‘Automatic’ Transmission: Does Auto-Enrollment Create Leakage?

Most people view automatic enrollment in a 401(k) as a good thing¹ – but apparently it has a heretofore unappreciated “dark” side.

At least that was the focus of a headline in a recent Wall Street Journal article (subscription required) that asked (and answered) the provocative question: “401(k) or ATM? Automated Retirement Savings Prove Easy to Pluck Prematurely.”

That is at least how the Journal chose to position its coverage of a study based on a single firm’s experience with automatic enrollment. That study, according to the Journal, serves to “answer a question that has long concerned employers that put workers into 401(k) plans and give them the option to drop out, rather than requiring them to sign up on their own: Will auto-enrolled workers treat their 401(k)s like automated-teller machines?”

Now, I’ve heard a lot of questions over the years from plan sponsors about automatic enrollment – but never that one.

Regardless, the Journal says that the study provides an affirmative response to the question – but (and you can almost hear the disappointed sigh) “…not to the extent that the workers spend all their gains from auto-enrollment.” Nor is it the first time that the Journal has taken aim at automatic enrollment.²

Now the researchers themselves – John Beshears, David Laibson and Bridget Madrian of Harvard, and James Choi of Yale – have solid retirement plan researcher “cred.” And, comparing employees hired in the 12 months after the introduction of automatic enrollment to those hired in the 12 months prior, they find that automatic enrollment increases total potential retirement system balances by 7% of starting pay eight years after hire.

On the other hand, they also find that leakage “in the form of outstanding loans and withdrawals that are not rolled over into another qualified savings plan” (more on that in a minute) also increase – by 3% of starting pay, which they say offsets approximately 40% of the potential increase in savings from automatic enrollment. Of course, even then, they acknowledge that the “net effect is that automatic enrollment increases retirement system balances by 4-5% of first year pay eight years after hire.”

‘Ample’ Turnover?

Here’s the thing: This is the experience at a single firm. Granted, it’s described as a large (approximately 7,500-participant), Fortune 500 financial services firm – but it’s one that the researchers concede has high turnover. It’s also, based on the salary information provided, one with relatively modest income workers. And automatic enrollment did “work” – transforming the plan’s participation rate from 62% to 98%.

So, this employer adopts automatic enrollment in a plan of modest income workers – creating more, albeit arguably smaller account balances – for a workforce that has high turnover – and since they have smaller balances, more likely to be below the cashout thresholds, and thus resulting in a higher number of termination payout “leakage.”

Cash Out ‘Cache’?

The Journal tries to craft a picture that automatically enrolled participants are more likely to cash out than other participants – and arguably they may well be less committed to the savings proposition. In fact, the study found (and the Journal article notes) that more than half of the auto-enrolled participants – 59% – cashed out their savings (largely driven by terminations), while among those who signed up for the plan on their own, the figure was 43%.

But was it automatic enrollment – or the smaller balances that resulted from a 3% default contribution rate at termination – that produced that result? I think we can all sense what the answer is – but the researchers note that a greater proportion of the automatically enrolled workers had balances below the $1,000 cashout threshold. Lest we need any further affirmation, even then, the researchers note that those net results “mask substantial differences across those who remain employed at the firm versus those who separate” – with the former seeing relatively little impact from leakage.

Change ‘Ranges’

And while the researchers don’t make much distinction in the impact of different types of leakage, the nonpartisan Employee Benefit Research Institute (EBRI) has previously considered the issue, and found that cashouts at job change were found to have a much more serious impact on 401(k) accumulation than either plan loan defaults or hardship withdrawals (even with the impact of a six-month suspension of contributions included). How much more? Well, cashouts at termination were approximately two-thirds of the leakage impact.

Even the best researchers are limited by the amount and quality of the data. While they are careful to outline those factors in the study, the coverage of such things tends to gloss over the details that might impact the broad-based applicability of the results – things like the fact that these results are from a single employer, with high turnover and modest-incomes, a combination that may well mean that the amount – and impact – of the leakage is exacerbated.

