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Make your 401(k) do its job

March 25, 2014

If you sponsor a 401(k) plan, you are making an investment in your ability to attract and hang on to good employees — not to mention assisting employees to retire some day. But left to their own devices, many employees just won’t take full advantage of the opportunity you have laid before them. That means for them, your investment in the 401(k) is wasted. Here are some options.

The battle to get most employees to participate in a 401(k) seems to have been won. A recent survey of businesses both large and small found more than 80 percent employee participation for 57 percent of employers. The survey was done by WorldatWork and the Employee Benefits Institute.*

When you add the 16 percent of employers with participation rates between 70 percent to 79 percent, you find that nearly three-quarters of employers have about three-quarters of their employees enrolled in the plan. But averages are only averages, masking outliers on both ends of the spectrum.

One administrative feature which distinguishes participation rates at different employers is auto-enrollment. Auto-enrollment means employees are automatically enrolled in the plan when they become eligible, unless they opt out. More than a third of employers with auto-enrollment have participation rates in the 80 percent to 89 percent range. For employers without auto-enrollment, only about 20 percent have comparable participation.

Here is a refined breakdown of what employers are doing with their plans. Sponsors with…

  • Auto-enrollment: 76 percent.
  • Auto-enrollment featuring automatic annual step-ups in deferral rates: 26 percent.
  • Auto-enrollment without automatic deferral step-ups: 30 percent.
  • No auto-enrollment but considering it: 18 percent.
  • No auto-enrollment and not considering it: 26 percent.

Philosophical Objections

What’s the downside to auto-enrollment? For some employers, it’s the fact that the amount they will pay for matching contributions would go up.

For a larger group of anti-auto enrollment employers, it’s likely to be philosophical. “Who am I to pressure employees to save for retirement if they don’t want to? How can I even be sure they need to?” is the thought process. While some employers will stick to their guns, those in the 18 percent “considering it” category, might conclude that a lot of employees just need help overcoming inertia to do what they know they should be doing.

About one fourth of survey participants said they use an auto-escalation feature which automatically raises the amount deferred into the 401(k) each year. This is an area which must be carefully managed. Many employers who use this feature start with a lower initial default rate on employee contributions. The assumption is, through escalation those contribution levels will eventually get to a reasonable level.

Unintended Consequences

There is a risk that the effect will be to lower average deferral rates, not increase it, if they set the default rate too low. The majority of employers which have an auto-escalation feature start the initial deferral rate in the 3 percent to 3.99 percent range, with the annual auto-increase rate between one and two percent. Just over one quarter of employers set the auto deferral rate at 4 percent or higher. For those employers who don’t use an auto-increase feature, 40 percent set the auto-deferral rate at 4 percent and above.

One commonly held belief is that employees should be setting aside around 10 percent or more of their salaries, depending on their personal circumstances. However,

  • less than one in four participants covered by the WorldatWork survey say they contribute more than 7 percent.
  • only 14 percent of employers said more than half of their employees make the maximum allowable contribution to their plan.
  • slightly more than half said less than 10 percent of employees contribute the maximum.

One-Click Enrollment

Another approach to boosting employee deferrals was pioneered by 401(k) giant Vanguard, and may serve as an example to others. This approach is called “Enroll Now” and focuses on maximizing the simplicity of the voluntary enrollment process as opposed to auto-enrollment.

Similar to Amazon’s “buy with one click” feature, employees can simply sign up with one click. If they do this, they will be defaulted into whatever you have set up, in terms of contribution rate, auto-escalation features, and qualified default investment alternative (or QDIA, see sidebar for definition).

Employees can move out of those defaults later, if they choose to.

Role of Target Date Funds

Target date funds are by far the most popular QDIAs. The research firm of Cerulli** estimates that 42 percent of all 401(k) contributions go into target date funds. Cerulli further predicts this number will rise to 63 percent in five years.

Vanguard predicts that within two years, 75 percent of newly enrolled 401(k) participants will be steering dollars into target date funds.

Target date funds generally work well for participants, for a variety of reasons. As employees reach and pass their intended retirement date, they tend to become more conservatively invested. Plus, they tend to maintain their chosen asset mix for any given stage of the “glide path” of changing allocations amid up and down markets. (See below.)

With the automatic rebalancing feature, if the stock market rises the proportion of stocks in the portfolio becomes a greater percentage of the total (by virtue of a higher stock price), according to the fund’s glide path. If that happens stocks will be sold to get it back to where it’s supposed to be. The opposite happens in a down market. This guards against the classic undisciplined investor’s blunder: buy high and sell low.

Target date funds also help employees avoid falling into the trap of being too conservatively, or too aggressively, invested.

Generally, the combination of automatic or a highly streamlined enrollment and target date funds will go a long way towards helping your employees get the most bang for their 401(k) investments — and therefore so will the employer.

Key Terms

QDIA or qualified default investment alternative refers to certain types of investment services which employers can use to manage retirement accounts on behalf of their employees.

Glide path refers to the formula used to allocate assets in a target date fund. The closer the fund gets to the target date, the more conservative the asset allocation becomes.

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