Testifying before the Senate Finance Committee in 2016, Alicia Munnell, the director of the Center for Retirement Research at Boston College, said that "given the enormity of the retirement savings crisis ... we need bolder steps" to help Americans prepare for their later years.
Munnell went on to recommend two features employers can provide in their 401(k) plans to help people save more: auto-enrollment and auto-escalation. You may be familiar with auto-enrollment -- that's when an employer automatically enrolls you in the workplace 401(k). The idea is to encourage you to start saving.
But on its own, auto-enrollment isn't enough; you also need auto-escalation -- the lesser known of these two 401(k) features. Auto-escalation is the one that will really get you to start saving some meaningful dollars in your retirement plan. Here's how it works.
Moving on up
If you think about everything you get with a 401(k) -- contributions lower your income taxes, money grows tax-deferred, employer matches, Roth options -- it's no wonder this workplace benefit is so popular. But if all you ever do is open a 401(k) and stick with the same low contribution rate, then you are missing out.
Auto-escalation means your employer automatically increases your contribution every year till it gets to a certain percentage of your salary. For example, a new employee starts at the company and is automatically enrolled in the 401(k). The employee then elects to auto-escalate -- or increase the contribution to the plan -- by 1% each year till it gets to 10% of salary.
If it sounds simple, that's the point: Automating your savings takes the decision-making out of the equation. If you're thinking you can do this on your own and start next year, you may be right. But I'm willing to wager something will get in your way -- like being too busy or forgetting about it.
Automating your investing is one of the best ways to accumulate money over time, whether its automating contributions to a 401(k) or 529 college savings plan, or automating an increase in your 401(k) contribution. Automating doesn't let you make an excuse or put off what you know you need to do. Instead, you find a way to adjust and live with the money left over after the automatic contribution.
Three savers, three different results
JPMorgan Chase's recent retirement guide highlighted the impact auto-escalation can have on a nest egg over time. To illustrate its point, the company pitted three savers against one another:
- Super Sam, who diligently saves 10% of his salary every year.
- Escalating Ethan, who starts contributing 3% of his salary and elects to auto-escalate his contribution by 1% each year till it gets to 10% of his salary.
- And Stubborn Sara, who -- like her name suggests -- starts off with a 3% contribution election and never changes over time.
They are all saving in their 401(k), but that is only half the battle. They need to contribute a meaningful amount to have enough for retirement.
The table below assumes they are each 25 years old and start off earning $50,000, with 2% wage growth, an employer match of 50% capped at 3% of their contribution, and an annual investment return of 6%. The table shows the impact higher contributions make over time. Spoiler alert: Super Sam and Escalating Ethan end up with more than twice the amount of Stubborn Sara's portfolio. The increased savings and the growth on those savings are a powerful combination over time.
|Saver||401(k) Balance at Age 66|
|Super Sam||$1.41 million|
|Escalating Ethan||$1.26 million|
Getting it going
If you're the disciplined type who will increase your 401(k) contribution rate each time you get a pay raise, then maybe you don't need to elect auto-escalation. But if you're the set-it-and-forget-it type (you use target retirement date funds, for example) and don't want to be bothered with updating your withholding over time, then maybe try auto-escalation.
The first step is to see if your 401(k) administer offers it. A call to human resources or the custodian who administers the plan is a good place to start. From there, all it should take is a form or online election to participate in auto-escalation. There may be a choice of different auto-escalation plans, such as varying the percentages to withhold, so maybe start small and see how it goes. If your 401(k) plan doesn't offer auto-escalation, you can always do it the old-fashioned way: logging into your 401(k) account each year and electing a higher contribution. A good time to do this is when you get a pay raise!
Before you go whole hog on auto-escalation, be sure you're taking care of your other financial planning needs such as building an emergency fund and paying down debt. Then, auto-escalation can work nicely as part of your overall savings strategy. As the table above shows, automatically increasing your 401(k) savings each year adds up over time.