The power of 401(k) automatic enrollment

LAST REVIEWED Jan 23 2024

Key Takeaways

• Automatic enrollment (“auto-enrollment”) provides eligible employees who don’t opt out of participation with a default deferral election into their 401(k) plan
• It may provide tax credits for small employers adding an auto-enrollment feature to a new or existing 401(k) plan
• Together with other plan design features, auto-enrollment may help drive plan participation

Americans aren’t saving enough for retirement. The retirement savings gap may grow to $137 trillion by 2050, as estimated by the World Economic Forum in 2017. Auto-enrollment may help increase access to plans and reduce behavioral biases towards savings. For a worker making average private sector wages— $1,116 per week, as of mid-2022—auto-enrollment at 6% could result in nearly $3,500 in contributions to a retirement account every year.

At Human Interest, we believe that auto-enrollment is a proactive plan design feature that may help increase your employee recruiting and retention efforts. In fact, almost 70% of all defined contribution plans had an auto-enrollment setup, according to 2019 data. Savvy candidates may now seek the best retirement plans as part of an employment opportunity. Let’s review auto-enrollment in greater detail—including its many benefits for you and your employees.

How does auto-enrollment work?

In an auto-enrollment setup, newly eligible employees who don’t opt out of plan participation will have a default percentage of compensation contributed pre-tax to their plan from each paycheck. Employers set the default election in the plan document—but employees may opt out of plan participation at any time.

Automatic enrollment: Benefits for you and your employees

According to a 2020 study from the Defined Contribution Institutional Investment Association, the majority of 401(k) plans responded they use auto-enrollment. Not only did nearly 70% of all defined contribution plans use an auto-enrollment setup, but that number also grew 9 percentage points from 2016 to 2019.

Here are some benefits that may explain the growth of the popular plan design:

• Boost participation rates: Vanguard found that auto-enrollment plans helped increase participation by nearly 50% in plans they administer, and triple participation rates among new hires in plans they oversee.
• Attract and retain talent: 401(k) plans are the most-wanted benefit after health insurance, according to a Human Interest commissioned survey—and auto-enrollment can help increase access and make plans more attractive to employees.
• Take advantage of tax credits: Small businesses may be able to claim a tax credit of $500 per year, for up to three years, when adding an auto-enrollment feature to a new 401(k) plan (in addition to the $5,000 they may claim, for three years, to cover the costs of starting a plan)

Help increase participation & reduce indecision

Auto-enrollment may also help reduce behavioral biases that could otherwise impede saving over the long term. Psychological inertia refers to the tendency to stay with a default election because there is no effort needed to make an alternate decision. auto-enrollment may help counteract this inertia by helping to reduce hesitation and indecision, pushing participants who may not initially choose to defer into the plan toward their retirement savings goal. Auto-enrollment could also help establish positive social norms. In fact, a Human Interest study found that 81% of respondents agreed they would either enroll in a plan or increase contributions if they learned the majority of their coworkers were already enrolled.

Automatic enrollment rules

Employers set the default deferral rate for auto-enrollment plans in their plan document—and may adjust this at any time. According to the 64th Annual Survey from the Plan Sponsor Council of America (PSCA), the most common default deferral rate was 6% in 2021. However, in an effort to boost savings rates among participants, Human Interest advises plans to increase default contribution rates to 7%.

Automatic enrollment notices

According to the IRS, employers must notify all eligible employees between 30 and 90 days before each plan year begins if a plan uses an eligible automatic contribution arrangement or a qualified automatic contribution arrangement (more on this below). Employers with these types of plans that auto-enrollment employees immediately upon hire may give employees the notice on their date of hire.

At Human Interest, all eligible employees may easily opt out of their 401(k) plan by clicking a link in their welcome email. If employees take no action within a week after their email, they’re enrolled at the default deferral rate (although they can change this rate at any time).

Which employees are eligible for automatic enrollment?

