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401(k) auto-enrollment helps workers, employers reach financial goals

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401(k) auto-enrollment helps workers, employers reach financial goals

Once a rarity, automatic enrollment programs have become a mainstream em¬ployer feature in 401(k) and other defined contribution retirement savings plans.

A decade ago, less than one out of seven employers included it in their defined contribution plans. Now, close to 60% of employers offer automatic enrollment, according to a recent survey by Aon Hewitt, the Lincolnshire, Ill.-based employee benefits consultant.

Once, “few employers wanted to be the first or second. Now, having an automatic enrollment feature is second nature,” said Ted Goldman, national retirement leader in the Washington office of Buck Consultants L.L.C.

Automatic enrollment programs are aimed at employees who don't say yes or no when asked by their employers if they would like to enroll in defined contribution plans, most often 401(k) plans.

Unless the employee rejects the offer — and generally, very few do — the employee is then automatically enrolled in the plan.

And with that simple change, 401(k) plan participation rates soar.

“Seventy percent participation rates bump up to 90%,” said Rob Austin, Aon Hewitt's director of retirement research in Charlotte, N.C. Indeed, some employers report even bigger participation increases when they added an automatic enrollment feature.

Several factors are driving the growth of automatic enrollment, the biggest being employers' desire to boost employee participation in their 401(k) plans.

“Automatic enrollment is designed to reverse employee inertia,” said Susan Pool, a senior vice president in Wichita, Kan., with TrueNorth Inc., a subsidiary of insurance broker IMA Inc.

That inertia has consequences for employers and employees. For employers, if employees aren't participating in their defined contribution plans — failing to put in their own money and also, as a result, missing out on employer matching contributions — the likelihood that employees won't have enough money saved to retire at a normal age significantly increases.

“That can mean that employees don't want to stay, but they can't afford to retire either,” Mr. Austin said.

And that, in turn, leads to other workforce management issues, including reduction in employee productivity as employees stay on the job longer than either they or their employers want and reducing openings for other employees who want to climb the corporate ladder.

“The 65-year-old may lack the means to retire. That can become expensive for the employer,” said Jack Abraham, a principal with PricewaterhouseCoopers L.L.P in Chicago.

The need to boost employees' retirement savings is greater because of another pension plan trend: the move over the past decade by employers to freeze their defined benefit plans, which makes their 401(k) and other defined contribution plans the only source of employment-based retirement income savings for their workers.

Indeed, only 30% of Fortune 100 companies, for example, still offer a defined benefit plan to their new salaried employees, according to Towers Watson & Co. research.

“The decline of defined benefit plans makes automatic enrollment even more important,” Ms. Pool of TrueNorth said.

“Many employers have frozen their defined benefit plans. Automatic enrollment is a way of compensating employees” for some of that loss, said Robyn Credico, national director of defined contribution consulting with Towers Watson in Arlington, Va.

And there is another benefit to adding an automatic enrollment feature to 401(k) and other defined contribution plans: By increasing employee participation, the likelihood that a 401(k) plan will fail federal nondiscrimination tests will decrease. Under those tests, plan contributions made by higher-paid employees cannot, on average, exceed those of lower-paid employees by an amount set by federal law.

When a 401(k) plan fails the nondiscrimination tests, contributions have to be returned to higher-paid employees. That's administratively complicated for employers and damaging to employee morale, because affected employees will have higher taxable income than they expected and less tax-favored retirement savings.

Since lower-paid employees are less likely to sign up to participate in 401(k) plans, adding an automatic enrollment feature will bring in more of them and reduce the likelihood of a plan failing the nondiscrimination tests. “Passing the nondiscrimination tests becomes easier,” Mr. Austin said.

Once an employer decides to add an automatic enrollment feature, its next decision will be how to design the feature — specifically, how much employees' salaries will be reduced, with the corresponding amount going to the 401(k) plan.

The most common contribution rate in automatic enrollment programs is one in which an amount equal to 3% of an employee's salary, plus an employer matching contribution, is made during the first year an employee is automatically enrolled.

Increasingly, to further boost employees' retirement savings, employers are adding another feature: automatic escalation.

After the first year of participation, employees' salary deferrals, under automatic escalation, typically increase by 1 percentage point a year until a cap — often between 5% and 10% of pay — is hit. Currently, more than 50% of company 401(k) plans offer automatic escalation, a roughly five-fold increase since 2005, according to several surveys.

“It is another way to boost employees' savings rates,” said Tom Simonson, a vice president with Lockton Retirement Services in Charlotte, N.C.

Automatic escalation is a weapon to combat the same problem — employee inertia — that led employers to add automatic enrollment.

If employees are automatically enrolled with a contribution of 3% of salary, few employees will ask their employers to bump up the amount they are contributing in succeeding years.

But few employees complain when their contributions are boosted each year automatically.

“Most employees don't resist a 1 percentage point increase through automatic escalation,” Mr. Simonson said.

While automatic enrollment has become a common design in 401(k) and other defined contribution plans, it is unlikely to ever become universal.

That's because the design makes little sense for industries in which employee turnover is often quite high, such as retail. Among other things, such programs would be largely irrelevant in building significant retirement savings.

“For low-wage, high-turnover workforces, there would be a lot of paperwork and administrative expenses relative” to the small amount of money contributed, PricewaterhousCooper's Mr. Abraham said.

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