How to Help Increase Your Participants’ Retirement Savings
Over the past thirty-plus years, defined contribution (DC) plans have become the primary means for the average worker to accumulate wealth to provide for a financially secure retirement. With longer life expectancies and increased health care costs, it is more important than ever for employees to adequately save for retirement. Accordingly, it is crucial that employees effectively utilize DC plans to achieve this objective. Unfortunately, several surveys and studies have concluded that this may not be happening.
There’s no disputing that automatic enrollment features, as our last newsletter discussed, can greatly enhance participation rates. Once an employee is participating, the next step is to help make sure that their savings rate is sufficient to meet their retirement goals.
Research has shown that features such as automatic escalation can have a profound impact on retirement savings.
Automatic escalation features provide participants with an option to have their contribution rates automatically increased by a set amount/percentage based on the passage of time or the occurrence of an event, subject to an overall cap. For example, the rate may be increased by 1 percentage point annually or by a set percentage of a salary increase until the overall contribution rate reaches 10%. An obvious benefit of this feature is that it helps participants get their contribution rates to a level necessary to meet their retirement needs. Commonly cited contribution rates required to ensure successful outcomes are in the 10% to 15% range. Considering that default contribution rates for plans utilizing automatic enrollment are generally in the 3% to 6% range, it is easy to see that adopting auto escalation in conjunction with auto enroll could be an effective means of helping participants achieve an adequate level of savings.
Several studies have reported on the positive impact of incorporating an auto escalation feature in a DC plan. For example, the Defined Contribution Institutional Investment Association (DCIIA) reported the results of its third biennial survey of plan sponsors’ use of auto features in a 2015 white paper. They found that plans that use auto escalation have higher savings rates compared to plans that do not. While this finding is encouraging, the same survey reported that the percentage of plans offering auto escalation has not increased over the past few years. In fact, the results of their surveys since 2010 reveal that the percentage of plans offering auto escalation seems stuck around 48%. A proportionally greater percentage (53%) of ‘larger plans’ (over $1 billion in assets) utilized auto escalation when compared to the percentage (11%) of ‘smaller plans’ (under $5 million in assets) using the feature.
While studies have consistently reported the positive effect of auto escalation features, it is curious that more plans are not adopting it. The DCIIA surveys have addressed this issue. The survey results show that the most prevalent reasons for not offering auto escalation are that it is too paternalistic or that employees would complain. Interestingly, the surveys showed that a lot of plan sponsors have not even considered it. When the plan sponsors were surveyed as to what would have to change to entice them to offer it, the most common answer (24%) was that they would not consider it under any circumstances. Smaller plans were much more likely to have this response. Other common responses were focused on having a better understanding of the feature, such as “a clear understanding of the risks or potential unintended consequences.”
With the adoption rate of auto escalation at less than 50%, there clearly is an opportunity to increase this rate and help participants improve their retirement readiness. The DCIIA surveys provide some indication of what needs to be done to achieve this. First, education can play a big role. It is clear that plan sponsors need to obtain a better understanding of the risks, rewards and consequences of adopting auto escalation. Additionally, having examples of best practices would have a beneficial impact. Further research would also be beneficial. For example, researchers should explore why such a high percentage of plan sponsors would not consider auto escalation under any circumstances.
The opportunity for sponsors of plans that do not have an auto escalation feature to improve their plans seems clear. In particular, based on the DCIIA’s findings, there is a big opportunity for smaller plans. Advisors to plans should communicate with their clients on this matter and develop educational and ‘best practices’ tools to help sponsors obtain a better understanding of how auto escalation could improve their plans, and aid in implementation.
In summary, plan sponsors should give consideration to adopting auto escalation. To maximize participant savings, an automatic escalation feature should be offered to all participants. Furthermore, a default automatic escalation feature should be utilized in conjunction with an auto enroll feature. Remember that participants always have the option of opting out of any default arrangement. Plan sponsors should be aggressive in setting the overall cap on the contribution rate to induce more savings. Escalation features such as these need to be accompanied by adequate participant notification and education.