Take a hike

A recent IRS ruling lets employers up the automatic contribution rates of employees. That’s probably a good thing all around.

Since 1998 employers have been allowed to enroll employees in 401(k) plans without their permission. The only catch: The employers must inform them that payroll deductions are going to be taken and that they can opt out. The program, known as automatic enrollment, received a shot in the arm last summer when the Internal Revenue Service ruled that plan sponsors can step up the contributions of employees that they deem to be saving too little in their 401(k) accounts. This latest enhancement is known as automatic escalation.

Earlier guidance from the IRS suggested that employers choosing to implement automatic enrollment start employee contributions at the default rate of 3 percent. But in the wake of the recent IRS ruling, sponsors can step up withholding and company-match rates as they see fit, within prescribed limits. The IRS mandates only that employees be informed of the change and allow reasonable time to decline.

“Most people do have a grasp of how much they ought to be saving,” notes Brigitte Madrian, an associate professor of public policy at the University of Pennsylvania’s Wharton School. “Most plan participants think it should be 10 to 15 percent of pay. But then they tell you they are actually saving less.”

Once employees join a plan, they’re likely to stay put. That tendency to do nothing works in favor of increases in withholding. “Automatic escalation takes advantage of the very thing we are trying to combat -- participant inertia,” notes Diane Talbot, head of 401(k) product development at Merrill Lynch & Co.

“Today there are not a lot of sponsors using automatic escalation, but this is a powerful emerging trend,” asserts Lori Lucas, director of participant research with Hewitt Associates.

“I have a feeling that users of automatic escalation will tend to be higher-wage companies,” says Stephen Utkus, a principal at the Vanguard Center for Retirement Research. Employers who choose to match, he says, “can afford the cost of the higher match.”

Plan sponsors that have trouble meeting ERISA’s antidiscrimination standard could find automatic escalation an easy way to comply. The rule requires that contributions by rank-and-file employees fall within certain percentages of contributions by owners and managers. Since automatic escalation is expected to boost the contributions of lower-level workers, who tend to save at lower rates than their colleagues, it should help keep plans in balance.

Vanguard has two plan sponsor clients in its automatic escalation program, known as One Step, and says ten to 20 prospects are considering it. T. Rowe Price Associates and Hewitt also offer the service.

“Automatic escalation represents a recognition that traditional methods -- ‘Let’s send out more communications!’ -- haven’t been successful,” says Vanguard’s Utkus. The new system therefore, should boost retirement savings.