The 67-page report by Jordan Cammarota of UC Berkeley (GO BEARS!) and others on the limitations of 401k auto-enrollment and auto-escalation is not an easy read. It could be that I am not the sharpest knife in the drawer or that it is past my bedtime as I write this. Still, readers of this space know that I am a fan of 401k auto-enrollment and auto-escalation. But what the authors observed through their experiments and subsequent data is interesting.
Leaving one company to join another company is actually detrimental in an auto-enrollment environment. If an employee is auto-enrolled at 3% and auto-escalated over years to say, 8%, when the employee leaves to join a new company, they could conceivably join the new 401k at 3%. Even with a higher salary (a primary reason for jumping ship), the 3% contribution could be less than the previous contribution.
The authors also noted the high opt-out rate on auto-escalation. They found that 57% of folks opted out of auto-escalation. Could it be that employees see the very real impact of auto-escalation while realizing that they are not guaranteed a raise? In other words, they could face shrinking paychecks while facing higher expenses. Perhaps auto-escalation should also be automatic?
Finally - and I am only halfway through the report -, I started to ponder other possible limitations of auto-enrollment/ escalation. My thoughts?
401(k) auto-enrollment has several limitations that plan sponsors and participants should consider:
Low Default Contribution Rates: Many plans set default contribution rates too low (e.g., 3%), which may not be sufficient for participants to meet long-term retirement goals.
Investment Default Risks: Participants are often auto-enrolled in default investment options, such as target-date funds, which may not align with individual risk tolerances or financial goals.
Opt-Out Choices: As noted, participants can choose to opt out, which may undermine the intended purpose of increasing plan participation. Granted, opt-out rates on 401k plans tend to be around 10%.
Lack of Participant Engagement: Auto-enrollment may reduce the likelihood that participants actively engage with their retirement plan, leading to less awareness about the need for adjustments or additional savings. Auto-enroll can lead to "auto-pilot" assumptions that everything is on track for retirement and that may not be the case.
Higher Employer Costs: Increased participation from auto-enrollment can raise employer matching contributions and administrative costs.
Disproportionate Impact on Lower-Wage Workers: Lower-income employees may struggle to afford contributions and may withdraw funds prematurely, incurring penalties.
Regulatory Compliance Burden: Plan sponsors must ensure compliance with rules, such as timely enrollment notifications and managing opt-out requests, which can increase administrative complexity.
Potential for Auto-Escalation Confusion: Auto-escalation, where contribution rates increase over time, may not be well-communicated or understood, leading to resistance from participants. As one CFO told me, "This whole things sounds like a socialist scheme".
Contribution Limits: Even with auto-enrollment, contributions are subject to annual IRS limits, which may not suffice for high-income earners.
The Parting Glass
By addressing these limitations through better plan design, communication, and financial education, the effectiveness of auto-enrollment can be significantly enhanced. We cannot ignore the need for a fair living wage as well.