Although defined contribution plans (401(k)) have been a staple of our society for decades, the degree to which Americans have taken advantage of these opportunities is alarmingly low. According to a recent study, one-third of Americans have less than $5000 saved towards their retirement, while 21% have no retirement savings of any kind.[i] Furthermore, median household retirement savings is currently estimated to be a mere $50,000.[ii] When you consider that the average cost of living has only continued to skyrocket over the past few decades, it paints a dark picture of the financial reckoning Americans are currently on track to endure in retirement. In short, there is a savings crisis in this country that must be addressed in order to ensure society’s long-term financial wellness.
Today, employer-sponsored retirement plans have become the primary means by which the majority of Americans can achieve financial security in retirement. Although this burden may not be one that most business owners necessarily anticipated at the inception of their entrepreneurial journey, it is a responsibility that has nevertheless fallen on their shoulders. For better or worse, our nation’s long-term financial security will largely depend on the degree to which employers are willing to answer the call that society has bestowed on them.
That being said, adding this feature may not be financially viable for smaller companies with fewer resources. While most people are familiar with the benefits a match can provide, a critical misconception is that without said match, a retirement plan offers little value. This common interpretation is extremely flawed, as it ignores the value that saving and investing creates over an individual’s lifetime. Furthermore, social security, which once provided all Americans with a reasonable pension they could live off in retirement, has steadily declined to the point that it is no longer likely to provide future retirees with significant income of any consequence. This unfortunate policy evolution further magnifies the need to invest in retirement plans as it does not appear that, short of winning the lottery or inheriting a fortune, any meaningful alternative exists.
If you’re already a business owner committed to your employees’ financial wellness, you probably offer some type of retirement plan. If so, you’re probably asking yourself what you can do to induce people to take advantage of this option. After all, you can only lead a horse to water, right? Well, not exactly. There’s actually another option that, if added to a 401(k) plan, can materially enhance your employees’ long-term financial prospects.
The IRS defines automatic enrollment as “a feature in a retirement plan that allows an employer to ‘enroll’ an eligible employee in the employer’s plan unless the employee affirmatively elects otherwise.”[iii] Once these automatic contributions commence, the participant’s assets are placed in an approved default fund (target date fund or similar type of investment) that is essentially designed to provide the baseline level of congruence with their respective investment objectives and risk tolerance threshold. Since the automatic enrollment option was introduced in the Pension Protection Act of 2006, employers have been increasingly implementing this practice for the benefit of their employees. While roughly half of all 401(k) plans currently utilize this option, its popularity continues to permeate the business community as evidenced by a 300% growth rate in feature adoption over the past 15 years.[iv] A similar analysis by Vanguard of its own client data observed that 46% of the plans it manages utilize this feature (as of 2018), up from only 20% in 2008.[v]
One concern that employers sometimes have when deciding whether or not to implement this feature is that they are worried it takes control away from the employee by potentially forcing them to contribute to a 401(k) plan against their own wishes. This is unequivocally not the case, as control of this determination still resides with the employee. The only difference is that rather than notifying the employer of their interest to participate in the company’s retirement plan, the employee must now indicate that they wish to be excluded from the benefit. The distinction may sound like semantics, but the impact this feature has on plan participation rates is staggering. According to the Department of Labor, plans with auto enrollment features average participation rates of 92%, versus only 57% for plans without this option.[vi]
The first, and arguably most significant benefit is that automatic enrollment enables eligible employees to overcome their greatest obstacle… their own inaction. While there are of course a number of reasons why someone may choose not to enroll in a 401(k) plan, the wide participation gap implies that a pretty significant percentage of us would like to save for retirement, but are just simply not taking the necessary steps to achieve this outcome by opting in.
Behavioral economists believe the wide participation gap between companies that offer automatic enrollment and those that don’t can be addressed by the introduction of a default option and the resulting “default effect,” which essentially states that making a specific outcome the default option increases the likelihood it is chosen. They recommend automatic enrollment options for this very reason, as it favors a shift from “opt-in” to “opt-out” behavior.[vii] The success of this type of policy shift is evidenced by the large increases in organ donor rates and contributions to retirement savings plans obtained when opt-out defaults are used instead of opt-in defaults.[viii] By incorporating an automatic enrollment feature, employers are effectively changing the default option to one that can provide more favorable outcomes to their employees.
From an employee’s perspective, the most favorable plans typically include an employer match, whereby the employer matches the contributions of each employee dollar for dollar up to a cap, typically in the 3-6% range. While most employees are familiar with the benefits a match can provide, a critical misconception is that without said match, a retirement plan offers little value at all. As such, going through the process of opting in to a company retirement plan may not seem like it’s worth the effort. This common interpretation is extremely flawed, as it ignores the value that saving and investing creates over an individual’s lifetime via compound growth and the time-value of money. Furthermore, social security, which once provided all Americans with a reasonable pension they could live off in retirement, has steadily declined to the point that it’s now unlikely to provide future retirees with regular income of any consequence. This unfortunate policy evolution further magnifies the need to invest in retirement plans as it does not appear that, short of winning the lottery or inheriting a fortune, any meaningful alternative exists. While it is certainly an individual’s prerogative to decline an offer to participate in an employer-sponsored retirement plan, shifting this decision to the “opt-in” choice inherently prevents certain employees from missing out on favorable long-term financial outcomes they might have forgone by thinking the juice wasn’t worth the squeeze.
