The paper, “BMO Defined Contribution IQ: Automatic Features,” is the first in a nine-part, bi-monthly education series titled “Defined Contribution IQ (DC IQ),” which was developed for retirement plan sponsors and their consultants. The reports will examine issues related to retirement plans, including plan design, participant utilization and operational efficiency.
The “Automatic Features” paper examines the use of automatic features within a DC plan. It notes that plan features such as automatic enrollment and automatic escalation typically increase employee participation and are likely to improve retirement readiness. However, the paper contends that plan sponsors have not traditionally received guidance on how to implement these features effectively. The paper identifies questions that plan sponsors need to address such as:
- When should employees be automatically enrolled?;
- Which default investment option should be used?; and
- What annual automatic escalation rate should be adopted?
“For increased transparency and ease of understanding, we believe access to a retirement plan should be treated like any other employment benefit,” says Todd Perala, author of the series of papers and director of Strategic Initiatives, Retirement and Trust Services for BMO Global Asset Management, based in Chicago. “We recommend that during the annual benefits enrollment, plan sponsors simply inform employees that unless they opt out, they will be automatically enrolled in the 401(k) plan at the beginning of the new benefits year.”
The paper also highlights that a deferral rate as high as 6% for automatic enrollees does not increase the number of participants opting out. For this reason, Perala suggests automatically enrolling participants at the maximum matching level. In the paper, Perala also recommends automatically escalating deferral rates by 1% to 2% annually, ideally timed with yearly salary increases to limit reductions in take-home pay.
In addition, Perala suggests a carefully chosen target-date fund may be the most suitable qualified default investment alternative. While traditionally, principal-safe investments were considered an ideal choice, he notes, these investments rarely generate the growth needed to provide for a financially secure retirement.
“While a target-date fund may have the potential for loss of principal, it also has the ability to generate the earnings over time that will be needed to support a more lengthy retirement period,” says Perala. “Among the universe of target-date funds, most of which use a fund-of-funds approach, we recommend plan sponsors select a fund family whose managers actively monitor the underlying investments. This ensures that no individual stock comes to represent an overly significant percentage of the fund’s total holdings.”
BMO Retirement Services is a part of BMO Global Asset Management and a provider of retirement services such as defined contribution recordkeeping and defined contribution investment-only services.