Article by: Lillian Kazmierczak - Finance Writer for Toarc United
Automated 401(k) plans have been around for a while and have recently grown popular in the last few years. In 2020, approximately 62% of businesses offered an automated 401(k) plan, up from 46% ten years ago.
In 1984, McDonald's was the first to offer an automated 401(k); by 2002, they had a 93% participation rate. However, the participation rate is disputed due to the lower paid wage and the turnover rate of McDonald's employees.
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An automated 401(k) requires an employer to enroll you in a 401(k) plan as soon as you become eligible (per the company policy) with the option to opt-out. A Vanguard study showed that 92% of employees remained enrolled in the plan three years later. Many of them had even increased their contribution amounts.
This same study showed that voluntary contributions (opt-ins) were only at 29%, but of that 29%, most had continued to contribute. Companies that offered automated 401(k) have also raised their default contribution from 3% to 6%.
A Brief History: Standard 401(k) to Automated 401(k)
The Revenue Act of 1978, contained a section known as 401(k) that allowed bonuses and or stock options to be tax-deferred for top executives who chose the option. It came at a time when traditional employee pension plans were drastically changing. Unfortunately, it took two more years for this to go into effect.
By 1981 the IRS set the rules that let employees use salary deductions to contribute to their 401(k)’s. This was the beginning of nationwide 401(k) usage in the workplace.
By 1983 more than half the large companies in the US were offering a 401(k). This took the burden of funding a 401(k) retirement plan off the employer and placed it on the employees. Employees were led to believe it would give them more significant retirement savings, which proved to be true for some, but not for all enrolled.
By 1990, the 401(k) had 19 million participants to equal $384 billion in 401(k) assets. By 1996, participation had increased to 30 million and over $1 trillion in assets.
In 2001, the Economic Growth and Tax Relief Reconciliation Act increased participant contribution amounts and let employers make contributions to employee 401(k)’s, and allowed employees over fifty to make "catch-up" contributions.
In 2006, The Pension Protection Act helped employers automatically enroll employees into 401(k) plans, with some employers increasing their employee contributions by 1% each year.
By 2017 401(k)’s had over $4.8 billion in assets, and private pensions were almost non-existent. The 2017 contributions were limited to $18,000, with catch-up contribution limits at $6,000.
The 2022 maximum contribution is $20,500, with the catch-up contribution limit of $6,500 over fifty. So, anyone fifty or older can contribute $27,000 to their 401(k) this year. Allowing them to save $594,000 in 401(k) contributions by age seventy-two (based on 2022 allowable contributions).
Why the Automated 401(k) Was Conceived
The 401(k) was conceived out of need; by 2013, less than half the households in the US had retirement savings. Less than half of those had a 401(k); Americans were not saving for retirement!
When the 401(k) was created, it was frequently referred to as the "salary reduction plan" because the contribution came from your salary.
Companies offered matching contributions to get employees to use the 401(k) option to replace their current pension plan. It was a boon for the employees because so many companies were going bankrupt and taking an employee pension with them. The 401(k) was in the employee's name and was protected if something happened to the company and their pension fund.
But, the founders behind the 401(k) never meant for it to replace traditional pension funds. The 401(k) was supposed to be another means for workers to save for their retirement. Its intent was as a supplement for your pension.
As traditional pension funds disappeared, employees did not have enough information about it, were suspicious of something so new, or just were too busy to care about investing in the 401(k).
As government and financial advisors realized fewer people were saving for retirement, Ted Benna was revamping a retirement plan for a client whose retirement model was the 401(k) without pre-tax wages. He redesigned the 401(k) to include pre-tax contributions with company matching contributions. His client hated it, but the company he worked for loved it. The Johnson Company immediately adopted it.
While some employees were using 401(k), most people weren't. Instead, their lives occupied their thoughts, and there was a significant decrease in saving for retirement.
Despite the 401(k) offering at most companies, the decision to opt-in was an employee's choice, but many never chose to opt-in. There is no clear reason for the lack of participation; it was felt at the time that people had just forgotten. New hires and younger employees were among this group.