Automatic enrollment features also serve to substantially simplify the enrollment process for employees, thus eliminating (or reducing) some of the primary reasons why people neglect to join 401(k) plans in the first place. While it may seem surprising, some individuals (particularly those with limited or no investment experience) actually find the prospects of developing a new investment plan to be somewhat daunting. Particularly when it comes to selecting investments, the responsibility for making “correct” decisions can seem overwhelming. These natural concerns are greatly alleviated by the default fund mentioned previously. While the employee’s investment options are not limited to the default fund, it provides the participant with an opportunity to enter the market with some degree of comfort while they wait for further investment guidance from the plan’s designated investment fiduciary advisor.
In addition to offsetting any psychological barriers the employee may have about investing, the automatic feature also eliminates the potential for an employee to put off enrolling due to a perception that the process is too cumbersome or time-consuming to engage at the moment. I’m sure we’ve all put things off until tomorrow because of convenience, time constraints, or simply just not being in the mood at the moment. The trap here is that, like many other things in our lives that we put off for one more day, it can sometimes turn into long stretches of time, or worse, indefinitely. As it relates to retirement planning, kicking the can down the road can negatively affect an individual’s long-term financial health due to the time-value of money principle (“TVM”). TVM is the concept that money available at the present time is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received (or invested).[ix] As such, the longer an investment is in the market, the greater the opportunity to benefit from this trend. While delaying enrollment over the short-term is harmless, significant delays will eventually erode investor’s long-term ROI potential.
Although the automatic enrollment option for 401(k) plans was primarily conceived to benefit plan participants, implementing the practice may also provide the plan sponsor with some unique advantages.
A primary consideration for high-value employees and prospects is the degree to which their employer is committed to their personal development and long-term financial wellness. According to a recent study, 88% of workers claim that 401(k) access is a must-have benefit when considering whether or not to take a job.[x] Adding an auto enrollment option to your plan is a good way to further demonstrate to current and future employees that you are committed to helping them reach their retirement goals.
Additionally, a 401(k) plan is considered to be safe harbored if it meets certain contribution requirements, including an employer match feature. If you’re plan is not currently qualified for safe harbor status, it is required to undergo yearly testing to ensure it doesn’t discriminate in favor of business owners or highly-compensated employees (“HCEs”). These tests require that owners and HCEs stay within specific contribution limits determined by the contribution amounts of the remaining employee base. Their intended purpose is to even the playing field between HCEs and lower income workers who could be struggling to save. Where this can sometimes become an issue is when the plan’s contributions become top-heavy, with a substantially higher amount of contributions coming from owners, Key Employees and HCEs as compared to the remaining employee base. When a company fails these tests, the remedy either results in a removal of excess contributions or worse, requires the employer to make a corrective contribution that includes lost earnings to the non-key employees (typically a contribution is 3% of compensation).[xi] An auto enrollment option can help address some of these issues by increasing participation rates across the entire organization, which subsequently increases the overall amount of contributions in the plan, thus reducing the likelihood of failing these tests.
For small business owners, time is an extremely precious commodity. With so much needed to be accomplished on a daily basis to support the company’s operations, any additional administrative burdens can sometimes feel a little daunting. As such, implementing an auto enrollment option can help to alleviate some of this workload by streamlining the entire process without the owner (or the designated administrator) having to engage in repetitive administrative processes each time a new employee becomes eligible.
Once the initial setup is complete, the enrollment process becomes fairly hands-off from the employer’s perspective. Employees are automatically enrolled at a predetermined default contribution rate without employers having to take on the additional work of facilitating the enrollment process. Employees can elect to “opt-out” of the company 401(k) plan if they wish, however that process becomes incumbent upon the employee to pursue. Additionally, using an advisor-approved default investment fund (like a target date fund or risk-based glide path) for the initial allocation of assets can also alleviate some of the fiduciary liability owners have regarding investment options within the plan. Of course, we strongly encourage consulting with your plan’s fiduciary advisor before determining which funds are most appropriate to serve as default investments.
As you can see, there are significant benefits to incorporating an automatic enrollment option into your company 401(k) plan. That being said, it is important that business owners consider all available options before making changes to their existing plans. As always, it is recommended that you consult with a fiduciary advisor to help you design a customized retirement plan that satisfies your organization’s unique needs while also providing your employees with optimal long-term financial wellness outcomes.
The opinions expressed are those of Integrity Financial Corporation (“Integrity”) and should not be taken as financial advice or a recommendation to buy or sell any security. Integrity is a registered investment adviser. Registration does not imply a certain level of skill or training. Any forecasts, figures, opinions or investment techniques and strategies described are intended for informational purposes only. Investors should ensure that they obtain all current available information before making any investment-related decisions. Additional information about Integrity’s investment strategies, risks, fees, and objectives can be found in Integrity’s Form ADV Part 2.