You can make employees 401(k) participants, but you can't force them to save.
Companies that have implemented automatic enrollment in their 401(k) plans are finding that while it dramatically increases participation rates, participants rarely move from the default deferral rate or diversify from the default investment option.
Indeed, employees can even perceive the default rate and investment option as recommendations of how much to save and where it is best invested. In some cases, automatic enrollment has caused certain employees to save less than they otherwise would have.
Despite the drawbacks, the Internal Revenue Service last month issued rulings designed to encourage plan sponsors to include automatic enrollment and a companion feature, automatic rollovers.
In July, the IRS issued rulings expanding automatic enrollment to 403(b), 457 and prototype 401(k) plans, as well as approving automatic rollovers into individual retirement accounts for participants who change jobs or retire.
Under automatic enrollment, all eligible employees become plan participants unless they specifically opt out of the plan.
"We see automatic enrollment as a promising method of encouraging participation by those who have disproportionately been missing the benefits of a regular, disciplined approach to retirement saving," Treasury Secretary Lawrence H. Summers and Labor Secretary Alexis M. Herman said in a joint statement. "Automatic enrollment is fully consistent with Labor and Treasury policies, and we encourage employers to consider adopting automatic enrollment."
Two years ago, the IRS issued its first revenue ruling that permitted automatic enrollment in 401(k) plans for new hires. Earlier this year, the IRS issued a second ruling allowing automatic enrollment in 401(k) plans for current employees, as well as new hires. Both rulings involved companies that had a default deferral rate of 3%, and most plan sponsors that have instituted automatic enrollment have used a 3% default contribution rate.
But plan sponsors should take the default savings rate and investment options in the revenue rulings as examples and not guidelines, an IRS official told Pensions & Investments in an interview. The recent rulings involved plans with various deferral rates.
"The recent rulings signal that it does not have to be a 3% deferral, said Mark Iwry, Treasury's benefits tax counsel. "There is no magic to 3%."
Automatic enrollment will get people who previously did not contribute to their company's plan to save, and the money will build up, the official said.
"We are trying to get new people into the (retirement savings) system," Mr. Iwry said. "Our hope is that those people who are brought into the system by automatic enrollment will improve their saving habits over time, as their appreciation of the value of retirement saving and tax-free compounding grows."
And in an attempt to limit the number of plan participants who take their account balances in cash and spend it when they leave their company's employment, the IRS also issued a ruling approving automatic rollovers for participants who have accounts of $5,000 or less that are otherwise subject to mandatory cash outs.
Use is increasing
Since the IRS rendered its first ruling approving automatic enrollment, somewhere between 7% and 10% of 401(k) plan sponsors have installed the feature, consultants have estimated.
In a 1999 Hewitt Associates LLC survey, 7% of the 490 sponsors of 401(k) plans answering the question had automatic enrollment, up from 4% in 1997.
Automatic enrollment has become increasingly popular this year, according to a study by Cerulli Associates Inc. that was commissioned by Morgan Stanley Dean Witter Investment Management. Overall, 10% of plan sponsors polled indicated they have used automatic enrollment in the past 12 months, and 25% stated they will be using the feature in the coming year, the survey revealed.
Automatic enrollment has increased participation rates:
* A study of United Health Group Corp.'s $656 million 401(k) plan found that participation increased to 86% from 49% after the plan adopted automatic enrollment two years ago. The study was conducted by Brigitte Madrian, a professor at the University of Chicago, and Dennis F. Shea, vice president of total compensation at United Health Group, Minnetonka, Minn.
* Another study of two plan sponsors with automatic enrollment found the participation rate for new hires increased to 97% from 45% at one company and to 99% from 54% at the other. This study was by James Choi and David Laibson of Harvard University and Andrew Metrick of the Wharton School of the University of Pennsylvania.
* The average participation at 10 companies increased to 93% from 76%, according to a study by the Profit Sharing/401(k) Council of America, Chicago.
Inertia plays big role
But automatic enrollment does not necessarily increase savings rates. The majority of the new participants at United Health Group elected the default savings rate of 3%. Many of the employees automatically enrolled would have elected a higher saving rate if they had not been automatically enrolled and given the default rate, the study revealed.
"Clearly, we're seeing the effect of inertia," said Laurie Lucas, at Hewitt Associates, Lincolnshire, Ill. Both companies in the study by Messrs. Choi, Laibson and Metrick are clients of Hewitt.
"When people are getting into the plans, they are staying. It's a positive thing that they are getting into the plan at any rate rather than not at all," she said.
Less than 4% of employees who are automatically enrolled opt out of the plan, Ms. Lucas said.
But participants are seeing the default rates as recommendations on how to invest, she added.
"It really raises the flag as far as the need for education along with the automatic enrollment," she said.
Consultants agree that an education campaign is critical to the successful implementation of automatic enrollment.
Typically, employees who fail to act by choosing their own deferral rates and investments are enrolled at a savings rate of 2% or 3%, and in a conservative investment option such as a money market fund, said William J. Arnone, a partner with Ernst & Young LLP, New York.
But education is important to move people from being passive savers to active ones, he said.
"Especially if there is no education, people will conclude that if a money market fund is the default option, that is where their money should be," Mr. Arnone said. "The real danger is that it reinforces incorrect thinking from an investment perspective."
Not all industry observers favor automatic enrollment. It should be considered a third or fourth choice in a campaign to increase participation rates, said Paul Heller, principal and head of The Vanguard Group's defined contribution business.
"For larger plan sponsors, automatic enrollment is still pretty far down the food chain," Mr. Heller said. "For example, the existence and size of the company match is a much more viable tool" for drawing people into the plan, he said.
Vanguard has an "automated enrollment" program in which employees are sent a kit as soon as they become eligible to participate in the plan. Vanguard has the employees information already in the system, so all they need to do to be enrolled in the plan is choose a contribution level and pick funds.