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Modest Deferral Rate Increases Could Have a Big Impact on Retirement Readiness

Practice Management

A modest increase in participant elective deferral rates would enable most plan participants to attain a 75% replacement rate in retirement, according to new research by Vanguard. 

To assess whether Vanguard DC plan participants are saving optimally in their current workplace retirement plan, Vanguard researchers Jeffrey Clark and Jean Young analyzed approximately 1.9 million eligible employees and 1.5 million actively contributing participants in approximately 880 plans for which the firm had completed compliance testing as of December 2020.

Their baseline model assumes that target saving rates are 9% where income is less than $50,000, 12% where income is between $50,000 and $100,000, and 15% where income is more than $100,000. It also assumes a 75% target replacement ratio, 4% real return, 1% real wage growth, 40 years of saving (from age 27 to 67), and a 4% withdrawal rate at retirement.

In the corresponding white paper—The Vanguard Participant Saving Rate Index—the researchers reveal that 7 in 10 DC plan participants are saving at rates that would enable them to attain a 65% replacement rate in retirement (saving rates include both the employee elective contributions and any employer contributions).

Auto Escalation Impact 

And while some participants may not be saving at or above their target rate, many are close, the paper notes. Currently, 4 in 10 participants are enrolled in automatic annual saving rate escalation and will automatically see their saving rates rise by 1, 2, or 3 percentage points over the next few years. 

As such, a modest increase in participant elective deferral rates of 1, 2, or 3 percentage points would enable 7 in 10 plan participants to attain a 75% replacement rate in retirement. Said another way, when considering the impact of automatic escalation in the original 75% replacement ratio scenario, an additional 20% of participants will reach their target saving rate, resulting in nearly 7 in 10 Vanguard plan participants saving effectively, the researchers explain.  

Targeting both a lower replacement ratio of 65% and modest increases in saving rates, however, indicates that 9 in 10 participants can achieve optimal saving rates in their current workplace retirement plan.

Not surprisingly, plan design—both the default enrollment rate and the value of employer contributions—remains a powerful driver of participant saving rates, the researchers observe. They found that half of Vanguard plan participants are saving at or above their income-based target saving rates and are saving effectively. But when they analyzed all employees eligible to participate in the plan, including those who chose not to, the rate drops to 40%.

Across all eligible employees in plans with automatic enrollment, employees are 70% more likely to be saving effectively—45% compared with 26% in plans without automatic enrollment—primarily because of the significant difference in participation between employees in the two plan designs, the researcher note. Additionally, plan size did not affect the results.

As of year-end 2021, 58% of plans default at a rate of 4% or higher, compared with just 32% 10 years ago. An automatic enrollment default of 6% or higher was a strong predictor of participants saving effectively, the paper notes. 

Plan Design Matters 

Notably, the results also indicate that automatic enrollment designs where the default is 1% or 2% lead to fewer participants saving effectively than when the default deferral design is 0%, as it is under voluntary enrollment. 

“Participation rates in automatic enrollment plans with low defaults are higher than those in the typical voluntary enrollment plan, although when focusing on participant total saving rates, setting low enrollment defaults can underserve many participants who would be more likely to save at higher levels in a voluntary enrollment plan,” Clark and Young write.  

As such, higher automatic enrollment defaults and generous employer contributions, in the form of incentive matching contributions and other nonmatching employer contributions, increase the probability that participants will save effectively, they add.  

Consequently, they suggest that the default automatic enrollment and annual increase rate of any plan should be set no lower than the levels whereby employer contributions are maximized and a participant’s total saving rate can reach at least 12% to 15% within five years. 

Moreover, given subdued return expectations over the next decade and more modest withdrawal rates, higher-income participants should focus on maximizing their contributions in their retirement plan as well as consider retirement savings options outside of the plan, Clark and Young add.  

The paper does emphasize, however, that it’s not possible to estimate retirement readiness from the current employer DC plan account balance because the current employer plan represents only a partial picture of retirement wealth and an assessment of retirement readiness requires a complete understanding of household wealth.