Ultimately, the point of the study might well be a call to make it easier for individuals with smaller balances to leave their employer without cashing out their savings.

That’s hardly the fault of a plan design that helped a third more workers who weren’t saving do better. But it seems that if there’s the slightest possibility of a potential downside, the negative coverage is… automatic.

- Nevin E. Adams, JD

Footnotes

1. There are some administrative issues with automatic enrollment – see Why Your Recordkeeper Might Not Be an Automatic Enrollment Fan. ↩
2. Earlier this year the Journal, in an article plainly titled, “Downside of Automatic 401(k) Savings: More Debt” (subscription required), cited another academic study noting that automatic enrollment has “pushed” millions of people who weren’t previously saving for retirement into those plans – but quickly cautioned that “many of these workers appear to be offsetting those savings over the long term by taking on more auto and mortgage debt than they otherwise would have.” And back in 2013, the Journal had an article titled, “Mixed Bag for Auto-enrollment,”  claiming that “employees who are automatically enrolled in their workplace savings plans save less than those who sign up on their own initiative.” That article, in turn, built on – and cited – a 2011 article that suthoir Anne Tergesen jaw-droppingly titled, “401(k) Law Suppresses Saving for Retirement.” In the case of the latter, Tergesen glommed on to one of 16 possible scenarios, and focused on the notion that some workers would simply rely on the mechanics of automatic enrollment’s 3% default, rather than picking the higher rate that they might if they filled out an enrollment form (encouraged by things like education meetings and incentivized by things like a company match). ↩

Why Your Recordkeeper Might Not Be an Automatic Enrollment Fan

I recently wrote about what’s wrong with automatic enrollment. Turns out there’s more – and it has to do with when things actually go “wrong” with automatic enrollment.

See, it’s one thing to say that eligible employees should be automatically enrolled – and yet another to actually get them enrolled automatically. Even the Internal Revenue Service (IRS) goes so far as to acknowledge that two common errors found in 401(k) plans are: (1) not giving an eligible employee the opportunity to make elective contributions; and (2) failing to execute an employee’s salary deferral election.

Now, as it turns out, both are “fixable” – through the Employee Plans Compliance Resolution System (EPCRS). But that’s only the start of things. See, in both of those situations you’re looking at a corrective contribution of 50% of the missed deferral (adjusted for earnings) for the affected employee. And then fully vesting the employee in those contributions – contributions that are subject to the same restrictions on withdrawal that apply to elective deferrals.

The only difference in the correction for the two situations outlined is the calculation of the amount of the missed deferral. In the case of an erroneously excluded employee, the missed deferral is based on the average of the deferral percentages (ADPs) for other employees in the employee’s category (for example, non-highly compensated employees), whereas if the error involves failing to implement an employee’s election, the missed deferral is based on the employee’s elected deferral percentage, or in the case of missed automatic contributions, the automatic contribution percentage. For plans with automatic contributions, however, the corrective contribution for the missed deferrals is reduced to 0% or 25% of the missed deferrals, depending upon how soon the error is corrected.

Your head starting to hurt?

Hold on – those corrective contributions also need to be adjusted for earnings – from the date that the elective deferrals should have been made through the date of the corrective contribution.1 In all cases the employer must contribute any missed matching contributions, adjusted for earnings.

‘Tell’ Tales

Now, in addition to the regular array of plan notices that will now be required for those new participants, automatic enrollment has its own special set of notices. While most larger plans rely on what is called an eligible automatic contribution arrangement (EACA), smaller programs may have in place what is called a qualified automatic contribution arrangement (QACA), a type of automatic enrollment 401(k) plan that automatically passes certain kinds of annual required testing (generally referred to as a safe harbor plan). A QACA must include certain features, such as a fixed schedule of automatic employee contributions, employer contributions, a special vesting schedule and specific notice requirements.