The biggest fear was that people would retire with little to no savings (and they have.) So when the government realized where this was heading, they stepped in to alleviate a retirement crisis.
How Automated 401(k) Works
The 401(k) was redesigned with an opt-out. You are automatically enrolled during the eligibility period in your company 401(k) unless you opt-out. Since most people weren't opting-in, it was expected that those same employees would not opt-out…this assumption proved correct.
Most company 401(k)’s contribute your wages at 3% or higher, with these companies matching your contribution. If you leave the company before you are vested (been with the company for so many years, usually 5 – 7 years), you get only what you put in. If you stay until you are vested, you get all the money in the 401(k), including the company matching contribution.
Employees are given the opt-out date and information on how to opt-out. Most employees never use their opt-out bids. It is designed so as an employee gets older, they can contribute more money and invest themselves in more appropriate investments as they get closer to retirement age. The option to opt-out is always available.
Plans under automated 401(k) include:
· 401(k), a profit-sharing plan that lets employees use pre-tax wages for their contribution.
· A Simple IRA is a 401(k) created for small businesses with fewer than one hundred employees.
· A 403b is a tax-sheltered annuity offered to public school employees, employees covered under Code Section 501(c) (3), tax-exempt organizations, and some ministers.
· A 457b is similar to a 401(k) but allows employee contributions up to 100% of includible compensation or $20,500 (2022 limit), whichever is less.
The Automated 401(k) Debate
The Secure Act 2.0 was reintroduced into Congress in July of this year. A provision requires companies to automatically enroll you and all other eligible employees into a 401(k), 403b, Simple IRA, or a 457b. In addition, the company is required to make matching contributions. The goal is to ensure that all employees are enrolled in a retirement savings plan and increase their contribution yearly.
Most employees understand the need to save for retirement and invest accordingly, they don't want to be told they have to or what they have to do with their money. Unfortunately, many people have no clue about retirement planning, and this option gets them started on retirement savings they may never have initiated.
The default contribution (minimum required amount) for the automated 401(k) is 3 – 6%, increasing yearly until you reach 10%. So, if you are making $120,000 a year, you aren't going to miss that money pre-tax, but that is not the case for someone earning minimum wage.
Disadvantages of Automated 401(k)
One major disadvantage of the automated 401(k) is its effect on minimum wage employees. The minimum wage differs from state to state. In Illinois, it is $12/hr,
but in Indiana minimum wage is $7.25/hr (that is less than a package of cigarettes in most states.) Their ability to save for retirement is severely affected by the amount they earn.
The studies have shown that young and lower-income employees ($15,000 or less) have an 82% participation rate with Automated 401(k) vs. the 4% voluntary participation rate. But the study did caution that this specific group has a high turnover rate, and four out of ten employees in the study had left the employer. Yet three years after enrollment, 92% of the automated employees are still enrolled vs. 29% who participated voluntarily. This is the group that will benefit from Pension Portability.
The second disadvantage is that an automated 401(k) may not be the investment some people need. There is no cookie-cutter investment; people choose investments based on their personal needs. Having an automated option removes a better-suited option from the table.
Perhaps, what we need instead is Automated Investing Education for each employee. I don't mean that five-minute sit down with the company rep who uses words you don't understand.
Companies should have a 401(k) HR employee to educate employees on the automated option. Sit with a group of employees at lunch, answer questions, and create a conversation about the 401(k). It would be easier for employees who don't understand it to sit and listen or ask questions in an informal lunch. If I'm at the table with my friend contributing 3% and helping me grasp the importance of this and I see that she can afford it, then I can afford to do it too. Your participation rate would improve, and your employees would see if and how your 401(k) plan will work for them.
Maybe the employees want more…is there more? The education, which they may not even realize you are providing, lets them decide themselves, which is what the automated 401(k) is all about!
