Every time it seems there’s nothing new to say about auto features, new questions arise. Most of them spring from fallacies that continue to be perpetuated throughout the 401(k) industry.

Some oft-repeated misunderstandings in the retirement plan industry are:
 

• A default contribution rate of 3% is standard.
• Capping auto-escalation lower than 15% is a good idea.
• Auto-sweeping non-participants into the plan is risky.
• Employees won’t appreciate full use of auto features.
  

Let’s dig into these misunderstandings and why they each may be inaccurate.

Why a 3% default contribution rate might be a mistake

One of the more confounding norms in plan design is the 3% auto-enrollment rate. No one is (or at least very few people are) retiring on 3% savings, yet many participants assume that the default rate is sufficient and are unlikely to increase it on their own. I’m sure you know this on some level, but when was the last time you actually looked at the numbers?

Median weekly earnings for full-time wage and salary workers in the United States were $1,139 in the first quarter of 2024.^* If we extrapolate that to $59,228 annually, a 3% contribution rate would be just $1,777. Obviously, that amount would grow with time and raises (one would hope), and investments would mature. But let’s run this through a retirement calculator. We’ll set the age at 40, giving this hypothetical individual at least 25 years to save. According to American Funds’ retirement planning calculator, someone looking for 80% of their final annual salary during a 20-year retirement, starting at $59,228, could need to save $1,186,534. With a 3% contribution rate, they’re projected to come out of 27 years’ worth of saving with $167,640.^†

For most financial professionals, it’s obvious that 3% is not enough to retire on. So then why did it become such a common default contribution rate? By the power of suggestion. When auto-enrollment was introduced, several influential sources, including leading behavioral finance experts, used 3% as a hypothetical contribution rate. Pretty quickly, a norm was born. Employers routinely used 3% as their base auto-enrollment rate, despite its insufficiency.

Fortunately, that tide is starting to turn. Six percent is gaining traction as a starting enrollment rate. This is definitely an improvement. But consider the hypothetical 40-year-old saver. Even if they raise their contribution to 6%, doubling their savings projection to $335,280, this number is still significantly shy of the goal.^†

Encourage plan sponsors to consider setting the default enrollment rate to at least 6% and to couple that with sufficient auto-escalation.

Embrace auto-escalation and raise the cap

Too many plan sponsors are afraid of auto-escalation and set their contribution caps too low. One objection that frequently arises: “I don’t want to upset employees.” The fear is that an imagined employee will discover that a higher percentage of their paycheck is being channeled into their retirement account than they expected.

Anecdotally, employees are rarely upset about auto-escalation, and they may be surprised when they hit the cap. Of course, most people are pleased when they discover a higher-than-expected balance in their 401(k)s, and the “problem” of an upset employee can be solved with a few clicks of a button. If they want to reduce their contribution, that is an easy fix.

A much greater risk is to your plan participants’ savings goals. People are often inclined toward inertia and underinformed about retirement savings needs. Left to their own devices, they’re likely to assume that their current contribution rate, whether it’s 3%, 6% or something else, will help them reach their goals. Fortunately, you have tools to leverage this inertia and help them overcome their own misinformed confidence. Auto-escalation provides this power, yet some sponsors are reluctant to use it to its full extent. This is particularly true when it comes to capping the escalation rate. I’ve seen sponsors set caps as low as 6%.

A key provision of the SECURE 2.0 Act of 2022 will require many retirement plans to automatically enroll employees and escalate their contributions annually. New 401(k) and 403(b) plans established on or after December 30, 2022, will need to add automatic enrollment and escalation for plan years beginning in 2025 (unless an exemption applies).‡ Impacted plans will require automatic enrollment starting with at least 3% and increasing by 1% each year until reaching at least 10% but no more than 15%. The increased cap supports ongoing efforts to encourage more employees to save for retirement at an adequate rate.

It’s also promising to see in the Callan Institute’s 2023 Defined Contribution Trends Survey that 22% of plan sponsors with an automatic enrollment safe harbor, called qualified automatic contribution arrangement or QACA plan design, intend to increase their cap to the maximum. Conversely, it is disappointing to see 9% intend to make no increases and 36% don't currently offer this type of plan design.

Encourage sponsors to consider setting escalation caps to 15% and let employees decide for themselves if they want to opt out.

Make non-participants opt out every year

If there’s a bogeyman of auto features, it’s the auto-sweep. “What if my employees get mad that I put them back in the plan when they already opted out?” But, what if they reach age 65 and realize they haven’t saved for retirement? It may be better to consider making employees opt out each year than to see someone forget they opted out once upon a time. The risk is far greater to the employee in the second scenario — years of potential saving wasted.

Encourage plan sponsors to embrace the auto-sweep feature and include the opt-out opportunity as part of their annual open enrollment, right alongside health insurance decisions.

Defaulting to a retirement income strategy comes with risks

As for the new trend toward guaranteed retirement income features in qualified default investment alternatives (QDIAs), proceed with caution. Target date investments are designed to meet the needs of the majority of participants, in that most individuals will want a greater share of more conservative investments as they near retirement. That said, the closer a person is to retirement, the more nuanced their needs will be — and the less room they will have for error. Income in retirement can involve many unique factors for an individual, which means it may require more attention than your average mid-career accumulation portfolio. Many guaranteed solutions add cost and/or reduce liquidity, which may not be right for the majority at that point in their timeline.

If QDIAs are designed to help people who aren’t necessarily thinking about their retirement investments, then those that include either a guaranteed or a non-guaranteed income element should be prepared to flip that script. Make sure participants are paying attention. Alert them to the income element(s) of the QDIA and what that could mean for them. This may involve much more disclosure, more education and more opportunities for the participant to make different choices.

I understand that including income-generating investments in a QDIA is designed to prevent people from reaching retirement without a plan, but people cannot afford to sleepwalk into distribution, either. If you choose to expand the retirement income aspect of your plan, here are my suggestions:
 

• Understand the retirement income aspect of your current QDIA.

• Consider offering multiple options that can help meet the diverse retirement income needs of participants.

• Consider offering both guaranteed (protected) and non-guaranteed options.

• Consider allowing participants to “opt in” to guaranteed options based on their needs and preferences.

A final point to consider

Professionals in the retirement industry have a duty to keep their sights on the long term, but for some reason, plan sponsors often fixate on the short-term feelings of employees over their long-term retirement readiness.

When it comes to plan design, financial professionals have a responsibility to encourage plan sponsors to use the tools available to help participants work toward their retirement goals. That sometimes means making decisions they wouldn’t necessarily make for themselves, like higher default enrollment rates, higher caps on auto-escalation rates and auto-sweeping employees back into the plan. It also sometimes means approaching trends with caution, as one should with retirement income.

To close, remember how infrequently plan sponsors report problems from raising default contribution rates or auto-escalation caps — or even from auto-sweeping. While some of these features may feel like an overreach, encourage your clients to make full use of them.

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