As members of Congress introduce legislation supporting the adoption of automatic enrollment among companies’ 401(k) plans, a new study by the Investment Company Institute (ICI) and the Employee Benefits Research Institute (EBRI) shows that such a mechanism could significantly increase saving levels for workers of all income levels–particularly low-income employees.
With automatic enrollment, an employee is enrolled in a company’s 401(k) plan unless he opts out. The employer decides on a contribution rate, and allocates the contribution into default investing options, which are typically money market funds or lifecycle funds.
The ICI/EBRI report notes that “the effects of automatic enrollment on income replacement rates at retirement depend heavily on the default contribution rate and default investment option that the plan sponsor selects.” The higher the default option, the higher the replacement rate at retirement, the study says. The study found that 401(k) plans using a lifecycle fund as the default option generate higher income replacement levels than plans that use money market funds. Lifecycle funds invest more aggressively in equities when workers are young and shift to more conservative investments as they age.
The ICI/EBRI study is based on a model developed by ICI and EBRI called the 401(k) Accumulation Model. The model examines how 401(k) assets might contribute to retirement income for future retirees based on decisions workers make throughout their careers: whether to participate in a 401(k) plan, how much money to contribute, how to allocate assets, whether to pull money out of a plan before retirement, and whether to roll over plan assets when changing jobs. According to the study, only 37% of younger employees earning lower wages contribute to a 401(k), whereas 90% of older, higher-income employees contribute to one.
The study found that low-income workers would benefit the most from automatic enrollment because they are less likely to participate in a 401(k) plan. For workers between the ages of 26 and 35, the median salary replacement from 401(k) accumulations would jump from 23% without automatic enrollment to 52% of salary when an employee contributes 6% of their salary to a lifecycle fund, the study found. Higher-income workers would not benefit as much from automatic enrollment, the study says, because they tend to choose more aggressive investments than lifecycle or money market funds.
401(k) catch-up contributions–which are available to workers 50 and older and already contributing the maximum–tend to increase higher-income workers’ projected income replacement rates, the study found. The study notes, however, that higher income workers see lower income replacement from Social Security, so catch-up contributions encourage them to save more for their retirement.
The ICI/EBRI study also examines whether IRAs can make up for lapses in 401(k) contributions. Low-income workers who contribute to an IRA during lapses in 401(k) coverage are less likely to “fall behind in retirement savings as are higher-income workers because contributions from low-income workers to 401(k) accounts tend to be close to IRA limits,” the study says. Higher-income workers who are not offered a 401(k) through their employer “will not be able to duplicate through IRAs the amounts they tend to contribute to a 401(k) plan,” the study found.–MW