The new and improved 401(k)?  Recent policy changes in the Pension Protection Act of 2006 provide an opportunity for employers to really make retirement savings work for lower income workers.  This month’s EQUITY program shows you how.

When it comes to asset building programs, often we think of the “big three” savings goals—home purchase, starting a business, or paying for education.  One area that is often overlooked is the area of retirement savings.

It is difficult at best, to think about a savings goal which is perhaps four or five decades away, when one has today’s worries of affording food, rent, and utilities.  However, the earlier one starts saving for retirement, the easier it is to amass a tidy nest egg.  A universal truth in financial planning is that the people in the best position to improve their financial condition are not the ones who make the most money, but the ones who are the most disciplined.

Thanks to a change in the 2006 Pension Protection Act, even small employers have the opportunity to really make retirement savings for all workers both simple and more effective.

Most people have great intentions when it comes to retirement planning.  When you start a new job, you’re handed all that information about the company’s retirement savings programs.  You know you should sign up; you may even plan to read all the disclosures, pick an investment plan, and select a contribution level and…voile! You are on your way to your savings goals.  Unfortunately, something happens, we never seem to get around to it.  Suddenly, you realize that you need all of your pay check just to make ends meet.

The problem is that, often, participation in an employer’s retirement program is voluntary.  Best intentions aside, most people never get around to signing up.  But what about this concept: What if the employer, also known as the plan provider, automatically enrolled all employees in the retirement plan at a pre-determined contribution percentage level?  Even better, what if the pre-determined contribution level was automatically escalated over time?
 
The Pension Protection Act (PPA) of 2006 implemented this long studied concept called auto-enrollment with auto-escalation.  Support for this concept grew as various studies showed relatively low participation rates among young and low-income workers, and as more defined benefit or traditional pension, plan sponsors began freezing their plans for future and sometimes current employees. PPA created incentives for employer plan sponsors to implement this concept with its 401(k) safe-harbor auto-enrollment and auto-escalation provisions.

The effects of this policy have been modeled and studied by the Employee Benefit Research Institute (EBRI), whose results are summarized below:

The EBRI analysis indicates that even under the most conservative assumptions for auto-escalation of contributions, switching 401(k) plans to auto-enrollment is likely to have a very significant positive impact in generating additional retirement savings for many workers, especially for low-income workers.

When results are aggregated across all income categories, the increase in the value of 401(k) accumulations at age 65 as a multiple of final earnings for those currently ages 25–29 would be approximately 2.4 to 2.6 times final salary by switching from voluntary enrollment to automatic enrollment.

Although the aggregate results favor automatic enrollment, distributional analysis of the differences between the two systems indicates that the higher paid are not likely to benefit as much from such a change.

In fact, it is the lowest-paid workers who are likely to see significantly higher 401(k) accumulations via the automatic elements of the program.  According to the study, The median 401(k) accumulations for the lowest-income quartile of these workers (assuming all 401(k) plans were voluntary enrollment) would only be 0.1 times final earnings at age 65 (this is largely due to the fact that 41 percent of workers—as opposed to participants—were assumed to have zero balances at age 65). However, if all 401(k) plans are assumed to be using the auto-enrollment provisions under PPA, the median 401(k) accumulations for the lowest-income quartile jumps to 2.5 times final earnings under the most conservative assumptions and 4.5 times final earnings under the most beneficial assumptions. Even for the top 25 percent of these workers (when ranked by 401(k) accumulations as a multiple of final earnings), there are large increases: the multiple under a voluntary enrollment scenario is 1.8 times final earnings, whereas auto-enrollment provides multiples ranging from 6.5 to 10.4, depending on auto-escalation of contributions.

Unfortunately, for many, higher assets from auto-enrollment will still not be enough. Comparing income replacement targets generated in previous EBRI work with these simulated 401(k) accumulations shows that, even with the large increases that can be expected for many workers under the safe harbor auto-enrollment plans introduced by PPA, and with current-law Social Security benefits, additional resources will still be needed to achieve full retirement income adequacy (Vanderhei, Jack and Copeland, Craig,The Impact of PPA on Retirement Savings for 401(K) Participants. EBRI Issue Brief No. 318, June 2008, Available at SSRN: http://ssrn.com/abstract=1152392).

While not the ultimate retirement panacea, the 401k with auto-enrollment and auto-escalation does offer significant savings opportunities for low-income workers.