Automatic Retirement Savings?

How can the nation attempt to increase pension savings to fund a record number of baby boomers that are expected to retire? One new tool may be the ability of employers and plan sponsors to automatically increase annual tax-deferred contributions to 401(k) plans, a practice recently blessed by the Internal Revenue Service. But before automatic escalation takes hold, experts at the Brookings Institution, a Washington-based economic think tank, are proposing a basic building block for increasing individuals’ savings.

They think that an automatic enrollment feature for 401(k)s would leave the task of figuring out investments and allocations to financial professionals instead of plan participants. Employees would have part of their salaries and raises automatically deferred unless they actively opted out, but they would retain the ability to make decisions at every stage of investment.

The next step might be allowing automatic increases in deferred savings into a plan annually without having to worry that employees would be reluctant to reduce their take-home pay by a larger amount. Participants would just choose “automatic escalation” from the beginning of their eligibility and the plan would take over from there, experts envision.

The need for bulking up savings is great. William Gale, a Brookings economist, is among those critiquing the current pension system with a goal of increasing both savings and participation among consumers in employer-sponsored 401(k) and other savings plans. Gale and some colleagues note in a recent white paper published by the Retirement Security Project, a Brookings offshoot, that the nation’s retirement savings system has several serious shortcomings. Faced with an elderly population that is expected to more than double by 2030, Retirement Savings and Long-Term Care Needs: An Overview examines problems for middle-class workers. About half of U.S. workers participate in a 401(k) in any given year, and even those who participate in tax-deferred retirement savings plans rarely make the maximum allowable contributions, according to the paper. It adds that lower-income families are more likely to come up on the short end of pension tax subsidies because tax preferences give the strongest incentive to participate in pensions to higher-income households. Mark Iwry, a nonresident senior fellow at Brookings and former chief pension regulator at the Treasury Department, co-authored the white paper with Gale. Iwry took automatic enrollment one step further by getting guidance from the Internal Revenue Service on allowing automatic salary deferment increases in employees’ 401(k) plans, if employees are notified and given the opportunity to opt out. Or they could do it on an opt-in basis–if they wanted to apply the contribution increase to future raises. Then the contribution rate would automatically increase year after year.

There has been a lot of interest in the two-page IRS response to Iwry okaying the practice, but it is a bit too early to see automatic escalations in practice. Indeed, a 2001 Hewitt Associates-led study showed that many people who were automatically enrolled never touched their plans; they instead stayed with the default contribution. The concern is that 95% participation with 3% of pay contribution rates leaves less in the pension system than 75% enrollment with a 6% contribution into 401(k)s, says David Wray, president of the Profit Sharing/401(k) Council of America. Automatic escalation will help get more people to a satisfactory level of savings, Wray believes. According to the PSCA, 8.4% of plans surveyed have automatic enrollment. It is most popular in large plans (24.2%) and least common in small plans (1.1%). The most common default deferral percentage is 3% of pay, present in 58.2% of plans.

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