The downside of automatic 401(k) enrollment

Nearly a third of Americans age 55 and over have no retirement savings, and defined benefit pension plans are going the way of the dinosaur. So you'd think that employers would be doing a great thing when they automatically enroll employees in 401(k) plans.

Not exactly.

Auto enrollment, as the practice is known, does increase employee participation in retirement plans. A recent study by Towers Watson found that the share of employers with more than 80 percent participation rates in defined contribution plans increased from 50 percent in 2010 to 64 percent in 2014 as the share of companies offering automatic enrollment rose from 57 percent to 68 percent.

But the good news stops there. Employees participating in auto enrollment tend to contribute less than people who sign up for 401(k) plans on their own, often because their employers set a low default contribution level.

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Vanguard has examined the defined contribution retirement plan assets it manages, and in a recent study the firm reported that average default contributions have decreased from 7.3 percent to 6.9 percent since 2007. "While automatic enrollment increases participation rates, it also leads to lower contribution rates when default deferral rate sare set at low levels," the report concluded.

"Participation is much higher, but the savings rate is much lower, unfortunately," said Rob Austin, director of retirement research at Aon Hewitt. He said that in the more than 140 plans Aon Hewitt recently studied, the rate of participation in defined contribution retirement plans reached an average of 85 percent for employers offering automatic enrollment, compared to 62 percent for those that do not.

Still, "over time, the average savings rate in plans with auto enrollment is lower than in plans that put in money themselves," he said. "People who put in money at a default rate of 3 percent leave it there, whereas if people pick their own savings rate, they would probably pick something much higher."

Austin said he knew of one employer that set a default contribution rate of 1 percent and then realized that employees were sticking at that low level, to their detriment, so employer dropped auto enrollment.

Employers matching less

Then there is the matter of employers' matching contributions. A study by the Urban Institute and Boston College's Center for Retirement Research examined the effect of auto enrollment on the levels at which employers will match employee contributions. It found that when employees are automatically enrolled in 401(k) plans, employers set lower limits on the contribution level they match, an average of 3.2 percent, compared to 3.5 percent in plans without auto enrollment.

"Auto-enrollment policies are very successful at raising participation rates but may not boost workers' total retirement saving if firms aim to keep their 401(k) compensation costs at a constant level," the Urban Institute and Center for Retirement Research concluded.

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Those lower match rates may in themselves affect what workers contribute. New research by T. Rowe Price suggests that roughly two-thirds of employees expecting an employer match determined their contribution rate to take full advantage of that match.

Employers have to balance several considerations when they design auto enrollment plans, experts said. For one thing, many are trying to keep their plan costs in check, so they look for ways to offset any costs resulting from increased participation.

"When we asked employers this question—why don't you do more—two-thirds of employers said it was due to the cost," Austin said.

In addition, setting the employees' default contribution rate is complicated. If employers "set that number too high, it might lead people to just opt out, but if they set it too low, then people may not save enough," said Richard Johnson, director of the program on retirement policy at the Urban Institute.

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T. Rowe Price found that 60 percent of workers automatically enrolled in 401(k) plans said they would have opted out if the default rate were set at 6 percent or higher.

But that does not appear to be a danger. Some 63 percent of the automatically enrolled workers said they were enrolled at the 3 percent level or lower, and 24 percent said their default contribution rate was 1 percent. (Tweet this)

False security?

Some employers are trying to encourage employees to increase their savings by implementing automatic contribution increases, known as auto escalation.

But auto escalation has not caught on to the same extent as auto enrollment. Among the employers surveyed by Towers Watson, 54 percent offered automatic escalation of employee contributions, but only 28 percent mandated it.

Employees without features like that may be lulled into a false sense of security about their long-term financial healthy simply because they are putting something away, even if it is wildly insufficient.

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"Automatic enrollment plans are a good thing. We know that they encourage individuals to save," Austin said. "But sometimes, they can be so good that they work against you."