The automatic enrollment notice details the plan’s automatic enrollment process and participant rights. The notice must specify the deferral percentage, the participant’s right to change that percentage or not to make automatic contributions, and the default investment. The participant generally must receive the initial notice at least 30 days, but not more than 90 days, before eligibility to participate in the plan or the first investment. Subject to certain conditions, the notice may be provided, and an employee may be enrolled in the plan, on the first day of work. An annual notice must be provided to participants and all eligible employees at least 30 days, but not more than 90 days, prior to the beginning of each subsequent plan year. And guess what happens if those notices don’t go out when they are supposed to?

So, it’s not as though you just have to flip a switch on payroll and you’re done.

Even When It Works

There are, of course, issues, even if there are no processing missteps. Cost, particularly as it relates to the match – which may have been designed to encourage workers to sign up, and which, with automatic enrollment, may no longer need to – and which may have been budgeted for a 70% participation rate that, thanks to automatic enrollment, may be more like 95%. Turnover can leave behind smaller 401(k) balances, which incur additional recordkeeping costs, and which can prove to be a real administrative burden with ongoing notice and communication requirements. Which again, if those notices aren’t going out when they should…

The bottom line is that automatic enrollment is an important component of helping more Americans save, and save effectively. But as is often the case, it’s not as easy as it sounds, and plan sponsors looking to embrace this design – and advisors who tout it – should do so with a full awareness and appreciation of all the implications.

For some other issues, see “Why Doesn’t Every Plan Have Automatic Enrollment?”

Nevin E. Adams, JD

1. Not that that’s not an improvement from how it used to be. Under Rev. Proc. 2015-28, if the error is detected within 9½ months after the year of the failure, no corrective qualified non-elective contribution (QNEC) is required to an affected participant’s account for the missed deferral opportunity, as long as the person is enrolled within the 9½ month period (or earlier if the affected employee notifies the employer of the mistake).

The Deification of DB-ification

I recently stumbled across another of those “DC plans are becoming like DB plans” articles — you know, the so-called “DB-ification” of 401(k)s? This is all supposed to be a good thing, of course, but is it?

We are, of course, routinely told that defined benefit plans do (or did) a better job of providing adequate income in retirement than defined contribution plans — though we aren’t generally reminded that that assumes that workers have actually managed to accumulate service credits sufficient to vest in those benefits, and that those programs are properly funded.

However, this interest in emulation of DB plans by DC plans is a relatively recent focus, fueled in no small part by the success of Pension Protection Act-engendered trends, primarily auto-enrollment (after all, nobody asks people to fill out a form to be covered by their DB plan) and asset allocation fund defaults (ditto on asking participants to choose the investments in the DB plan). But while it’s said that imitation is the sincerest form of flattery, it’s not like those auto-designs were actually copied from DB plans.¹

Don’t get me wrong — anything that turns employees into participants (and automatic enrollment surely does that) and helps them make better investment decisions (and, generally speaking, asset allocation solutions fulfill that need) has to be a good thing. But to suggest — as many of these reports do — that these trends are essentially helping DC programs mature into their more “responsible” DB counterparts seems a gross misinterpretation of what is going on.

If we’re really looking to bring the best of the DB approach to DC plans, we need look no further than the definition of a defined benefit. Defined benefit plans are funded — at least, they are supposed to be — with an eye toward the benefit that will be paid out. As the name suggests, the benefit is defined — and the decisions that are made about how much to contribute to the plan and how those contributions will be invested are also done with that in mind.

Defined contribution plans, on the other hand — even the “automatic,” DB-ified ones — have an entirely different focus. They are (still) mostly focused on how much participants can afford to put into them (or can be forced to put into them without them opting out), not how much you need to get out of them. Oh, sure, the PPA’s safe harbor automatic enrollment — and a growing number of DC plans — includes a provision to increase those contributions on an annual basis. But is it any replacement for the kind of true funding discipline that a defined benefit focus represents? More importantly, will it be enough to provide the same kind of retirement security that the DB system promised?

Let’s not kid ourselves — when they worked (and they didn’t always), DB designs were “better” not because they made decisions for individuals (though that helped), but because somebody else was generally doing the funding,² but more importantly doing so based on specifically targeted outcomes.

