Getting the Default Rate Right

Sixty-two percent of sponsors doing automatic enrollment have a default rate of 3% or less, according to a Defined Contribution Institutional Investment Association (DCIIA) paper released in March 2011.

“A lot of employers think they are being helpful to employees [by setting a low default],” says Barrie Christman, a vice president at Principal Financial Group. “They can be dooming them to failure, if they do not set the bar high enough. Individuals who let you default them into something are almost by definition passive. We find that they stay passive: If you put them in at 3% and do not auto-escalate them, they will stay at 3%.”

Auto-enrolling people seemed like a tremendous move to many employers, so they set the default low, says David Castellani, CEO of New York Life Retirement Plan Services. Some sponsors timidly ask themselves, “‘Boy, do I really want to do this? How are people going to react to this?’” Castellani says. “Once you are past that, it is economics.”

Pensionmark Retirement Group has observed many sponsors reconsidering their default rate recently, says Devyn Duex, vice president of client relations. Evidence now shows that most people opt in regardless of the default rate set, she says. “Whether you do 3%, 5% or 8%, people still go in the plan,” she says.

And yet, a disconnect exists for many sponsors, says Catherine Peterson, the DCIIA report’s principal author, and vice president and director of retirement insights at J.P. Morgan Asset Management. Eighty-seven percent of plan sponsors say that participants should save 10% or more, even before the company match, the study found. But “if you look at the companies that have automatic enrollment, more than half are at 3% or less,” she says. “Others are slightly above that, but they are not nearly what they need to be. What is problematic is that, because of inertia, people likely will stay at that rate.”

The industry best practice emerging on the default rate is “at least 6%,” Peterson says, calling it “a good starting level.” Of the 3% norm, she adds, “we have heard from plan sponsors that this is seen as palatable.” Many worry they will increase employee opt-outs if the default rate goes up.

But sponsors that automatically enroll participants at higher deferral rates actually see lower opt-out rates, concludes a New York Life Retirement Plan Services study released in June. Plans that auto-enroll participants at more than 3% have an average 95% participation rate, exceeding the 88% average of plans deferring less than 3%. And 30% of participants in plans with defaults higher than 3% proactively increased their deferral rate within a year of being auto-enrolled, the study says. 

In fact, New York Life has found that the higher the participant account balance, the more engaged people tend to become, Castellani says. People grow amazed at the compounding, he says, and they realize the power of the employer match. “If you can get a 25% match, where else are you going to get a 25% return on your money today?” he says. And small contribution differences go unnoticed by most participants who see balances growing, he says. “We do not miss as much what is coming out of our paycheck. That extra 1% is not all that dramatic a difference to take-home pay,” he says.

Indeed, plans with a 6% default rate have an average deferral of 7.1%, compared with 6.3% for those with a 3% default and 6.8% for plans without automatic enrollment, according to The Principal research released in May 2011. The difference in deferrals “may not seem like a lot, but when you add the employer match, it is dramatic,” Christman says. “The most common match is 50% up to 6%. If you set the default at 6%, you get a 7.1% average deferral, and the employer match adds another 3% to that, so you are at 10%.” Principal thinks that participants need to save 11% to 15%—including the employer match—through their entire working career to save enough for retirement, based on an 85% replacement ratio. “When you put in a 1% auto-escalation, you very quickly find yourself at 11% to 15%,” she says of plans that start at 6%.

What deferral rate works best? “At least 6%,” Christman says. “Partly, that is because the most common match is 50% up to 6%. So most people would then get the maximum match. And that gets them darn close to 11% to 15%.”

All that sounds good, but an adviser still may struggle with convincing an employer to raise the default rate during a long-range economic downturn, since it likely means making higher matching contributions. “I do not think you can convince a plan sponsor enduring financial difficulties to take these steps,” Castellani says. “But given a pretty clean balance sheet, it is up to us—the providers—to provide a clear argument to sponsors, with evidence.” Asked what advice he has for advisers about approaching the topic with employers, Castellani says advisers should underscore their faith in escalation, telling sponsors, “‘We believe you should do this, and we want to look at statistically what happens when that occurs.’ If you are going to talk to sponsors and advise them about this, you have to back it up with facts.”