The Pension Protection Act of 2006 provided changes in 401K plan regulations making auto enrollment more feasible for companies to administer. The Act reduced employer liability and allowed for auto escalation, encouraging employers to implement auto enrollment in 401K plans.
What is Auto Enrollment?
A company participating in auto enrollment will automatically sign-up new employees for the 401K upon reaching eligibility. Employees must opt-out, rather than opt-in to the company retirement plan.Inaction will lead to enrollment, and the company will begin deducting a set percentage of your paycheck, into the 401K or company retirement plan.Prior to enrollment, the company sends required notifications, giving you anopportunity to adjust the percentage invested, choose your investments, or opt out of the program.
If you participate in the corporate plan, the IRS requires all contributions to qualify for the company match.You may withdraw contributions and earnings within 90 days of the first deduction. At any time, you may change the percentage withdrawn or terminate your participation.
Companies with an auto enrollment program will also decide where to invest funds, should you not make a selection.
Pros of Auto Enrollment
- Raises the rate of participation in the company plan.Automatic programs create inertia for savings without the intimidation or decisions required to get started. In this respect, auto enrollment is an enormous success. Saving for retirement is one of the largest financial challenges families face. You must fund an average of 20 or more years in retirement during your working career. Starting late or investing too little can lead to significant shortfalls.
Breaking down participation by income and age shows more benefits to auto enrollment because it helps the most vulnerable workers.Employees earning less than $30,000 per year had participation rates of 72%, nearly double the rate within companies not sponsoring automatic enrollment. Younger workers, under 25, also benefitted with participation rates rising from 26% to 73% due to auto enrollment. Studies also indicate less than 1% of employees opt out of auto enrollment after receiving notice of participation.
- Increases overall plan balances for employers.When more employees participate, the company 401K grows at a faster rate, giving employers more leverage to reduce plan costs and offer more services, such as research tools, which help plan participants.Larger overall balances in 401K plans give employers more leverage to keep costs down.
- Auto escalation increases balances faster. When a company establishes auto enrollment, they can choose to increase contributions at a set rate for plan participants. Such a move increases balances faster without significantly impacting take home pay. The pre-tax treatment of contributions keeps the impact on net pay at a minimum, when the company selects small annual increases. In Qualified Automatic Contribution Arrangements (QACA) the IRS allows companies to increase the employee contribution each year, up to 10%. Most companies deduct between three and six percent of employee pay. When choosing the escalation option, companies must also provide an employer match, under IRS guidelines.
Cons of Auto Enrollment
- Lower individual balances. The biggest downside to auto enrollment is that companies tend to choose a lower payroll deduction than employees would choose on their own. Employers can begin plans with as little as 1%, which will not grow accounts fast enough to pay for retirement. Forced enrollment eliminates the need for action and results in fewer employees raising the percentage each year on their own accord. When the company does not include automatic escalation, balances can remain lower, than in companies where employees are more actively involved in the retirement planning process.
- Not maximizing the company match. Auto enrollment typically does not begin at a level that would optimize the employer match. Starting all employees at the higher level would cost the company more money in terms of matching dollars and could lead to higher levels of opt-outs among employees. Companies tend to err on the side of caution and select small pay deductions for auto enrollments.
- Paying higher fund fees. There is no way for employers to have a complete understanding of each employee’s financial needs and tend to choose target date funds for the auto enrollment process. Target date funds adjust the investment selection based on your age, buttake a one size fits all approach to investing. These funds typically have the highest expenses. You can potentially increase your return, by redirecting funds based on your needs rather than your employers pick.
- Complacency. When investing requires no initiative, you leave the responsibility of your retirement planning to your employer who makes policies to reduce risk and that may not meet your retirement needs. Complacency robs you of the opportunity to use the 401K has an effective investment tool and can lead to a false sense of security. Setting aside 1% or even 3% will likely leave you short of funds in retirement.
While auto enrollment does increase employee participation and reduce the number of workers with no savings, it also makes it easy to do nothing and rely solely on your employer to address your retirement funding goals. If you contribute to a 401K through the auto enrollment process, take the time to increase contribution levels each year and review the investment selections to ensure you buy funds based on your priorities and needs.