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The problem with too-low 401(k) contribution rates

  • Automatic enrollment has boosted participation rates.
  • While more of us are saving, automated "default" rates are woefully low.

Despite good intentions, your employer is likely screwing up your retirement plans.

Over the past decade, many employers have been hot to build self-driving 401(k) plans stuffed with autopilot features designed to help workers save — and save smarter.

Land a new job and, if there's a 401(k) plan, then there's a good chance you will be auto-enrolled, and your money will be automatically allocated for you based on your age (hello, target date funds). The better 401(k) plans also offer automatic rebalancing.

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But there is one potentially fatal design flaw in many 401(k) offerings that have embraced autopilot features: Workers are assigned an initial contribution rate of 3 percent.

"No one is going to get to retirement in good shape with a 3 percent starting rate," said David Blanchett, director of retirement research at Morningstar Investment Management. "It's ironic.

"All these great changes that were made have had such a good impact — auto enrollment, auto investing — but this one important piece removes the benefit of all the good automation that has been put in place."

Even if you receive a matching contribution from your employer, adding another few percentage points to a 3 percent savings rate isn't going to move your retirement security needle far enough.

An annual savings rate of 15 percent – assuming you start saving in your 20s – is the typical goal planning pros recommend. Yet Vanguard reported that, in 2016, the median deferral rate among the 401(k) plans it runs fell to 5 percent, from 6 percent the year before. And that included company matches.

"While automatic enrollment increases participation rates, it also leads to lower contribution rates when default deferral rates are set at low levels, such as 3 percent or lower," Vanguard explained in its 2017 How America Saves data release.

"We don't have an investing problem. We have a saving problem." -David Blanchett, director of retirement research at Morningstar Investment Management

Blanchett says plans should set the floor no lower than 6 percent. Studies have shown that the majority of workers who contribute at 3 percent are going to keep contributing at 6 percent.

Granted, a higher default rate would increase the operating costs for employers that offer a company match based on what the worker contributes. But for the CFOs who blanch at the notion of sharing more free cash flow with the rank-and-file, changing the match formula can nudge workers to save more without increasing the dollar outlay for the employer to match.

For instance, an employer match of 50 percent of 3 percent is the same as an employer match of 25 percent of 6 percent.

A risk for anyone on the move

It's not just millennials new to the work force who are in the crosshairs of being automatically defaulted into a too-low default contribution rate. According to the Bureau of Labor Statistics, the median job tenure for workers age 35 to 44 years old last year was under five years.

For folks age 45 to 54 the median was under 8 years. Any time you switch jobs you're at risk. "You will be reset at 3 percent if you're not paying attention," says Judith Ward, senior financial planner at T. Rowe Price.

And there's the rub. While the subconscious message of 401(k) auto pilot features is "don't worry, we got this for you," the fact is, design flaws make it imperative for workers to proactively manage their future. A beautifully diversified portfolio isn't going to finance a comfy retirement if you're saving just 3 percent of your salary.

"We don't have an investing problem. We have a saving problem," says Blanchett.

Not exactly automatic 

Don't settle for 3 percent. More employers are slowly leaning into boosting their default savings rates. T. Rowe Price reports that one-third of plans set their employees' default contribution rate at 6 percent. But that still leaves the majority implicitly condoning a lower savings rate.

"The lower default is a lose, lose," says Blanchett. "The people who stick with it aren't saving enough and the people who reject it still use 3 percent as an anchor and might increase their rate slightly from there."

Ward says new workers should aim to start at no less than 6 percent with a goal of getting to 15 percent, including the company match, ASAP.

More from Personal Finance:
Switching jobs? Don't forget that old 401(k) balance
Why high 401(k) plan fees are here to stay
Like hefty tax bills? Stick with your old 401(k) plan

Say yes to automatic increases. Many 401(k) plans now offer the ability to have your contribution rate raised annually, typically by one percentage point. This auto-escalation feature is a textbook nudge to get us to save more. But most plans require workers to proactively sign up for it, rather than automatically turning it on and allowing workers to opt-out if they want.

If your plan offers automatic escalation, tick the box. Or create your own annual escalation schedule: At your annual work anniversary, birthday, or during annual open enrollment, boost your contribution rate by at least 1 percent.

Avoid the job-hopping backslide. When you land a new job, take a few minutes at orientation to figure out how to over-ride the low contribution rate you're likely to be automatically assigned.

"At a minimum you always want to contribute enough to get the maximum company match," says Ward. "And never reduce your savings rate. You want to maintain the savings rate you had at your old job. If your new job was a step up in salary, your goal should be to increase your savings rate."