A new research paper suggests that defined contribution (DC) plan sponsors should focus on increasing the default savings rate to help boost participants’ retirement savings for new employees rather than increasing employer matching contributions.
Researchers David Blanchett, from QMA; Michael S. Finke, from the American College; and Zhikun Liu, from Empower Retirement, examined the interaction between employer match thresholds and default savings rates to understand how each may affect how much lower-income employees save for retirement and which employees receive a greater share of employer contributions. Selecting a higher default rate has the largest impact on employee savings rates for new employees, according to the research paper, “The Impact of Employer Defaults and Match Rates on Retirement Savings,” published by the Social Science Research Network (SSRN).
“Implementing a default rate that is greater than the match rate results in a savings rate that is 0.64 percentage points higher, and selecting a low default rate and a higher match rate results in a predicted savings rate 0.19 percentage points lower,” the paper states.
Defined contribution (DC) plan sponsors set the two parameters that influence employee savings rates: the default savings rate and the percentage of an employee’s DC contribution matched by the employer.
Higher employer matches can encourage greater savings but is likelier to benefit higher-earning cohorts, the research shows.
Plan sponsors have used employer matching contributions to spur an increase in participant savings, but research shows that millions of American workers are not contributing enough to the workplace retirement plan to benefit from the full company match.
“A generous employer match motivates individuals who have greater financial literacy or a higher optimal savings rate but may result in a regressive distribution of employer retirement contributions,” the paper states.
Plans with low default rates that match a high percentage of employee earnings induce higher income participants to actively move away from the low default savings rate, resulting in a wider savings gap between higher- and lower-income employees, according to the paper.
However, the research found that when employees are defaulted in at a higher rate, fewer move away from the default savings rate, which results in higher and more equal savings rates among employees at all income levels. In addition, the researchers note that lower-income workers can benefit from remaining in the default plan investment by taking advantage of institutionally priced diversified funds.
After lawmakers passed the Pension Protection Act in 2006, employers using auto-enrollment in their DC plans often used a 3% default deferral rate. However, prior research has shown that increasing the default deferral rate does not deter employees from participating in the plan.
According to the 2021 PLANSPONSOR Defined Contribution Survey the percentage of DC plans with a default deferral rate greater than 3% had reached 51%, with one-quarter defaulting participants at a rate of 6% or greater.