‘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). ↩

A Preference on ‘Preferences’?

A research paper finds that introducing a Roth 401(k) option doesn’t have much impact on current plan savings rates — but what does that have to do with their preference for tax preferences?

Well, according to “Does Front-Loading Taxation Increase Savings? Evidence from Roth 401(k) Introductions,” governments could actually increase private savings by taxing savings up front, rather than in retirement. This conclusion basically suggests that taking away the current 401(k) pre-tax contribution and replacing it with a Roth assumption would not only not decrease, but it might actually increase, retirement savings, and with no additional cost to the government.

For years a key education element touted about 401(k) plan participation has been the ability of the individual to put off paying taxes on their contributions and on the earnings attributable to those contributions (and those of their employer, if any) until retirement, at which point they would ostensibly find themselves in a lower income tax bracket. Moreover, by saving on a tax-deferred basis, the theory went that you could get more bang for your buck in leveraging the taxes deferred.

A Preference for Roths

The researchers look at that scenario a little differently — gauging that paying taxes upfront on the contributions and foregoing paying taxes on the accumulated earnings amounts to a better deal. They then anticipate that participants would shift their 401(k) contributions to Roths.

To test their hypothesis, the researchers drew on administrative 401(k) plan data from 11 companies that introduced a Roth 401(k) option between 2006 and 2010 to analyze the impact of a Roth option on savings plan contributions. They found no evidence of a change in total contribution rates between employees hired after a Roth option is introduced and employees hired before. In fact, they note that if anything, contributions rise slightly when a Roth option is available.

Having found no evidence of the anticipated shift to Roths, they seek to explain it.

To do so, they turn from actual data to a survey of participants who are asked to provide a savings recommendation to a couple of fictional participants — basically to come up with a recommended savings rate for a pre-tax 401(k) option versus one that allows for both a pre-tax 401(k) deferral and a Roth 401(k) contribution. Despite what the researchers see as obvious advantages with the Roth, the contribution recommendations (in terms of a total contribution) are almost identical.

No ‘Wonder’

While considering several possible explanations for why this occurs, they settle on one that seems fairly obvious: “ignorance and/or neglect of the 401(k) tax rules.” But since the introduction of the Roth 401(k) option didn’t lead to any major shift in contribution rates, the researchers conclude that this suggests that governments may be able to increase after-tax private savings (because participants will have more savings accumulated with the Roth) while holding the present value of taxes collected roughly constant (the government gets less money, but gets it upfront, rather than waiting for the individual to retire) by making savings non-deductible up front but tax exempt in retirement, rather than vice versa.

In other words, since the addition of the Roth option didn’t lead to any significant changes in contribution behaviors, policymakers could consider shifting those current tax preferences to a post-tax savings assumption without being worried that individuals would react negatively, and perhaps save less, in response.

What If?

While acknowledging that a Roth-focused savings design could be advantageous to some, perhaps many workers (especially younger workers who may currently be paying the lowest tax rates of their working lives), I’d like to posit an alternative perspective.

What if those workers didn’t shift to Roth just because they liked the notion of putting off paying taxes — that they appreciated the logic of getting a dollar’s worth of savings for 85 cents worth of paycheck (that might, however, even account for the small uptick in contributions for the Roth — trying to make up for that “gap”)? Or that, having contributed on a pre-tax basis for some period of time, they were simply disinclined to make a change. After all, if plan sponsors simply added a Roth contribution type to the play, without changing default assumptions or matching formulas, simply presenting it as an additional option, I think it’s fair to say that, under those circumstances, most participants wouldn’t have any reaction or response to the new option. Indeed, considering normal behavioral inertia, it would be surprising if they did.

Let’s face it — they didn’t save more, they didn’t save less. They pretty much held the status quo.

So, what does this non-response of participants to the addition of a Roth option tell us about their likely response to the elimination the ability to defer paying taxes on income they haven’t received?

Well, Newton’s First Law of Motion is that objects at rest tend to stay at rest unless acted on by an external force. If you wanted to really test the reaction of participants to losing their pre-tax deferral choice — their “preference” for tax “preferences” — it seems to me that you’d need to actually take that option away from them. And then perhaps consider Newton’s Third Law of Motion: that for every action there is an equal — and opposite — reaction.

There is, it seems to me, a big difference between participants ignoring an additional choice and having an existing choice taken away. And policymakers who ignore that distinction in effecting tax law changes for retirement plans do so at their peril.

- Nevin E. Adams, JD