September 25, 2022

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Auto Escalation For A 401k: Definition, Rules & Benefits

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Social Security & 401k Plans

The recent 2021 Social Security Trustees report came to the startling conclusion that beginning in 2034, the Social Security Administration will run out of its excess reserves, and it will only be able to fund retirees at 78% of their full benefit amount.

The Social Security system is funded by employed individuals through the payment of a payroll tax (6.2% of salary) and a matching employer tax. That money then goes to current retirees in the form of Social Security payments.

The system works so long as the number of tax dollars coming in meets or exceeds the payments owed to the beneficiaries. The decline in the birth rate following the Baby Boomer generation is believed to lead to a fewer number of people in the workforce, which may not be able to support a large number of retired Baby Boomers.

The conclusion is that, rather than relying on Social Security as their primary source of retirement income, individuals will have to take more responsibility for funding their retirement. This situation is what is behind the current push for auto-enrollment 401k plans with automatic escalation.

How a 401k Annual Increase Program Works

Auto-enrollment in a 401k plan means that employees are automatically enrolled in the 401k plan. That is the default, and the employee needs to take no action. It is only by taking an action and affirming that they don’t want to be a part of a 401k plan that an employee can opt-out of the plan.

In an auto-enrollment 401k plan, an employer specifies the percentage of an employee’s pre-tax salary that will be withheld and automatically placed into a retirement account. Some employers then make a matching contribution, the most common employer matching contribution is 50% of an employee’s contribution up to 6% of that employee’s yearly salary. That works out to a matching contribution of 3% of an employee’s yearly salary.

On March 29, 2022, the House approved the Securing a Strong Retirement Act which is more commonly known as SECURE Act 2.0.

The SECURE Act 2.0 contains provisions for:

  • Auto-enrollment: employers automatically enroll new employees in a retirement savings plan at a contribution rate of 3% of the employee’s pre-tax pay.
  • Auto-escalation: the employer raises the amount withheld yearly by 1% up to at least 10% but not more than 15% of the employee’s pre-tax salary.

Before the SECURE Act 2.0 becomes law, it must first be passed by the Senate, and what its provisions will be regarding auto-enrollment and auto-escalation are still unknown. The SECURE Act 2.0’s provisions would only apply to new 401k and 403b plans that are established after the legislation’s enactment date, and they wouldn’t apply to existing plans.

Exceptions would be given to small businesses having 10 or fewer employees, new businesses open for less than three years, and church and government plans.

401k Automatic Escalation Rules

Auto-escalation rules mean that a newly hired employee would have the following amounts automatically deferred from his or her paycheck:

  • Year 1: 3%
  • Year 2: 4%
  • Year 3: 5%
  • Year 4: 6%
  • Year 5: 7%
  • Year 6: 8%
  • Year 7: 9%
  • Year 8: 10%
  • Year 9: 11%
  • Year 10: 12%
  • Year 11: 13%
  • Year 12: 14%
  • Year 13: 15%

Most economists agree that 3% is too low a rate for employees to achieve a successful retirement, and rates starting at 6% might be a more realistic floor. According to the trade group the Plan Sponsor Council of America, starting in 2020, more employers start employees at the 6% rate than the 3% rate.

Benefits of an Annual Savings Adjustment Program

Employer Benefits

Employer matching contributions are tax-deductible, meaning that employers will save money on taxes despite making higher matching contributions. This is not necessarily a benefit for the employer but something that is factored into the equation of whether a company will offer a sponsored retirement plan.

Employee Benefits

  • Employees will save more for their retirement than they would without auto-escalation
  • Employees’ taxable income will be less since deductions are made pre-tax
  • At a minimum, employees should contribute enough to trigger their employer’s matching contribution.

Downsides of an Annual Increase Program

Employer Downsides

A 2020 report by the Defined Contribution Institutional Investment Association (DCIIA) found that while 62% of large retirement savings plan sponsors included auto-enrollment, only 48% included auto-escalation. Some of the reasons cited by the DCIIA for employers not offering auto-escalation were:

  • Feeling they were being too paternalistic toward employees
  • Fear that their employees would complain
  • Fear that their employer-matching contributions would become too costly

Letting their employees know that they can either opt-out entirely from participating in a 401k plan or reduce their contribution level can go a long way toward easing employees’ fears. Other employer downsides were:

  • Auto-escalation requires more oversight to ensure that escalation amounts align with payroll withholding.
  • Auto-escalation requires more coordination with third-party service providers.

Employee Downsides

  • While having 3% of their pre-tax paycheck deferred isn’t likely to cause hardship, when amounts rise to 10% and beyond, it’s going to have a definite impact on employees’ buying power
  • If employee raises don’t keep up with auto-escalation levels, employees will experience less take-home pay.

Auto-Enrollment Vs. Auto-Escalation

Auto-enrollment refers to the program where an employer automatically enrolls their employees into contributing to a retirement savings fund, withholding a certain percentage of their pay to fund the plan. Employees are permitted to opt out.

Auto-escalation is when an employer-sponsored retirement plan automatically increases the percentage of an employee’s salary withheld for retirement each year the employee holds the plan and stays with the company. Employees are also permitted to opt out.

Employers may offer auto-enrollment but not auto-escalation. As we described above, the report by the Defined Contribution Institutional Investment Association showed that almost two-thirds of large retirement savings plan sponsors included auto-enrollment, while less than half of them included auto-escalation.

Who Offers 401k Auto-Escalation?

Plan sponsors are increasingly re-examining their auto-escalation caps since the SECURE Act raised the auto-escalation cap for safe-harbor plans to 15% from 10%, while non-safe-harbor plans have no cap restrictions. Safe harbor plans require employers to contribute to their employees’ accounts whereas a traditional 401k plan does not.

According to a December 2021 article in Pensions & Investments, Nestle USA Inc., whose 401k plan stands at $7.3 billion, automatically enrolls employees at an initial rate of 6% and then auto-escalates them annually up to a maximum of 25%.

How to Enroll in Auto-Escalation

When an employee joins a company that provides auto-enrollment in their 401k plan and auto-escalation, they won’t have to do anything. That’s the beauty of these provisions. For employees wanting to opt-out of the plan or to change their auto-escalation amounts, they can talk to their plan administrator or HR department.

The IRS provides considerable information on auto-enrollment-type plans.

Should I Enroll in Auto-Escalation for my 401k?

When employees start saving earlier through auto-enrollment and have their deferral rate increased annually through auto-escalation, it can have an enormous impact on their retirement savings. Financial experts recommend that workers save between 10% and 15% of their pay annually in order to fund a comfortable retirement and both auto-enrollment and auto-escalation can help them do that.

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