WITH THE PENSION

Protection Act of 2006, Congress sought to counteract one of Americans' biggest flaws: the tendency toward inertia. People have a hard enough time settling on a flavor of yogurt, much less deciding how much income to defer to a 401(k) plan. Hence the nation's inadequate retirement savings.

Almost one-quarter of eligible workers choose not to participate in their employer's 401(k) plan, and of those who do participate, only roughly 11% contribute the maximum, according to a study by the Center for Retirement Research at Boston College that was based on the Federal Reserve's 2004 Survey of Consumer Finances. (Why so many workers don't participate is another matter. A separate study by the center found that financial literacy and employee-employer trust have significant impacts on 401(k) savings behavior.)

According to Jack VanDerhei, an associate professor of risk management and insurance at Temple University's Fox School of Business and Management and expert on retirement savings behavior, that should soon change.

"I think the number of companies that will implement automatic enrollment for 401(k)s is going to grow a lot," he says. "The question is by how much."

The PPA (see sidebar) allows companies to automatically enroll every employee in a 401(k) plan, and starting in 2008 it gives them more incentive to do so. Come January, the act allows them to implement automatic "contribution escalation" features for their 401(k) plans. That means an employee who doesn't actively opt out of a company's 401(k) plan will be automatically enrolled in one and will contribute 3% of salary in the first year and an additional 1% every year after that (until maxing out at 10% of income).

The new enrollment plan hasn't existed long enough to determine how it will change employee contribution behavior or how much workers' retirement income will grow. But a September study by VanDerhei, also a fellow at the Employee Benefits Research Institute, provides the first estimate of the expected impact of the legislation.

After plugging in various assumptions and scenarios into his simulation model, VanDerhei found that automatic escalation would increase 401(k) accumulations by 11% to 28% for participants in the lowest-income group, and 5% to 12% for participants in the highest-income group.

SM: What part of the Pension Protection Act will go into effect beginning in 2008?

Jack VanDerhei: January will be the start of the automatic escalation part of the PPA. The automatic enrollment in general has been around since 1996 or 1998 ... [but] in January the new safe harbor feature goes into effect. Employers don't have to do it. But if you want to do something that gets you out of the nondiscrimination testing, it will automatically get you out of having to do that. If you want the safe harbor provisions, you have to automatically enroll everyone at 3% of compensation and then every year after that you have to bump them up by 1% until they hit someplace around 6% to 10% of their salary.

SM: Do you think it's an effective feature of the policy?

JV: If the objective for public policy is to get more employees into some kind of retirement plan in addition to Social Security, once you've got an in to get their contribution rates up to a sufficient level to live on during retirement, I think it's a good thing to get as many incentives for employers to adopt this.

SM: So this is essentially making it more convenient and beneficial for employers to implement 401(k) automatic enrollment for their workers?

P's and Q's of the PPA

The

Pension Protection Act of 2006

allows employers to automatically enroll workers in the company's 401(k) plan and to automatically increase a worker's 401(k) contribution annually, though the employee can decline both enrollment and the increase. The provision was added in an attempt to boost 401(k) accounts, the primary vehicle for worker retirement savings.

To qualify for nondiscrimination protections, automatic (or default) contributions must be at least 3% in the first year and increase regularly. The company must also either make a matching contribution or a nonelective contribution on behalf of each non-HCE (highly compensated employee). If the employer chooses to make matching contributions, they must equal 100% of the first 1% of compensation contributed by the employee, plus 50% of the next 5% of compensation contributed. If the employer chooses to make nonelective contributions (i.e., not based on the employee's elective deferral contributions), they must equal at least 3% of the employee's compensation.

If these guidelines are met, employers wouldn't have to subject their plans to nondiscrimination testing, which essentially ensures that a company's highly compensated employees such as executives don't benefit more from a 401(k) plan than a non-HCE.

Source: The Tax Adviser

JV: It's more convenient for employers in that it's giving you the carrot: If you do this, you don't have to do nondiscrimination testing. I think if they didn't have this, automatic enrollment wouldn't be nearly as popular as it will be among employers. I think the number of companies that will implement automatic enrollment for 401(k)s is going to grow a lot. The question is by how much.

You're telling your employees "If you adopt this, your contributions have to go up 1% every year...." Nobody actually knows how high those numbers are going to get. After three years, are the employees going to say it's enough, I don't want to increase my contribution anymore?

So for my research I got to ask [workers] a question: Assuming your employer starts you at a 3% default contribution rate and increases you by 1% a year, how much are you going to go? You don't know what they're going to do..... But I think my paper is the first time we're figuring out what percentage of employees are willing to go how high.... Once we got the answers it's very easy to go back and basically load that information into my simulation model [that covers an entire career from ages 21 to 65] and say how much automatic-escalation contributions by themselves increase the overall retirement money that's in workers' 401(k) plans. For instance, nobody knows if, let's say you start at a company and you're there for a few years, and your contribution rate eventually goes to 5%. You get another job. Would you start contributing at the minimum 3% rate, essentially, from the beginning, or would you start with the amount where you left off? I ran different models assuming both of those scenarios.

SM: One of your findings indicated that the automatic escalation will benefit low-income workers the most. Why?

JV: We found there was an 11% to 28% increase [in the amount in 401(k) plans] for low-income workers.... The 11%-28% kind of surprised me. I never did the calculations before. We knew it was going to increase, we just didn't know by how much. Probably 20% would be as high as I would have thought.... The low-income workers tend to be the ones who keep their contributions far below where they needed to be in. People who were doing worse than that number prior to this are going to gain the most. They have less income to invest, so low-income workers gain the most from this.

SM: How do companies decide what the default rate will be?

JV: This is 100% anecdotal, but a lot of them, especially now that automatic escalation is there, don't want to go over the 3% minimum because they don't want to scare employees away. It's a lot smaller than if you start them at 6% or higher. But once you get them in there, and get them used to seeing account balances every quarter hopefully growing, you've got a higher chance of retaining them. The PPA says companies have to have at least a 3% default rate, and I think most companies will use that minimum [and not go higher]. The higher the percentage, the more likely it would be to scare employees away.

SM: Is the 1% a year escalation dependent on an employee's raise?

JV: No. [Richard] Thaler and [Shlomo] Benartzi's "Save More Tomorrow" plan is based on that, but if you try to track every time someone got a raise in order to bump up their 401(k) contribution rate especially at a big company it would be more problematic.

SM: Can you see workers objecting to that aspect of the plan? Let's say an employee doesn't get a salary increase for several years?

JV: Certainly that's the downside. Just because your contribution goes up every year, it doesn't mean you get any raise at all. I think that was just one of those concessions. It's not going to be ideal for anyone, but it's the best single design you can get for the majority of employees. I don't say this often, but I think Congress did the right design on this one. It was the best compromise I could think of.