Why Automating Retirement Savings May Not Be Enough
Participants are saving at rates far less than the recommended percentages.
Posted Nov 06, 2017
In the 1970s and early 80s, and even before that, most major employers offered defined benefit pension plans. When the person retired, usually after a long and stable career with one company, they received a pension check in the mail every month for the rest of their life. Since the 1980s, however, the number of companies offering such pensions has declined steadily.
The Retirement Savings Challenge
Today, virtually no company offers a guaranteed life-long pension in retirement. The responsibility of saving for our own retirement lies squarely on our shoulders. Beyond social security benefits, what we save in our working years plus the growth of these savings is what we will have to spend in retirement.
Psychologists know only too well how easy it is for us to procrastinate, form overly rosy images about the future, buy impulsively, overspend, make bad spending decisions, and so on. What is more, emergencies today, whether they are medical or personal (divorce, job loss, etc.) can devastate personal finances. The upshot is that it is very difficult for many people to save adequately for their retirement.
Compounding this challenge, life expectancy has increased significantly, by approximately two months per year between 1960 and 2015 in the United States. This value was even greater in many other countries. No one will argue that getting to live longer is amazing, but it also means that we must save more money to fund a potentially decades-long retirement.
The Rise of the Automatic Retirement Savings Plan
Fueled by the popularity of nudging practices, the practice of enrolling employees automatically in retirement savings plans has become widespread in the United States over the past decade. In one recent survey of large employers, 68 percent of companies automatically enrolled their employees in 401(K) savings plans. Similarly, Vanguard reported that 45 percent of its 4.6 million plan participants are subject to some form of automatic saving.
The logic of an automatic retirement savings plan is compelling, as explained by this quote:
“Automatic features harness the power of inertia by taking the workers who may not take action and making sure that they begin to save today for retirement. This helps increase the chance that more people will be on a favorable path to a more secure financial future.”
How Much Do We Need to Save to Retire Comfortably?
Expert opinions on how much money people should save for retirement vary. The age at which an individual begins to save, and how consistent they are with saving, both matter. For instance, if you start early, say in your early twenties and save each and every month until you retire, you can save around 10 percent of your income and still have a healthy nest egg when you retire.
Despite the individual variability, most experts recommend that people must save at least 15 percent of their pre-tax income over multiple decades to be able to retire comfortably, at an income level close to their pre-retirement value. What is more, the recommended saving percentage has been going up as longevity and length of retirement increase. Many experts are revising their recommendation higher, to an 18 percent or 2 percent savings rate, rather than 15 percent, to enjoy a comfortable extended retirement.
A Majority of People Enrolled in Automatic Retirement Savings Plans Are Not Saving Enough
When compared to these recommendations, a majority of people enrolled in automatic savings plans are not saving enough money. Take Vanguard’s “How America Saves 2017” report released this summer. Of its customers enrolled in an automatic savings plan, 52 percent were in a program that only saved 3 percent. Another 28 percent had savings rates of 4-5 percent and only 20 percent had a savings rate of 6 percent or greater. This report did not specify how many participants were saving 15 percent or more but it was likely a fraction of 20 percent. On average, Vanguard’s customers saved 6.2 percent of their income and had a median saving rate of 5 percent in 2016. Interestingly, these numbers were lower than any time since 2007, and Vanguard attributed the declines to an “increase in automatic enrollment.”
Similarly, in its report titled “Driving Plan Health 2017”, Wells Fargo reported that fewer than 40 percent of individuals automatically enrolled in its savings plan have a savings rate of 10 percent or more. And in its 2017 survey of large employers, Alight Solutions found that 37 percent of employers provided a default savings rate of 3 percent and another 30 percent have a rate of 6 percent.
One encouraging note in these statistics is that the nudges used in designing automatic savings plans have improved since they were adopted. Both the default savings rate and the automatic escalation rates have been going up for these companies. Compared to 2009, for example, when most companies used a default savings rate of 3 percent, far more companies used 6 percent in 2017. However, none of these values are yet close to the recommended 15 percent saving rate threshold.
I also have some other concerns with automatic savings plans. One is that participating in such a plan may create the illusion that one’s retirement is taken care of, making people falsely complacent and unprepared. Another is that it may encourage passivity in personal finances, and steer some individuals away from taking the time and making the effort to learn about their own personal finances, how to make investments, etc. and make prudent investing decisions. In Vanguard’s study, for example, a remarkable 97 percent of participants in automatic retirement savings plan simply chose a target-date fund, leaving the fund manager to determine such things as asset allocation between stocks and bonds, and growth vs. income-focused investments. In other words, people are treating defined contribution retirement saving in the same "hands-off" way as they would treat a defined benefit pension plan. Except that they are completely responsible in the first case, while they had no such burden with a pension.
Automatic Saving Is One Part of a Complex Skillful Activity
There is no doubt that automatic retirement savings plans do considerable good. They prod us into getting started on a path of saving regularly for our futures. The problem arises when we see them as a complete solution, rather than one piece of a complex and difficult set of behaviors that we will need to perform and integrate into our lifestyles. Saving money is a challenging, effortful, and skillful activity. It requires us to harness motivational and habitual behaviors, and think about and regulate how we spend money.