Pros and Cons of Opt-Out Employee 401(k) Plans

Retirement saving rightfully gets a lot of press, since it affects all of us. One of the most widely talked about retirement vehicles is the 401(k) plan, in which employees can make tax-deferred contributions to plans administered through their employer. It’s become the default retirement savings scheme for most people, replacing pensions, and there are actually a lot of options out there when it comes to 401(k) administration. One option that has come up a lot in recent years is the opt-out 401(k) plan.

What Is an Opt-Out 401(k) Plan?

An “opt out” plan is like any other 401(k) plan—the primary difference is in the administration and in employer automatic actions and responsibilities. With an opt-out policy, an employer automatically enrolls employees into the 401(k) plan and makes contributions out of their paycheck on their behalf, excluding only those who specifically opt-out of the program. This type of 401(k) administration is also sometimes called an “automatic 401(k)” or “automatic enrollment 401(k).”

This type of plan is meant to be beneficial for employees because it removes the inertia in getting a retirement account started. Getting started sometimes feels like half the battle.

It is at the employer’s discretion how to handle many of the details. For example:

• The employer can include an automatic escalation clause. This means the employee contribution level will automatically increase at set amounts each year. For example, a plan might include an initial contribution level of 3 percent of the employee’s salary, but increase by 1 percent each year for x years. Or the increase may continue until the maximum level is reached that the employer will provide matched contributions, or until it reaches the maximum amount that the employee can contribute by law.
• The employer can choose how much of an employer match to provide, if any. The employer can also opt (or not) to contribute to the plan (often at a percentage of the employee’s salary) even if the employee opts not to make their own contributions.
• Employers can choose whether to use the opt-out program only for new hires or for all employees not currently enrolled in the company’s 401(k).

Obviously, there must be clear communication about the plan and employees must acknowledge they understand they have the right to opt-out—otherwise, the employer would risk taking a wage deduction without permission. Employers that use automatic enrollment 401(k) plans have a responsibility to provide all plan information to all eligible employees and to understand their responsibilities in administration. The Department of Labor provides guidance.

Pros and Cons to Opt-Out 401(k) Plans

Pros

• The retirement savings accumulate for the employee even without any action. This generally results in a higher percentage of employee participation than opt-in programs.
• It can be an employee recruitment and retention tool.
• The employee still has control and can change any of the terms at any time, including opting out completely.
• The employee benefits from a decreased income tax obligation (regardless of whether there is any employer match on the contributions).
• With higher participation rates and increasing contributions, the employer may be able to negotiate a reduction on plan administration fees over time, especially if they can move into higher total investment tiers quickly.
• Employees benefit from tax-deferred investment growth.
• A 401(k) is often the only retirement savings an employee has.

Cons

• Fiduciary responsibility and investment liability rest on the employer. (There are safeguards in place with the Department of Labor and regulations that outline employer obligations to mitigate these risks).
• There are administrative obligations with any 401(k) plans, including employee communications and reporting to government agencies as well. Employers need to be sure they understand all responsibilities.
• Some argue that an opt-out program increases employee complacency about the plan, making it less likely to be changed in the future. This may mean:
• The employee may not change defaults, even if he or she would have preferred to contribute more or invest in different plan options.
  
• Employees may not take other proactive steps to ensure they have enough saved for retirement (though this may be true without the 401(k) enrollment as well).
• Some employees will opt-out if they don’t understand or think the savings rate is too high, rather than just changing the amount.
• Some employers offset the increased employee participation by offering lower matching contributions.
• The default investment option may not account for any given employee’s risk tolerance.

Note: This article does not constitute legal advice.
 

About Bridget Miller:

Bridget Miller is a business consultant with a specialized MBA in International Economics and Management, which provides a unique perspective on business challenges. She’s been working in the corporate world for over 15 years, with experience across multiple diverse departments including HR, sales, marketing, IT, commercial development, and training.