Plan Design Features to Drive Higher Savings Rates
4/24/2022 1:30:00 PM
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 help employees prepare for a financially secure retirement and staying on budget. 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 advisors evaluate how combining various features could drive strong participant savings outcomes.
Typical Auto Enrollment is Not Enough
Automatic enrollment in a 401(k) plan can increase the number of workers contributing to the plan. With this feature, workers who don’t actively choose to participate 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 helps 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. However, those who are automatically enrolled, even older employees, are actually less likely to later increase their deferral rates than workers who voluntarily enrolled.2
Automatically enrolled workers tend to accept the default rate and stay there. Since these rates are historically low, automatic enrollment is associated with higher plan participation, but lower employee contribution amounts and rates.1
Stretch Match Doesn’t Motivate All Employees
A plan design feature 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 6% of pay to receive the maximum 3% employer match.
A stretch match formula, on the other hand, requires higher employee savings to receive the full employer match – for example, a 25% match up to 12% of compensation. Under this formula, a participant needs to defer 12% of pay to receive the full 3% employer match. The expectation is employees will increase deferrals to receive the full match.
This strategy encourages employees to save at a rate more likely to prepare them financially for retirement, but assumes they understand the concept, appreciate the value of the employer match, and will take action necessary to increase deferrals to receive a higher match. The types of employees most likely to do this have higher incomes and are financially literate. If your employee demographics have fewer of these employees, the disparity between retirement savings accumulations of higher income and lower income workers increases. Consequently, a stretch match formula may have little impact on overall savings rates because too few employees are taking action to benefit from it.2
A high default deferral, low contribution requirement to receive full employer match, and qualified default investment alternative all drive strong savings rates.
According to one study, the combination of plan features that results in better savings outcomes for all employees, including those who are lower-paid, is a high default deferral rate, a lower contribution requirement to receive the full employer match, and a qualified default investment alternative. A high deferral rate, as defined by the study, is 5% or 6% of compensation, and a rate to receive full match 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
Employees who passively stick with the default deferral rate also tend to stick with the plan’s chosen default investment.
A prudently chosen qualified default investment alternative (QDIA)4 is a 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 may want to ensure adopting a new automatic enrollment feature or higher default deferral rate also benefits existing employees. Plan participants with a low savings rate or inappropriate investment selection, and eligible employees who are not participating in the plan, could benefit from a “re-enrollment” feature. Re-enrollment pulls these employees into the plan at the default deferral rate and invests their contributions in the default investment, unless they actively elect a different savings rate or investment or opt out of the plan.
Automatic escalation is another feature that can be used to boost employee savings. It is often paired with automatic enrollment, enables an eligible employee to start contributing at the initial default deferral rate and, without any further action, gradually increases their savings rate over time – for example, 1% each year until reaching a designated cap, such as 10%. Employees must be given the opportunity to stop automatic deferral increases, but if they do not take action, their savings will increase automatically.
Plan sponsors have several plan design options to help drive stronger participant savings outcomes. The most beneficial strategy may be a combination of features, such as an automatic enrollment with a high default rate and low required rate to receive full match, along with a qualified default investment alternative. Contact your Bell Bank retirement plan consultant 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.
Information courtesy of Newport Group, Inc., a preferred Bell Bank Wealth Management partner. This article is for the general information of clients and friends of Bell Bank. It is not intended, nor may it be relied upon, as tax or legal advice with respect to any matter. This article also cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by the Internal Revenue Service or other taxing authority.
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