested in money market accounts because of the risk of investing in stocks.

According to Vanguard, "under ERISA, retirement plans are not required to invest in conservative assets and the law permits fiduciaries to invest in assets that may experience short-term losses in pursuit of long-term returns." In addition, 70% of corporate defined benefit plans are invested in equities or other long-term growth assets. (Stephen P. Utkus, Selecting a Default Fund for a Defined Contribution Plan)

Bruce Ashton, a partner at the ERISA law firm of Reish Luftman Reicher & Cohen, "couldn't agree more" that the default allocation should include stocks and that defaulting to a money market account could be a breach of fiduciary duty. He noted that "the Department of Labor is charged in the new pension legislation with coming out with regulations defining a ‘safe harbor’ default account as a mixture of stocks and bonds or cash-equivalents—and, in fact, such regulations are already in the works." He is optimistic that such a safe harbor will become the standard, even in non-automatic 401(k) plans.

New Automatic 401(k) Legislation Smooths the Way for Employers
With the pension bill signed into law on August 17, 2006, the automatic 401(k) provisions should alleviate some employer concerns mentioned above. The legislation should result in new savings by even more American workers because it:

  • Encourages employers to automatically enroll their workers in 401(k) plans by giving them protection from lawsuits if the investment options chosen are " reasonable, " such as a balanced fund, with investments in stocks and bonds or cash-equivalents
  • Preempts any state garnishment laws when it comes to 401(k) automatic enrollment
  • Establishes provisions for a safe harbor design that will meet employer non-discrimination and top-heavy tests

Taking the First Step

You are in the best position to maximize value for your employees through the retirement plans that you offer or contemplate offering. The first step could be as easy as setting up 401(k) automatic enrollment (along with informing employees they can opt out). It may be worthwhile to take the initiative now to help achieve a more secure retirement for your employees in the future. Your efforts can potentially reward you with a happier, more productive, more loyal workforce that is also on the road to a secure retirement.

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