We’re not likely to shift the funding paradigm — but there’s nothing to keep us from emphasizing the focus on the ultimate benefit, the outcome that we hope to achieve — and the discipline to fund those DC accounts so that they can provide it.

- Nevin E. Adams, JD


Footnotes

1. Another DB “innovation” – the annuitization of the benefit — is certainly talked about (though not yet widely adopted) in the context of DC plans. Ironically, the trend in DB plans seems to be to replace that with the lump sum option so prevalent in DC plans.
2. Another significant DB/DC difference — and one that tends to get glossed over — is that DB plans not only don’t ask employees to sign up or make investment decisions — they — at least the ones in the private sector — generally don’t ask participants to fund them. Oh, sure, that DC plan frequently comes with a match, but the primary source of funding for most of these programs lies with the participant.

More or Less?

Earlier this week, the Wall Street Journal’s Anne Tergesen wrote a story titled “Mixed bag for auto-enrollment.” Citing data presented at last week’s EBRI policy forum,¹ the article claimed “employees who are automatically enrolled in their workplace savings plans save less than those who sign up on their own initiative.”

She then proceeded to cite Aon Hewitt data presented at the policy forum that illustrated how workers at various salary levels at plans that offered automatic enrollment saved at a lower rate, on average, than workers at the same salary levels at plans that didn’t offer automatic enrollment. The article then went on to note that “The data confirms an analysis EBRI performed for The Wall Street Journal in 2011.”

Well, not exactly.

In a response to an article titled “401(k) Law Suppresses Saving for Retirement” that Tergesen wrote in 2011, EBRI Research Director Jack VanDerhei challenged the premise behind the headline of that article, explaining that it “…suggests that it is actually reducing savings for some people. What it failed to mention is that it’s increasing savings for many more—especially the lowest-income 401(k) participants.”

Not only that, he took issue with the conclusion, explaining that “The Wall Street Journal article reported only the most pessimistic set of assumptions and did not cite any of the other 15 combinations of assumptions reported in the study.”

The other statistic attributed to EBRI in the original WSJ article dealt with the percentage of automatic enrollment-eligible workers who would be expected to have larger tenure-specific worker contribution rates had they been voluntary enrollment-eligible instead. The simulation results EBRI provided showed that approximately 60 percent of the AE-eligible workers would immediately be better off in an AE plan than in a VE plan, and that over time (as automatic escalation provisions took effect for some of the workers) that number would increase to 85 percent (see chart below).

Are there those who once might have filled out an enrollment form and opted for a higher rate of deferral (say to the full level of match) that now take the “easy” way and allow themselves to be automatically enrolled at the lower rate adopted for most automatic enrollment plans? Absolutely. However, as the EBRI data show—and, for anyone paying attention, have shown for years now—the folks most likely to be disadvantaged by that lack of action are higher-income workers.

In fairness, while that 2011 article was titled “401(k) Law Suppresses Saving for Retirement,” the more recent coverage not only characterized automatic enrollment as a “mixed bag,” but acknowledged the “very positive effect on participation rates” as a result of automatic enrollment.

Indeed, the simple math of automatic enrollment is that you get more people participating, albeit at lower rates (until design features like automatic contribution acceleration kick in). Said another way, participation rates go up, and AVERAGE deferral rates dip—at least initially.

That might, in fact, mean that some individuals do, in fact, save less by default² than if they had taken the time to actually complete that enrollment form, or if they fail to take advantage of the option to increase that initial default.

But that ignores the reality (borne out by the data) that many workers will be saving more—because that initial savings choice was automatic.

Nevin E. Adams, JD

¹ Materials from EBRI’s 72nd Policy Forum, including a link to a recording of the event (courtesy of the International Foundation of Employee Benefit Plans) are online here.

² EBRI has recently considered how much difference setting a higher default contribution rate can make in improving retirement readiness. See “Increasing Default Deferral Rates in Automatic Enrollment 401(k) Plans: The Impact on Retirement Savings Success in Plans With Automatic Escalation,” online here.