New estimates on the benefits of automatic enrollment for 401(k) plans

The Pension Protection Act of 2006 gave companies some carrots for adopting auto-enrollment 401(k) plans, a favorite nudge of ours. A paper out earlier this summer by the Employee Benefit Research Institute draws some preliminary conclusions about its effect – chiefly that there is a “very significant positive impact in generating additional retirement savings for many workers, especially for low-income workers.” (Go here for the full summary)

For example, under one set of assumptions used in the Issue Brief, the median 401(k) accumulations for the lowest-income quartile of workers currently age 25–29 (assuming all 401(k) plans were voluntary enrollment) would only be 0.1 times final earnings at age 65 (this is largely due to the fact that 41 percent of workers—as opposed to participants—were assumed to have zero balances at age 65). However, if all 401(k) plans are assumed to be using the safe harbor automatic enrollment provisions under PPA, the median 401(k) accumulations for the lowest-income quartile jumps to 2.5 times final earnings under the most conservative assumptions and 4.5 times final earnings under the set of assumptions most beneficial to participants.

Even among higher paid workers the increases are considerable. The multiple jumps from 1.8 times final earnings under a voluntary enrollment scenario to between 6.5 to 10.4 times final earnings under an automatic enrollment scenario, depending on one’s assumptions about automatic escalation of contributions.

While individual company adoption of auto-enrollment is good for that company’s workers, a bigger lesson of the paper is the need for universal adoption. In an age when workers switch jobs more frequently than ever, the risks to saving among many, especially those predisposed not to enroll, are large. Based on projections by the authors (with some assumptions for average savings rates and salaries), individuals who are automatically enrolled in a 401k at their work and remain there for life end up with median replacement rates at retirement ranging from 51–69 percent. The replacement rate is the percentage of a worker’s final salary that is replaced in retirement by a nominal annuity purchased with 401(k) assets. If a worker switches jobs, however, and only has an average chance of being automatically enrolled, the replacement rate range drops to 21-26 percent. That’s serious money.

Hat tip: Mostly Economics

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