Savings and Retirement: What is an automatic 401(k)?
An automatic 401(k) is simply a 401(k) plan that automatically enrolls workers in the plan, rather than requiring workers to decide on their own to sign up. Eligible workers are assigned a default contribution rate, usually 3 percent or less of wages, and a default allocation of funds contributed to the retirement account. As with a traditional 401(k), workers still have a choice about whether to participate and how much to contribute: they can opt out of automatic enrollment or change the default contribution rate. The difference is that, under an automatic 401(k) plan, inaction on the worker’s part will automatically result in the worker saving for retirement.
- In traditional 401(k) plans, workers must make numerous choices, including whether to sign up, how much to contribute, how to allocate their investment funds, how often to rebalance their portfolios, what to do with the accumulated funds when they change jobs, and when and in what form to withdraw the funds during retirement. These decisions can be difficult, and many workers, daunted by the complexity, either make poor choices or never sign up at all. Thus they remain outside of the retirement savings system and are deprived of the tax-advantaged saving opportunities that 401(k)s provide.
- With an automatic 401(k)-sometimes called an opt-out plan-workers are automatically enrolled unless they actively choose not to participate; they are assigned a reasonable contribution level, which rises over time, and a reasonable allocation of investments across stocks and bonds. That is, each stage of the process is automatically set at a pro-saving default. Workers can choose to override any of these choices, but the same inertia that leads them not to make decisions in a traditional 401(k) is likely to make them stay at the defaults in an automatic 401(k).
- Automatic enrollment has been shown to raise 401(k) participation rates dramatically when applied to new hires, especially those who are female, members of minority groups, or low earners.
- The automatic escalation of contributions over time raises overall contributions to 401(k)s relatively painlessly, as employees become accustomed to deferring receipt of a portion of their pay. Escalation also helps ensure that inertia does not keep some employees at a default contribution rate lower than the rate they would have chosen absent the default.
- Under reasonable assumptions about the effect of the automatic 401(k) on overall saving behavior, it is estimated that this simple proposal, applied nationwide, would raise national saving by 0.06 percent of GDP. Private saving would rise by 0.07 percent of GDP, but because 401(k) contributions are tax-favored, government saving would fall by 0.01 percent of GDP.