By: Scott M. Cloud, MBA, CPC
A well-designed 401(k) plan can help to recruit and retain employees, and – for most workers who have access to a company 401(k) plan – it serves as the primary (or only) investment vehicle to accumulate savings for retirement. To promote employee participation and retirement readiness, employers can choose to automatically enroll employees in the company 401(k) plan rather than requiring employees to “opt-in” in order to contribute to the plan. According to a 2020 study by the Plan Sponsor Council of America, approximately 62% of employers with a 401(k) plan choose to automatically enroll employees in their 401(k) plan 1. While automatically enrolling employees is more common than not, however, over one-third of employers choose not to do so.
In determining whether automatic enrollment is appropriate for a 401(k) plan, there are several pros and cons that employers are encouraged to consider.
To say that automatic enrollment significantly increases employee participation rates is perhaps an understatement. According to a Vanguard study, the average participation rate in 401(k) plans with automatic enrollment is 91%, compared to only 28% in 401(k) plans with voluntary enrollment 2.
Employees who are automatically enrolled are placed in a suitable default investment unless they instead wish to make their own investment selections.
The automatic enrollment program can use an “automatic escalation” feature, whereby the 401(k) contribution rate of employees increases by 1% each year before leveling off. For example, an automatic enrollment program might start employees at a contribution rate of 6%, then increase by 1% as of the beginning of each year until leveling off at 10%
401(k) plans that do not make a “safe harbor” employer contribution are subject to the actual deferral percentage (ADP) test, which generally limits owners and other “highly compensated employees” (HCEs) to an average 401(k) contribution rate that is only 2% higher than the average 401(k) contribution rate of “non-highly compensated employees” (NHCEs). 401(k) plans with automatic enrollment typically have much higher participation rates than those without, which enables owners and other HCEs to make higher 401(k) contributions themselves.
For 401(k) plans with an automatic enrollment feature, it is very important that the employer administers the program correctly. Failure to administer the program correctly can result in a plan operational failure, which may incur penalties and corrective action in the event of a random IRS or DOL plan audit. For employers that cannot commit to properly administering an automatic enrollment program, automatic enrollment is not a good fit.
Some employers feel that automatically enrolling employees in the 401(k) plan is paternalistic and that employees – with the help of the plan’s investment advisor – should instead be encouraged to make their own decision about whether or not to participate in the 401(k) plan.
For many employees who are automatically enrolled, the automatic contribution rate is not high enough to generate the savings that they’ll require for retirement. Instead of completing a comprehensive plan enrollment to determine an appropriate savings rate, some employees complacently accept the default contribution rate.
Because in most 401(k) plans automatic enrollment results in high employee participation rates, it can significantly increase the matching contribution expense for employers who make a matching contribution.
Automatic 401(k) enrollment significantly increases employee participation rates and promotes employee retirement readiness. Before implementing an automatic enrollment program, however, employers should carefully consider how employees will respond to being automatically enrolled in the plan and whether the employer and its plan representatives are able to commit to properly administering the automatic enrollment program.