How Do Employers Get Workers to Save for Retirement?
When the Employee Retirement Income Security Act, commonly known as ERISA, was enacted in the mid-1970s, more than 70 percent of all employer-sponsored plans were defined benefit pensions that were managed entirely by the company.
In the nearly 40 years since President Gerald Ford signed ERISA into law on September 2, 1974—appropriately, Labor Day—the number of defined benefit plans has steadily dwindled and the number of defined contribution pension plans, especially so-called 401(k) plans, has grown.
What does this mean for the retirement security of American workers? In effect, the responsibility for funding and managing retirement benefits has switched hands from employer to employee.
It is generally acknowledged that most employees are not adequately saving for retirement. Without changes in this behavior, many employees will discover a future much different from the one they imagined.
In a defined benefit pension plan, eligible employees are automatically enrolled in the plan when they reach the prescribed criteria. The employer makes all the contributions, and at retirement the employee receives an annuity for life based on length of employment and compensation.
Today, less than 7 percent of all employer-sponsored retirement plans are defined benefit plans. More than 74 percent of the 700,000 employer-sponsored retirement plans today are 401(k) plans, a type that did not even exist in 1974.
In a 401(k) plan, employees make contributions with pre-tax dollars. Those contributions go into an account on their behalf along with any contributions their employer might make, usually either a “matching contribution” or an across-the-board contribution for all employees. The benefit received by the employee at retirement is the balance in that account.
There are a number of reasons for the decline of defined benefit plans and the rise of 401(k) plans. Some of the most significant ones:
- • Global competitive pressures on US employers
- • Changes in the tax law that made defined benefit plans increasingly more complicated and defined contribution plans more attractive
- • Changes in the financial accounting treatment for defined benefit plans
- • Lawsuits and government delay in issuing guidance with respect to defined benefit plans
- • An increasingly mobile workforce
- • Changes in employers’ attitudes with respect to their responsibilities to their workers
In these plans, the contribution made by a highly compensated employee (in 2013, someone making more than $115,000) is limited to a multiple of what the non-highly compensated employees contribute.
Basically, highly compensated employees (as a group) cannot contribute a percentage of their compensation exceeding the greater of
- 125 percent of the percentage of compensation contributed by the non-highly compensated (as a group), or
- 200 percent of the percentage of compensation contributed by the non-highly compensated employees (as a group) with a limit of two percentage points.
Therefore, an employer cares about how much its non-highly compensated employees annually contribute to its 401(k) plan for two reasons. First, the amount the employer’s highly compensated employees can contribute to the plan is directly tied to the amount the non-highly compensated employees contribute. Second, some employers are legitimately concerned about whether their employees will have saved enough to retire comfortably.
Despite employers’ efforts, it is generally acknowledged that employees who are eligible to contribute to a 401(k) plan, especially non-highly compensated employees, are not participating in sufficient numbers—and those who do participate are not setting aside enough for retirement.
A Congressional Research Service study identified several reasons why non-highly compensated employees weren’t enrolling in employer-sponsored 401(k) plans. First and foremost, most nonparticipating workers did not believe that they were eligible to participate in the plan.
For those who were aware that they could participate, the study found that some
- • did not believe they could afford to participate,
- • did not want to tie up their money until retirement,
- • had more immediate saving goals, like saving for the down payment on a home or for their children’s education, and,
- • in the case of lower-income workers, a belief that Social Security benefits would replace a relatively high percentage of their pre-retirement income.
In addition, many employees are intimidated by the enrollment process: when to start contributing, how much to contribute, how to invest the contributed funds. This, combined with their hectic daily lives, means that the inertia of doing nothing is a controlling motivation behind their unwillingness to participate in the plan.
Changing Employee Behavior
In an attempt to encourage greater participation by non-highly paid employees, employers first tried educating them about the benefits of saving for retirement, especially on a pre-tax basis such as the 401(k) plan offers.
These efforts included email campaigns, written educational materials, live group presentations, personalized analyses, and, in some cases, individual counseling. Although this approach met with some success, many employers had difficulty raising the level of non-highly compensated employee participation above 50 percent.
The next step in the process of expanding participation by non-highly paid employees was the addition of employer matching contributions. While a wide range of matching contribution formulas continue to be used, under most matching arrangements employers agree to match a percentage of employee contributions up to a specified percentage of income.
For example, one of the common matching formulas involves an employer match equal to 50 percent of an employee’s contributions up to 6 percent of compensation. Under this sort of matching formula, an employee making $50,000 a year who contributed 6 percent of her compensation ($3,000) to a 401(k) plan would receive an employer matching contribution of $1,500.
Other formulas matched less as contributions increased, while others provided an employer match in excess of the amount the employee contributed. The addition of matching contributions when combined with educational efforts resulted in an upsurge that often raised participation rates for non-highly compensated employees from the 50 percent range to 65 percent or above.
Not There Yet
Many employers were not satisfied with these participation rates, however, and continued to search for ways to increase participation. As employers and employee benefit consultants continued to analyze the issue, some proponents of behavioral economics concluded that many of the nonparticipants had not deliberately rebuffed the idea, but rather were simply passive procrastinators.
According to a study by the General Accountability Office, “Workers may intellectually understand the importance of saving for retirement but have trouble overcoming their own inertia to start saving or to save effectively. …Further, workers may also decline to participate, in part, because they believe the decision to participate in a 401(k) plan requires time-consuming and complex decisions, such as choosing how much to contribute and how to invest their contributions.”
In response, employers started to look at the possibility of automatically enrolling employees in a 401(k) plan and using the employees’ inertia in favor of saving instead of not participating in the plan. Under this arrangement, employees would become plan participants unless they explicitly opted out.
Since this was a novel approach to 401(k) plan design, there was concern as to whether the IRS would view such an arrangement favorably and whether the employer might have other legal liability. Yet in 1998, and again in 2000, the IRS affirmed that 401(k) plan sponsors could automatically enroll new employees and current employees who were not participating.
In 2006, Congress and the IRS used further regulations to facilitate automatic enrollment programs with incentives and the promise of protection from legal liability.
Under the Pension Protection Act of 2006, if a “safe harbor” automatic enrollment design is followed, the plan is considered qualified and the employer is protected from fiduciary liability under ERISA, and state laws governing wage garnishment are preempted.
Most studies that have looked at the effect of automatic enrollment have concluded that it substantially increases the level of 401(k) participation. One study published in the Quarterly Journal of Economics looked at comparison groups before and after adoption of automatic enrollment. Participation skyrocketed from 37 percent to 86 percent.
Another study by Fidelity Investments found that overall participation rates for plans with automatic plan enrollment is, on average, 28 percent higher than for other plans. Individual employers have seen participation rates as high as 95 percent after instituting automatic enrollment.
There’s also proof that the practice has a significant affect on demographic groups that do not traditionally have a high participation rate, such as lower-income workers and young employees.
Some employees even interpret automatic enrollment programs as implicit advice from their employer with respect to optimal saving and investment choices.
There seems to be little question that adding an automatic enrollment feature to a 401(k) plan can overcome the inertia, procrastination, and sense of intimidation employees feel when it comes to saving for retirement.
Up to this point, large employers have been more inclined than smaller ones to adopt these programs. Regardless of size, employers who want to encourage more employees to save for retirement should carefully consider instituting automatic enrollment.