401(k) auto-enrollment and auto-escalation were supposed to help people save for retirement. Here's what happened instead.

By Jessica Hall

Behavioral finance 'nudges' and other helpful features ran into a surprising obstacle

We may be our own worst enemy when it comes to retirement savings.

Innovations such as auto-enrollment, when an employer automatically sets a worker up in the company's retirement plan, and auto-escalation of savings, which increases the contribution to a worker's retirement plan automatically, were intended to boost overall retirement savings. But new research found that these features help less than previously thought, mainly because people end up sabotaging their own retirement success.

"We're not saying auto features are bad or useless. These policies we think are a good idea, but they're just not as effective as originally thought," said Yale School of Management professor of finance James Choi.

"In the real world, looking at how people behave - people leave jobs, cash out their 401(k)s or opt out of savings rates - it's different once human behavior plays a role," Choi said.

In the new research, "Smaller than We Thought? The Effect of Automatic Savings Policies," Choi and his colleagues studied nine 401(k) plans and found that auto enrollment and default auto-escalation are actually less effective in increasing retirement savings than earlier research suggested.

That's because people leave jobs before their 401(k) matching dollars are fully vested; they start over at new companies at the entry point for 401(k) savings rates rather than their prior, higher savings rate; or they leave a job and liquidate their 401(k) funds rather than rolling them into a new retirement savings plan, Choi said.

Read: What are vesting schedules? They can turn your 'free' 401(k) match money into 'pretend' money if you don't know.

"The job-transition point is a very critical transition. People lose unvested matching dollars and don't think about that or calculate that into their decision. Or they tap their savings for immediate needs rather than keeping it for retirement, which seems forever away," Choi said. "It's not the moving of the jobs, per say, that's the bad idea. It's the decision to cash out."

In fact, 42% of 401(k) balances are cashed out upon departure from a job, the research found.

"The rules allow it. The U.S. retirement system is permissive about taking retirement money before retirement. Secure 2.0 made it even easier to get money out," Choi said.

Retirement legislation known as the SECURE Act 2.0 requires most 401(k) retirement savings plans established after 2022 to automatically enroll new employees and auto-escalate their contribution rate. However, features of the law now allow you to tap retirement funds more easily, such as the ability to withdraw $1,000 a year for emergencies.

Read: Taking $1,000 from your 401(k) for emergencies is easier than ever - but consider these options first

Also, people with limited retirement savings often make out the worst when it comes to changing jobs. For example, if an employee has a retirement balance of less than $1,000, an employer will send you a check in the mail for your savings balance. Most people, rather than putting it in an IRA, cash the check and spend it, Choi said.

For people with balances between $1,000 and $7,000, the employer can roll over those funds into an IRA of their choosing - but the funds sit in cash, rather than an investment, Choi said. The employee needs to make an investment selection for that money and many often don't, so the money just sits as cash, he said.

With auto-escalation, the research found that the nudges to boost people's savings rate don't work because people opt out of the program. For example, the acceptance rate of the auto-escalation default was 43% on the first escalation date, 36% on the second date, and 29% on the third date, the research found.

Incorporating human behavior and its effect on retirement funds, the researchers found that overall, auto enrollment increases retirement net contributions by only 0.6% of income per year, and auto-escalation by only 0.3% of income per year.

So what can be done to make retirement savings more effective?

"Making retirement savings accumulated at previous jobs less easily accessible, creating infrastructure that allows high contribution rates attained at a previous job to be automatically enacted at one's next job, and/or making the auto-escalation contribution level dependent on something like employee age instead of only tenure at one's current job may significantly increase the impact of automatic policies on retirement savings accumulation," the researchers said in the paper.

Choi also added that workers should work hard to maximize any matching dollars they get from an employer and not leave money behind.

"When you change jobs, part of the calculation should be how much you're going to forfeit. People don't seem to pay attention to the vesting schedule when job-changing," Choi said. "And people should be more reluctant to take money out when you leave a job."

-Jessica Hall

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09-21-24 1151ET

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