As the debate over Social Security reform reaches the boiling point in Washington, the Investment Company Institute and the Employee Benefit Research Institute are urging employers to step up their use of automatic enrollment for 401(k) plans to help shore up the retirement savings of millions of American workers.
The two Washington-based institutes are also calling for higher contribution rates when new employees default, or in other words, when they fail to declare the percentage they'd like removed from their paychecks.
The effort, however, is not without its hurdles. For starters, employers in the U.S. are not required by law to conduct automatic enrollment, and many choose to allow their new employees to decline a 401(k) contribution because of the liability and costs associated with determining choices and plan maintenance for them. Many employees, meanwhile, particularly younger workers with lower income levels, put off saving for retirement until their later years.
"If a plan sponsor puts you in, say, a value fund, what if it doesn't make enough money and you don't meet your goals?" asked Sam Campbell, a research analyst with Financial Research Corp. in Boston.
"Or say they put you in a balanced fund or a lifecycle fund and you end up losing money. There is a lot of potential liability around automatic enrollment," Campbell said. In addition, plan sponsors and their providers could be hit with potentially high administrative costs, particularly to support small accounts, he added. Several pieces of legislation aimed at clarifying a plan sponsor's legal and fiduciary obligations under automatic enrollment are currently being debated on Capitol Hill, Campbell said.
No. 1 Savings Vehicle
As the ICI and EBRI detailed in their report last Wednesday, employment-based 401(k) plans have become the No. 1 retirement savings option for American workers.
In recent years, the type of retirement plan provided to employees has gradually shifted from defined benefit, where the employers use a formula to determine a particular amount of retirement income for the employee, to defined contribution, which includes 401(k)s and empowers employees to make many of their own benefit decisions based on a menu of choices provided by the employer, or plan sponsor.
For example, 20 years ago, according to the study, about 75% of all private plan participants were under the DB umbrella, but by 1999, the latest data available, that had plummeted to just 30%. By contrast, 401(k) plans, which first came into existence in the early 1980s, now command 53% of all the active participants in private plans and 41% of all the assets.
Going forward, 74% of all new contributions going into private pension plans today are going into 401(k) plans.
Auto Enroll Not Insignificant'
While difficult to quantify exactly, the assets that increased automatic enrollment could provide the mutual fund industry "would not be insignificant," Campbell added.
What is known, the study points out, is that at the end of 2004, participants in 401(k) plans had accumulated $2.1 trillion in assets, compared to the $184.5 billion held by defined contribution plans 25 years ago.
"When you look forward and try to figure out where most of the retirement wealth for Baby Boomers is going to come from it's very important to focus on 401(k) plans," said Jack VanDerhei, an EBRI fellow from Temple University who is co-author of "The Influence of Automatic Enrollment, Catch-Up, and IRA Contributions on 401(k) Accumulations at Retirement."
But according to the study, which leverages a database of 15 million records from 45,000 plans, not all employers offer their workers a 401(k) plan or have an automatic enrollment feature. In fact, only about 19% of all large corporations in the U.S. employ automatic enrollment, VanDerhei said, and that figure falls to 9% among smaller companies. And without automatic enrollment, 401(k) participation depends strongly on a worker's age and income. Among the youngest, lowest-income workers, or those employees aged 26 to 35, about 37% who are eligible for a 401(k) plan opt to participate. The median replacement income from those workers is 23%. With automatic enrollment when the default contribution rate is 6% and the money is placed in a lifecycle fund, the study finds, that number jumps to 52%.
The 401(k) participation rate among older, higher-income eligible workers, meanwhile, is upwards of 90%. They also contribute more money and choose more aggressive investment than is typically the case through automatic enrollment, the study notes.
Therefore, the real impact an automatic enrollment feature can have on income replacement rates at retirement depends heavily on the default contribution rate and the default investment option that the plan sponsor selects, VanDerhei said.
3% Input Not Good Enough
"Automatic enrollment will almost always be beneficial when it comes to participation," VanDerhei said, "but the default contribution rates - and far and away the most common is a 3% contribution rate - are far below what employees tend to do on their own. Even lowest income, young workers average about 5.3% of compensation and that goes up to as high as 9.3% for the high-income, older workers."
The study also finds that since equities securities tend to generate higher returns than fixed income securities, 401(k) plans that select a lifecycle fund as the default investment option provide higher income replacement rates than those that choose a money market fund.
Another key element of the study examines whether IRAs can make up for missed 401(k) contributions, when, for instance, a worker switches to a job that doesn't offer a plan. The study found that whether or not a person will lean on an IRA to make up for the lack of a 401(k) option depends greatly on their income.
For example, if employees contribute to IRAs during lapses in 401(k) coverage, the study indicates, lower-income workers aren't as likely to fall behind in retirement savings as their high-income cohorts. That's because contributions from low-income workers to 401(k) accounts tend to be close to IRA limits, the study says.
"This is also good news for many workers in the U.S. today who do not have a retirement plan at work, because if they were to take the initiative to contribute to an IRA, they could build significant nest eggs for retirement," noted Sarah Holden, a study co-author and senior economist at the ICI.
Higher-income 401(k) participants, whose contributions are typically above IRA limits, cannot replicate their 401(k) contribution activity with IRAs, Holden said.
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