Automatic Enrollment Hurts Retirement Saving

Workers save less for retirement when they are automatically enrolled in a 401(k) plan.

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Automatically enrolling new employees in the 401(k) plan generally gets more people to participate in the retirement plan. But it also leads to low contribution rates because the default saving rate is usually 3 percent or lower, according to several recent studies.

[See 7 Signs of a Good 401(k) Plan.]

Automatically signing up all new employees for the 401(k) plan typically dramatically increases 401(k) participation. Employees in plans with automatic enrollment had a 401(k) participation rate of 82 percent in 2010, compared with a 57 percent participation rate in plans with voluntary enrollment, according to a Vanguard analysis of 2,000 401(k) plans with more than three million participants. Automatic enrollment has been especially effective at getting young and low income workers to join the 401(k) plan. Over three-quarters (76 percent) of employees earning less than $30,000 annually utilize the 401(k) plan when they are automatically enrolled, compared to a quarter (26 percent) of low income employees who voluntarily participate in the plan. And 72 percent of people under age 25 save in 401(k)s when they are automatically enrolled, compared to just 18 percent who take action on their own to sign up for the retirement plan.

However, plans with automatic enrollment have lower average savings rates. Participants in 401(k) plans with automatic enrollment had an average deferral rate of 6.3 percent in 2010, which is 15 percent lower than the 7.4 percent of pay participants in plans with voluntary enrollment saved, Vanguard found. Even young and low income workers saved more in plans with voluntary enrollment. Workers earning less than $30,000 annually saved 6 percent of pay in plans with voluntary enrollment compared to 4.4 percent in 401(k)s with automatic enrollment. And young workers under age 25 voluntarily chose to save 5.2 percent of pay for retirement, but saved just 3.4 percent of pay when they were automatically signed up for the plan.

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Savings rates are lower when workers are automatically enrolled in the 401(k) plan because most 401(k) plans (73 percent) have a default savings rate of 3 percent or less. The most common default savings rate, used by 58 percent of 401(k) plans, is 3 percent of pay, Vanguard found. Companies that provide a 401(k) match may have an incentive to keep the default savings rate low. An Aon Hewitt survey of 210 mid-size and large U.S. companies with 6.2 million workers found that 73 percent of employers without automatic enrollment cite the increased cost of the employer match for all the new 401(k) participants as the primary reason for not changing their 401(k) plan.

Other studies have also found dramatically lower savings rates in 401(k) plans with automatic enrollment. A recent Mercer analysis of 1.2 million 401(k) participants found that those automatically enrolled in 401(k) plans (without an automatic savings increase) had an average savings rate of 3.5 percent of pay in 2010, compared to 8.5 percent among self-enrolled participants. “Those who self-enroll and set their own contribution rate are contributing nearly two and half times those who are automatically enrolled,” says Dave Tolve, U.S. retirement business leader for Mercer’s outsourcing business. “While automatic enrollment obviously increases overall plan participation, it does little to overcome the inertia of unengaged employees.” Workers who were automatically enrolled and also had their contribution rate automatically increased saved slightly more, an average of 4.4 percent of pay, but still much less than individuals who voluntarily enrolled in these types of plans (7.4 percent of pay). “While further enhancing defined contribution plans with automatic increase features does drive increased savings, there is no comparison to the contribution and account values of actively engaged participants who consciously make retirement savings decisions,” says Tolve. The most common default contribution rate for Mercer-administered 401(k) plans is 3 percent.

Automatic enrollment is also changing how people invest for retirement. Many workers are invested in target-date funds by default, unless they choose a different investment. Target-date funds tend to have high concentrations of equities for young individuals and gradually become more conservative over time. The growing use of target-date funds has caused young investors to take on more risk in their 401(k)s. 401(k) participants age 35 and under who own target-date funds had an average of 8.5 percentage points more in equities than employees without a target-date fund, Vanguard found. And target-date fund owners ages 36 to 54 held 7.9 percentage points more in equities. However, investors over age 54 who own target-date funds have only 1.6 percentage points less allocated to equities than older investors without them.

[See How to Strengthen Your Retirement End Game.]

Nearly a quarter (24 percent) of Vanguard 401(k) plans had automatic enrollment in 2010, up from just 5 percent in 2005. And almost half (45 percent) of large 401(k) plans with 5,000 or more participants automatically enroll employees in the 401(k) plan unless they opt out. Aon Hewitt found that over a third (36 percent) of mid-size and large U.S. companies without automatic enrollment say they are likely to begin automatically enrolling new employees this year.

Twitter: @aiming2retire