Plan eligibility refers to certain conditions that must be met by employees before they’re allowed to participate. The plan sponsor determines what eligibility will be for its plan, within parameters set by law. A plan may set eligibility requirements based on age or length of service—but employers may find that extending eligibility to all employees, regardless of service, may be advantageous. For example, immediate eligibility may help recruit top employee talent. And eliminating service requirements from a 401(k) can help improve employee access and possibly boost participation.

For new startup 401(k) plans that include an auto-enrollment feature, all eligible employees who don’t opt out will be automatically enrolled. Existing plans adding an auto-enrollment provision can choose to offer the feature only to newly eligible employees or to extend the feature to currently eligible employees who defer less than the chosen default deferral percentage.

3 types of automatic enrollment contributions

1. Basic automatic enrollment (Automatic Contribution Arrangement or ACA), as the name suggests, is the simplest auto-enrollment option.

• Employees are automatically enrolled in ACA plans unless they elect otherwise
• Plan document specifies the percentage of wages that will be automatically deducted
• Employees can elect not to contribute or to contribute a different percentage of pay
• May be added at any time

2. Eligible automatic contribution arrangement (EACA) is similar to ACA, but allows employees the option to withdraw automatic contributions, including earnings, within an established timeframe.

• May be designed to allow employees to withdraw automatic contributions, including earnings, within a specified number of days of the date of the first automatic contribution. The number of days is stated in the plan document and cannot be more than 90.
• Uniformly applies the plan’s default deferral percentage to all employees after giving them the required notice
• Provides the plan sponsor with an extended 6-month testing window for annual ADP and ACP testing
• May only be added as of the start of the plan year

3. Qualified automatic contribution arrangement (QACA) is an auto enroll design that also includes safe harbor provisions that exempt the plan from annual actual deferral percentage and actual contribution percentage nondiscrimination testing requirements:

• Uniformly applies the plan’s default deferral percentage to all employees after giving them the required notice
• The initial default deferral percentage must be 3% or higher and be automatically increased each year an employee participates until 6% is reached. The plan may continue automatic increases up to 15% of compensation. If the initial default is set at 6%, automatic increases are permitted but not required.
• Require one of the two employer contributions:
  • Matching contribution: 100% match for elective deferrals that don’t exceed 1% of compensation, plus 50% match for elective deferrals between 1% and 6% of compensation; or
  • Nonelective contribution: 3% of compensation for all participants, including those who choose not to make any elective deferrals.
• Employees must be 100% vested in the employer’s matching or nonelective contributions after no more than 2 years of service
• May only be added as of the start of the plan year

Is auto-enrollment enough to solve the retirement crisis?

In short, probably not. Although automatic enrollment increases participation rates, some research indicates it could lead to lower contribution rates in cases when default deferral rates are at low levels. According to a 2021 report from the Social Science Research Network, many employees simply accept the default deferral rates selected by their employees. However, if default savings rates are lower than employees would have otherwise chosen if required to opt in to that same retirement plan, they may find themselves at a disadvantage.

The strongest retirement plans may be those that combine several plan design options. Auto-enrollment can be combined with automatic escalation (auto-escalation), a provision that automatically increases an employee’s contribution amount on a regular schedule. Because employees don’t need to remember to make adjustments themselves (until they reach the escalation cap), auto-escalation may increase retirement savings beyond what they’d normally save. In fact, a study found increasing default contribution rates is more effective than raising matching contributions when it comes to increasing savings levels.

Consider adding automatic enrollment to your 401(k)

Automatic 401(k) enrollment combined with automatic escalation and appropriate opt-out provisions may help turn the lack of employee action into a powerful tool to boost both participation and deferral rates. By helping to reduce indecision, employers may help encourage employees to better prepare for retirement early in their careers—which will hopefully yield better long-term results for both them and the company.

Human Interest offers and recommends auto-enrollment to our 401(k) clients. According to our estimates, if auto-enrollment was instituted overnight with a 7% deferral rate for all employees with access to a retirement plan but were not participating, Americans could save $83 billion¹ in just one year.