A third disadvantage is 3% is not enough contribution for anyone older than 34 – 40 or employees building or catching up on retirement savings. 3% is great to start your investment journey at 20 years old when you have years to save. But for those of us who need to catch up or who haven't even started, 6 – 8% is probably required. Those who are not aware of what they need will fall short on retirement savings.
Contributions are a flat rate; when an employee gets a raise, will they have the option to increase their contribution? Will they even know they should do that? What about a bonus, which 401(k) was designed to address? Can these funds be a contribution as well? Lots of unanswered questions!
The fourth disadvantage is asset allocation. The investor chooses his allocations and risk; automation eliminates that. However, the wrong allocation in a volatile market could scare a lot of 401(k) participants. Will they know to ride it out or impulsively withdraw, which has tax penalties attached?
Some options may not be offered, like a Roth IRA vs. a 401(k). When it comes to the choice of investing your money, do you want your employer to be making your decisions?
While the participation rate is improving, the savings rate is low. The studies have shown that people in automated 401(k)’s save less than voluntary participants. This is most likely due to the low default rate of the automated plan. People that voluntarily join a 401(k) tend to pick a higher contribution rate.
The studies have also shown that most companies offering automated enrollment offer lower matching contribution rates; the average is 3.2% vs. 3.5% higher on voluntary enrollees. Unfortunately, the studies have shown that auto-enrollment may actually work against the employee in some cases.
Advantages of Automated 401(k)
When you look at the advantages, you need to look at both sides, employees and the employer. The employee advantages include:
More Americans than ever before will be saving for and be enrolled in a retirement savings plan. In addition, the current studies show that more employees save over time using automated enrollment.
It simplifies retirement savings for those who do not know or understand their options and would not opt-in voluntarily.
The advantage for employers includes:
Employers assist and ensure that their employees start preparing to save for retirement as soon as they are eligible. Increasing 401(k) participation will validate/improve companies’ future development of the 401(k) plan and whether or not it is effective. Plus, there are significant tax advantages for companies with automated enrollment.
If you are a small business looking to set up an automated 401(k), this link to the US Department of Labor will explain the process and take you step-by-step through the implementation process. There’s some great information on this site, and the PDF is downloadable.
Auto-Escalation or Automatic increase lets the employer set the amount of your 401(k) contribution and when the increase will occur. All automated plans are set to increase by 1% yearly. It cannot go higher than 15% unless the employee requests the deduction.
An advantage to auto-escalation is the amount of paperwork it eliminates for both the employer and the employee. The rate and the terms of the escalation are outlined in the company's 401(k) plan, which they are required to give employees when they become eligible to participate. The law requires a thirty-day notice and not more than ninety-day notice, plan details, contribution rights, and withdrawal/opt-out requests and information. Some even offer a grace period to get the contributions refunded if you opt-out.
The Future of Automated 401(k)'s
Many states are trying to increase 401(k) accessibility through mandatory state programs. As of October 2021, eleven states (California, Illinois, Maryland, Massachusetts, New Mexico, New York, Oregon, Vermont, and Washington.) For example, businesses with more than five employees must implement the state retirement program in California.
The future will need to include the same components and resources for small businesses as large companies. Many employees want to work for a smaller company, and the inability to offer 401(k) availability could severely affect small business employee retention, which is already challenged.
There is a chance that if the Secure Act 2.0 passes, we may get improved auto-enrollment features, safe harbor (a plan that ensures every participant will get an employer-matched contribution,) more eligibility options, and better investing options.
The Secure Act 2.0 will be a game-changer until it's passed and plan/plans are revealed; there is no telling what will be in it. Perhaps the immediate future of automated 401(k) is served by the education of all participants to get the most out of their plan. Starting with workers over forty and the workers with ten years left until they retire (if they can afford to retire.)
Then we have the gig workers; where do they fall in this, and were they considered in the Secure Act 2.0? The answer to that is NO! So, accessibility will still be an issue for those 59 million gig workers in the US. Perhaps gig workers will be the ones to change the future of automated 401(k)'s!
If you're looking for more Thoughts of a Random Citizen, head to the podcast section. You will find some fascinating podcasts and other information.