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The Law of Inertia: A body in motion will stay in motion and a body at rest will stay at rest unless an external force acts upon it.
The Law of Inertia, while originating in the world of physics, is amazingly applicable to the world of retirement planning. As plan sponsors and financial advisors know, getting people who are not saving to start saving requires a force nearly equal to the gravitational field of a planet. And getting people to save more than they are already saving is an accomplishment of galactic proportions.
Automatic enrollment achieves the miracle of getting people to start saving. In a plan with auto enrollment, employees who don’t want to participate are required to opt out, while employees who do nothing are enrolled in the plan. By automatically enrolling eligible employees in their retirement plan, sponsors make use of inertia to encourage saving. A recent Fidelity study found that the average participation rate in plans that offer auto enrollment is 82 percent, compared to a 55 percent participation rate for plans without automatic enrollment. For younger workers, the gap is even greater: 76 percent participation with auto enrollment among 20-24-year olds versus only 20 percent without it.
Auto enrollment is growing in popularity; according to the 2013 Trends in 401(k) Plans survey, 56% of retirement plans include an auto enrollment feature.
So auto enrollment gets people saving, but how do you get them to save more? Behavioral economists Richard Thaler and Shlomo Benartzi devised an ingenious method to help overcome participant inertia, initially called the SMarT plan, or Save More Tomorrow plan. In the SMarT plan, the contribution rate for participants would automatically increase periodically, incrementally raising their deferral rate over time. Now called automatic escalation, 26 percent of plans with auto enrollment include this feature as well.
Does it really work?
It seemed like automatic enrollment and escalation had inertia beat. Participation rates were dramatically higher, and everyone was happy that people were saving! But a closer look shows that inertia may be plaguing plans with automatic features in a different way.
Automatic enrollment requires that a plan set a default contribution rate at which to enroll participants who don’t make an active election. A Vanguard survey revealed that the most popular default contribution rate is 3% (with some plans using an even lower default rate), much lower than what most people need to save to achieve a secure retirement. Automatic escalation isn’t that helpful, either; a one or two percent increase each year will take a long time to get to the 12% to 15% of salary most people should be saving to reach their retirement goals.
The law of inertia should be rewritten to read: a contribution rate at rest will stay at rest. Participants tend to leave their contribution rates at the default level set for them, usually woefully low. And with automatic escalation, workers are even less likely to increase their savings themselves, since they assume it is being taken care of for them. There is an unintended implicit inference that the rate set by the plan is an optimal rate, and participants treat that default rate as a recommendation. But of course, it’s not usually optimal at all: a study by Vanguard showed that 40 percent of plans with automatic enrollment had inadequate contribution rates; even after five years in the plan, participants’ contribution rates were less than 9% of pay.
What’s the solution? Does it take a galactic effort?
Automatic features can be a force for overcoming inertia to help people save for retirement. But plan sponsors need to structure their automatic enrollment and escalation carefully. Choosing a higher initial default contribution rate, including an employer match, and escalating in greater increments are all ways to boost the power of these features. Jean Young of Vanguard’s Center for Retirement Research suggests a starting default contribution rate of 6%, with a 50% employer match up to 3% of pay. That’s an initial 9% savings. Then, an automatic escalation of 2% per year raises the saving rate above 12% within three years.
Employers might also consider providing education and/or advice to help participants understand how much they need to save. Educational materials, gap analyses, and retirement savings calculators help reinforce the message that participants need to calculate a savings goal to understand how much to save rather than rely on a default contribution rate.
Inertia will always be a factor, but there are lots of external forces that can positively effect and get the momentum moving in the right direction for retirement plan participants.
“Some Employees Short-Shrifted by 401(k) Auto Enrollment Boom” by Ashlea Ebeling; Forbes; November 30, 2011
“Trends in 401(k) Plans,” A Report by WorldatWork and the American Benefits Institute; March 2013
“Automatic Enrollment: Does It Help or Hurt Savings?” by Joanne Sammer; Society for Human Resource Management; July 22, 2011