Mar 18, 2022
Several plan design features have been introduced – and tweaked – over the years to help more workers save for retirement through workplace retirement plans. Plan sponsors must find the right balance between adopting plan features that will help their employees prepare for a financially secure retirement and staying on budget with plan expenses. Different combinations of plan features are going to be right for different types of employers, depending on their employee demographics. A few recent studies may help plan sponsors and their advisors evaluate how combining various plan features could drive the strongest participant savings outcomes.
Typical auto enrollment is not enough
It’s been proven over the years that an automatic enrollment feature in a 401(k) plan can increase the number of workers contributing to the plan. With this plan feature, workers who don’t actively choose to participate in the plan are automatically enrolled and a portion of their pay (selected by the plan sponsor as the default deferral rate) is deposited into the retirement plan on their behalf. This has been shown to help narrow the savings gap particularly for employees who are least likely to participate in a retirement plan, including those who are young, lower paid, Black, or Hispanic.1 Automatic enrollment is successful because employees who don’t take action to enroll in the plan typically don’t take action to opt out of the plan.
Default deferral rates have historically been set at a low 3%, for fear that a higher rate would cause more employees to opt out. But those who are automatically enrolled, even older employees, are less likely to later raise their deferral rates than workers who voluntarily enroll.2 Automatically enrolled workers tend to simply accept the default enrollment rate and stay there. Because of the historically low default rates, automatic enrollment is associated with higher participation rates but lower employee contribution amounts and rates.1
Stretch match doesn’t motivate all employees
A plan design feature that has been used to inspire participants to raise their deferral rates (while not increasing the employer’s cost) is the “stretch” employer matching contribution formula. The most common match formula is a simple match of 50% of the participant’s deferrals based on the first 6% of the participant’s compensation.2,3 Under this formula, a participant needs to defer no more than 6% of her compensation to receive the maximum 3% employer matching contribution.
A stretch match formula, on the other hand, is designed to require higher employee savings to receive the maximum employer match, for example a 25% match up to 12% of compensation. Under this formula, a participant needs to defer 12% of her compensation to receive the full 3% employer match. Employees are expected to increase their deferral rates so they can receive the full matching contribution.
This strategy encourages employees to save at a rate that is more likely to prepare them financially for retirement, but it assumes that most employees understand the concept, appreciate the value of the employer match, and will take the actions necessary to increase their deferral rate to get a higher match. The types of employees who are most likely to do this and make active decisions regarding their retirement plan benefits have higher incomes and are financially literate. In a plan where there are fewer of these types of employees, the disparity between the retirement savings accumulations of higher income and lower income workers increases under this plan feature. Consequently, depending on the demographics of a plan, a stretch matching formula that raises the percentage of deferrals matched by the employer could have little impact on overall savings rates because too few employees are taking action to benefit from it.2
A high default deferral, low match, and qualified default investment alternative drives strong savings rates
According to one study, the combination of plan features that result in better savings outcomes for all employees, including lower-paid employees, is a high default deferral rate, a low employer match rate, and a qualified default investment alternative. A high deferral rate, as defined by the study, is 5% or 6% of compensation and a low rate is 3% or 4%. With a high default rate, the employees who tend to remain at the default rate save more, and higher income employees are less likely to increase their deferral rates, which results in more equal savings rates among all employees.2
Those who passively stick with the default deferral rate also tend to stick with the plan’s chosen default investment. The plans with the highest percentage of employees holding default investments were those with a high default deferral rate and a low match rate as compared to plans with a low default deferral and low match rate and plans with a low default deferral and high match rate.2 Employees who stay in the default investment were shown to have a higher savings rate (6.01%) when the default deferral rate was high and the match was low compared to when the default deferral was low and the match was high (4.76 savings rate).2
A prudently chosen qualified default investment alternative (QDIA)4 can provide an institutionally priced, diversified fund that is likely to be suited to employees’ long-term investment needs.
Re-enrollment and automatic escalation could also help
The study on the effects of low and high default deferral and match rates was conducted with new employees. Plan sponsors of established plans may want to ensure that adopting a new automatic enrollment feature or a higher default deferral rate also benefits existing employees. Plan participants with a low savings rate or inappropriate investment selections and eligible employees who are not participating in the plan could benefit from a “re-enrollment.” Re-enrollment is a process that pulls these employees into the plan at the default deferral rate and invests their contributions in the default investment alternative unless they actively elect a different savings rate or investments or opt out of participating in the plan.
Automatic escalation is another plan feature that can be used to boost employee savings rates. This feature, often paired with automatic enrollment, enables an eligible employee to start contributing to the plan at the initial default deferral rate and, without any further action, gradually increase their savings rate over time, for example 1% each year, until it reaches a designated cap such as 10%. Employees must be given the opportunity to stop automatic deferral increases, but if they do not take action to stop the increases, their savings rate will increase automatically.
Plan sponsors have several plan design options to help drive stronger participant savings outcomes. The most beneficial strategy for some plans may be a combination of features such as an automatic enrollment feature with a high default rate, low match rate, and a qualified default investment alternative. Contact your Newport Representative for more information.
1 Butrica, Barbara A. and Karamcheva, Nadia S., Center for Retirement Research at Boston College, The Relationship Between Automatic Enrollment and DC Plan Contributions: Evidence from a National Survey of Older Workers, July 2015, https://crr.bc.edu/working-papers/the-relationship-between-automatic-enrollment-and-dc-plan-contributions-evidence-from-a-national-survey-of-older-workers/
2 Blanchett, David and Finke, Michael S., and Liu, Zhikun, The Impact of Employer Defaults and Match Rates on Retirement Saving (December 24, 2021), https://ssrn.com/abstract=3992899
3 Investment Company Institute, The BrightScope/ICI Defined Contribution Plan Profile: A Close Look at 401(k) Plans, 2018, July 2021, https://www.ici.org/system/files/2021-07/21_ppr_dcplan_profile_401k.pdf
4 Three investment vehicles qualify as a QDIA: life cycle or target date funds (TDFs), professionally managed accounts, and balanced funds.
The information contained herein is general in nature and is not intended to address the circumstances of any particular individual or entity. Please consult with your tax, accounting or legal advisors before making decisions. Newport Group, Inc. and its affiliates provide recordkeeping, plan administration, trust and custody, consulting, fiduciary consulting, insurance and brokerage services.