A 401(k) deserves better than your 3%
More employers putting workers into plans, but minimum is too limited
More employees are participating in 401(k) plans, mainly because an increasing number of employers are automatically enrolling them unless they opt out.
Once enrolled, employees tend to stay put. On the downside, employees who are auto-enrolled tend to contribute a lower percentage of pay than those who sign up themselves. And most people “stick with whatever (savings rate) they were put into,” said Judith Ward, a senior financial planner with T. Rowe Price.
The most popular default contribution rate, for employees who don’t choose one, is a measly 3 percent of pay, among plans administered by Fidelity, T. Rowe Price and Vanguard, which
tend to be larger plans.
For most employees, 3 percent is not nearly enough to retire on. It’s not even enough to get the full match at most companies that match employee contributions up to a certain limit.
The average employee contribution needed to get the maxim match was 6.9 percent of pay among Vanguard-run plans last year and 6 percent among plans managed by T. Rowe Price.
Employers are gradually adopting higher default rates, but not fast enough.
Last year, 43 percent of Vanguard-run plans with auto enrollment had default contribution rates higher than 3 percent, up from only 25 percent of plans a decade ago.
T. Rowe Price reported that 54.1 percent of the plans it runs with auto enrollment had default rates higher than 3 percent last year, up from 41.4 percent of plans in 2011.
Among Fidelity-managed plans, 38 percent have default rates higher than 3 percent, up from 23 percent in 2011.
In January 2013, Google raised its default investment for autoenrolled workers to 10 percent of compensation from 6 percent, according to BrightScope, which rates 401(k) plans.
The 3 percent rate seems to have had its genesis in two revenue rulings issued in 1998 and 2000, in which the Internal Revenue Service explained how plans could automatically enroll workers in 401(k) plans without jeopardizing their tax benefits. In the rulings, it used a 3 percent default rate as a hypothetical example.
“That became the default default,” said Brigitte Madrian, a business and public policy professor at Harvard University.
In 2004, the IRS said in a general information letter that the default rate could be greater or less than 3 percent. And in a 2009 revenue ruling, it gave an example of a plan that started at 4 percent and went up.
So why does 3 percent seem to be set — if not in stone — at least in mud?
It’s partly inertia. Employers tend to get stuck just like employees.
It’s partly fear that starting at a higher rate would cause more employees to opt out, although there has been little evidence to support this. Madrian co-wrote a study of three companies with default contribution rates between 3 and 6 percent and found that their participation rates were not strongly influenced by their default rates.
In a survey last year, T. Rowe Price asked workers at what investment rate they would have opted out instead of enrolling in a plan. Sixty percent said 6 percent or higher.
A third, and maybe the biggest, reason default rates aren’t higher is cost. If the employer matches contributions, a higher rate costs more money.
“The finance people will say, ‘Why should we give money to someone who won’t even sign up on their own? Will they value the money?’ ” said Jon Chambers, a retirement plan consultant with SageView. “That’s a valid criticism. But everyone needs to retire at some point.”
Financial planners say workers without a defined-benefit plan should save 10 to 15 percent of pay each year, including any employer match.
The two most common match rates are dollar for dollar up to 3 percent of pay, or 50 cents on the dollar up to 3 percent of pay, said Katie Taylor, a director with Fidelity. So an employee with a 3 percent match should be socking away 7 to 12 percent of pay.
Some plans offer to automatically increase a worker’s savings rate each year until it hits a certain limit. But auto escalation is less common than auto enrollment and usually requires the employee to opt in rather than opt out.
Even if a default rate starts at 3 percent and goes up one percentage point each year to 6 percent, “When you are in an economy with a fair amount of labor mobility,” Madrian said, many people will never get to 6 percent. Workers who leave after five years will have been at 6 percent for only two of those years.
“You also have the problem, in some companies that offer a match, the match doesn’t vest immediately,” Madrian added. Employer contributions typically vest, or become available to the employee, over one to six years. Departing employees forfeit any unvested contribution.
Slightly less than half of employers in Vanguard-run plans offer immediate vesting.
Jean Young, a senior research analyst with the Vanguard Center for Retirement Research, said it’s true that workers who enroll in a plan on their own save a greater portion of their salary (7.2 percent on average) than those who are autoenrolled (6.1 percent).
But Vanguard-run plans with auto enrollment also have an 88 percent average participation rate, compared with 48 percent for plans without this feature.
As more plans offer auto enrollment (41 percent last year versus 10 percent in 2006), the average savings rate has come down slightly (to 6.8 percent from 7.3 percent over the past decade).
“What automatic enrollment really does, it gets everyone in the plan,” Young said. “The real power of these plans is that you create a savings habit.”
These habits would be vastly improved if employers raised the initial investment rates.