A recent study investigated the impact of certain defined contribution features on employee saving rates. Head of Defined Contribution and Wealth Advisor Services Matt Sommer reviews the findings and discusses the implications for plan sponsors who may be considering making updates to their plan designs.
Last month, the Center for Financial Planning hosted the fifth annual Academic Research Colloquium for Financial Planning and Related Discipline. I attended the (virtual) event and was intrigued with the findings that were presented from a working paper that investigated the impact of auto-enrollment defaults and employer matching contributions on employee deferrals.
Leveraging data from one of the largest defined contribution recordkeepers, the researchers (Zhikun Liu, David Blanchett, and Michael Finke) studied the behaviors of approximately 157,000 participants from 1,018 plans. The selection of participants was limited to those with less than one year of service to eliminate the potential impact of auto-escalation. All participants were also required to have been eligible for an employer matching contribution. The average age of participants in the study was 38 and their average annual income was $64,000.
What the Research Found
The study found that establishing a higher default auto-enrollment rate had a greater impact on employee deferrals compared to higher employer matching contributions. In fact, in plans with low default rates but high employer contributions, participants tended to move away from the default rate and increase their deferrals. However, it’s important to note that this tendency was limited to higher income employees. As a result, the disparity in saving rates between high- and low-income workers was even more pronounced in plans with low default rates. Conversely, when participants were defaulted at higher rates, many opted to stay the course, which helped close the savings rate gap between high- and low-income participants.
While this research supports the adoption of higher default rates, plan sponsors must still decide on an appropriate default rate for their organization. Historically, the most commonly used rate was 3.0%. In fact, approximately two-thirds of the plans in the research described above use a 3.0% or 4.0% default rate. More recently, however, we have begun to see many sponsors increase their default rates to 5% or even higher. While employee resistance has always been one of the primary barriers to higher default rates, we have observed minimal resistance to higher default rates.
Auto-enrollment is another important consideration. While this feature can help new employees save for their future, it will not help existing employees who have opted out or are participating in the plan at a rate lower than the default. In these cases, an annual or periodic re-enrollment can help ensure that these employees are not left behind.
Lastly, while any savings is better than no savings, most initial default rates are not high enough to replace the recommended percentage of pre-retirement income (often defined as between 60% to 80%). As such, plan sponsors may want to consider incorporating auto-escalation to help employees who are nearing retirement reach their goals.
For sponsors looking to incorporate plan design changes, an ideal time to do make those revisions is when documents must be amended and restated to comply with ERISA. The next deadline for most plan sponsors who use pre-approved documents is July 31, 2022.
For plan sponsors who have not adopted auto-enrollment, or that offer auto-enrollment but at lower rates, this research provides strong evidence that higher default rates are associated with more robust overall employee saving behaviors. Plan sponsors may also wish to use the plan amendment and restatement process as an opportunity to reevaluate the use of re-enrollment and/or auto-escalation to help drive even higher employee saving rates.