Putting 401(k)s on autopilot: Take plan design to the next level in 2023

2022 was certainly an eventful year for retirement savers. As participants adjusted to a “new normal” amidst the COVID-19 pandemic, 2022 brought additional uncertainty, record inflation, and a market downturn. But not everything was doom and gloom. Participants continued to make meaningful progress against their retirement goals, and Washington further improved Americans’ ability to save for retirement, including the IRS’ decision to increase plan contributions and the anticipated passage of SECURE 2.0.

But more work needs to be done to make sure participants are maximizing the benefits of their retirement plans. With defined contribution plans now being the preferred retirement savings vehicles for American workers, the responsibility for the effective management of one’s retirement savings now falls on the individual. Millions of people now act as their own chief investment officer and financial planner for their retirement portfolio. And while the benefits of the shift from defined benefit to defined contribution plans cannot be overstated, research shows that more participants than ever need help saving for retirement.

Our research reveals that participants’ lack of planning skills leads to inaction in voluntary enrollment plans. In 2021, of the plans record-kept at Vanguard, those with automatic enrollment had a 93% participation rate, compared with a participation rate of 66% for plans with voluntary enrollment. When presented with voluntary plan options, eligible nonparticipants, unsure what to do, often postpone their decision, thinking they’ll come back to it another day. And while many employees know they are not saving enough and express an interest in saving more, they simply never get around to joining the plan—or to increasing their contribution rates over time if they do join.

Employers are uniquely positioned to help more of their plan participants improve their financial wellness. One of the simplest ways to do so is through smart plan design that harnesses the power of participant inertia. As we all look to the year ahead, now is a helpful time to take stock of your company’s retirement plan and ensure your plan has adopted the following automatic features that help set your workforce up for investment success.

Related: ‘Show me the income’: Employees seek guidance for their long-term retirement income

1. Automatic enrollment: Participant behavior is increasingly influenced by employers’ automatic enrollment and automatic escalation default designations. Plans with automatic enrollment had a 93% participation rate, compared with a participation rate of 66% for plans with voluntary enrollment. When including nonparticipants, employees hired under automatic enrollment plans saved an average of 10.9%, considering both employee and employer contributions whereas employees hired under a voluntary enrollment design saved an average of 7.3%, due to significantly lower participation.
2. Annual deferral increases: Annual deferral increases can be a particularly powerful feature in helping participants save for retirement. Vanguard research found that a modest increase in participant deferral rates of 1, 2, or 3 percentage points would enable an additional 20% of participants to attain a 75% replacement ratio in retirement. You may expect that plans with initial deferral rates of 2% or 3% would see fewer employees quitting the plan, given that these lower deferral rates have little impact on take-home pay. However, our research suggests that employee quit rates do not appear to vary in response to a plan sponsor’s choice of the initial deferral rate. This suggests participants have more of a tolerance for higher default rates than we’d initially expect.
3. Higher default rates: The aforementioned automatic solutions are proven to increase plan participation and saving rates, but the success of these strategies hinge on how they are implemented. For example, Vanguard participants saved an all-time high average of 7.3% of their income in 2021. In part, the result of the fact that 58% of plans now default at rates of 4% higher—a trend that continues upward year-over-year. By increasing the initial default and marrying it to an automatic escalation feature, you can help more of your participants achieve a recommended savings rate of 12-15%.
4. Undersaver sweeps and re-enrollment: Automatic features have made tremendous progress in helping more employees take advantage of their employers’ retirement plan benefits, but a notable percentage of eligible employees still do not participate in their workplace plan. There is also a population of participants who do not increase their contributions, which can jeopardize retirement readiness as well. To help these employees get their retirement savings back on track, conduct regular undersaver sweeps (periodically “sweeping” eligible nonparticipants into the default design) to re-enroll nonparticipants and ensure they save at an appropriate rate, ideally complementing these sweeps with adoption of an automatic escalation feature to help them achieve a savings rate of 12-15%. We generally recommend reenrolling participants into a low-cost, diversified target-date fund with a vintage close to their retirement age. This can further reduce inertia risk and ensure participants’ portfolios are age appropriate and properly diversified.

Dave Stinnett is Principal and Head of Strategic Retirement Consulting at Vanguard Institutional Investor Group.