Morningstar Magazine - June/July 2017 - 66

Strategies

EXHIBIT 2

High Impact DC participants save more
as default savings rates rise.

new enrollees is one of the largest expenses
associated with auto-enrollment and a significant
hurdle to its adoption by firms (Hess and Xu, 2011).

Participant Weighted
Average Initial Deferral Level
Plan Weighted
7.0

6.4

5.9
5.1
4.3 4.1

8
%

7.6

6

4.8
4.0

4

3.0

2
0
2
3
4
5
Default Savings Rate (%)

6

Source: Morningstar.

Average Savings Level Across Respondents
Given that default savings rates are well below
Average Savings for Respondents
where they should be to give participants a
Who Don't Save at the Base Savings Rate
reasonable chance at saving enough for retirement,
we can say that the nudge here failed. As an
Average Initial Deferral Level (%)
industry, we are missing an opportunity
12
to help participants save more for retirement.

There are two solutions to mitigate the costs
associated with increased participation (and higher
savings levels): Stretch the match out further
(for example, match 25% of the first 8% of
employee deferrals versus matching 50% of the
first 4% of employee deferrals) or move to
a discretionary match approach.
Plan sponsors also say they worry that higher
default savings rates discourage participation.
This perspective suggests plans should select
a low default rate to get employees to
participate and then auto-escalate their savings
rate. DCIIA (2015) reported that 16% of plan
sponsors selected their default rate because they
thought it was the amount with which their
participants would be comfortable.4

8.18

6.97

11.54
11.00

9.92
9.80

9.04
9.84

Research suggests that plan sponsors shouldn't
worry about offering higher default savings rates.
Choi et al. (2004) demonstrated virtually no
difference in acceptance of default savings rates of
3% versus 6%. Additionally, we saw little difference
in the acceptance of the savings rates from
2% to 6% across roughly 200 DC plans in a test
dataset (Blanchett et al., 2017).

10.51

We think there are two reasons plan sponsors
select BrightScope/ICI
low default savings rates:
thePrice
costs
T. Rowe
associated with higher employee savings levels
% of Plans
and the impact on participation. If the employer
offers 60
a matching contribution
and both
59
participation and savings rates increase, the costs
of the plan increase for the plan sponsor. The
money40required to fund any38employer match for

9.41

9 default savings rates are low, they appear to
While
be increasing. T. Rowe Price (2016) reported
that629% of plans had a default rate of 6% or more
in 2015, up from 17% in 2011. Meanwhile, plans
using a 3% default fell to 38% from 50% in the
3
same period. While this is obviously an
0
improvement,
default savings today are still well
2
3
4 to achieve
5
6
below required
savings
levels
Default
Savingseven
Rateafter
(%) factoring in
retirement
readiness,
employer contributions.

But a problem with counting on higher future
savings rates through auto-escalation is turnover.
The median employee tenure is about four years
for U.S. workers and less than three years for
workers under the age of 34.5 Turnover could result
in perpetually low savings rates for people
who continually find jobs at employers that offer
low default rates. Employees rarely carry their
escalated rate to a new job. Take an employee
who is automatically enrolled at the savings
rate of 3% and receives 1% increases for three
years. She then leaves the company for a
new job that reverts her savings rate to 3%. If she
changes jobs every three years, her rate would
never exceed 6%.

The evidence from this dataset, however, suggests
that the default savings rate has a significant
impact on savings levels, especially among
newly enrolled participants. EXHIBIT 2 shows that
as rates rise, average initial deferral rates
rise, too.6
In fact, initial savings rates are significantly higher
in plans that have higher default levels. This
occurs for two reasons. First, participation rates
are the same regardless of default level,
so higher defaults aren't limiting participation.
Approximately half of participants accept
the default savings rate, regardless of the level
reviewed (between 2% and 6%), so the higher the
default rate, the more participants save.
Second, participants who don't accept the default
still tend to choose to save more. In other words,
the default rate appears to serve as a
psychological anchor that participants use to
determine how much they need to save. So, if the
plan sponsor sets the default at 3%, participants
(in this case wrongly) assume that 3% is an
appropriate savings level. In contrast, a default
of 8% suggests a higher savings rate is required,
and participants respond accordingly.
It's fair to ask whether improved savings rates
(because of auto-enrollment) are actually good for
all participants. For example, do individuals
(or households) who choose to save more for
retirement accrue higher levels of credit card debt
because their take-home pay is lower? Fellowes
and Spiegel (2013) noted this effect. However,
Chetty et al. (2013), which looked at responses to
increases in employer contributions when
Danish workers changed jobs, suggested that
automatic changes in retirement savings increase
overall savings.
This isn't to say that saving more for other
goals (such as college or paying down student
loans) might not benefit a household more,
but there is general agreement among financial
planners and economists that most Americans
are not saving enough for retirement.

29

20

4 Ironically, the most common reason plan sponsors
11 note they selected their default rate is that it was recommended by an industry consultant or other professional.
14
13
7
5 https://www.bls.gov/news.release/tenure.t01.htm
11
5
5
4 3
6 The data 0for this exhibit is from a forthcoming white paper titled
0 1"Save More Today: Improving Retirement Savings Rates with Carrots, Sticks, and Nudges."

66

1
2
3
4
5
6
Default Deferral Rate for Automatic
Morningstar
June/July
2017
Enrollment
Plans
(%)

>_ 7


https://www.bls.gov/news.release/tenure.t01.htm

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