Second Thoughts on Automatic-Enrollment Retirement Plans
The case for boosting retirement savings by automatically enrolling workers in tax-deferred retirement plans is often thought to be unassailable. Oregon, Illinois, and California have recently passed laws requiring employers who do not offer retirement plans to automatically transfer a fraction of employees’ paychecks to an individual retirement account (IRA). Similar “auto-IRA” legislation is in the works in other states. Nobel-prize winning behavioral economist Richard Thaler recently tweeted: “There is no coherent argument against these state plans.”
My research collaborators and I beg to differ. In our recent Journal of Retirement article, Jason Scott, John B. Shoven, John G. Watson, and I show that saving for retirement may not be in the best interests of many – if not most - young people, who have more pressing spending needs. Therefore, automatic enrollment programs that boost saving across the board, regardless of age and circumstance, may do more harm than good.
The rationale for automatic enrollment is based on the premise that while people should save for retirement, they often don’t because they have difficulty with planning or lack self-control. Automatically enrolling them in a retirement plan leads to increased participation rates because people suffer from inertia and tend to stick with defaults: once they’re automatically enrolled, they’re unlikely to opt out.
But arguing that people should be saving more for retirement requires a benchmark that tells us what optimal saving behavior looks like. For this, many economists turn to what’s known as a “life cycle model.” In a standard life cycle model, fully rational individuals earn wages during their young and middle-aged years and are retired in old age. They have the option of saving money during their working years, by spending less than their earnings, and drawing down on their savings during retirement. Our recent study shows that in this model, retirement saving is unlikely to start until middle age.
First let’s consider typical higher-income, college-educated workers. These workers’ starting salaries are relatively low, but their earnings increase rapidly as they progress through their careers. Given the difficulties involved in borrowing against future earnings, these workers are restricted to spending no more than their current earnings when young. In the life cycle model, additional dollars of spending are assumed to be more highly valued in years when spending is relatively low. That’s a reasonable assumption because when spending is relatively low, any additional dollars are spent on goods and services that are crucial for well-being (e.g., food, rent, or student loan payments). Saving for retirement when young therefore requires giving up spending that’s highly valued – that’s not worth it even with a generous employer match.
Next, let’s consider typical lower-income workers, whose earnings mostly stay constant over their careers. Social Security benefits replace a relatively high share of these workers’ earnings. That’s because of the progressive Social Security benefit formula: people with higher career-average earnings receive higher monthly benefits in dollar terms but lower monthly benefits as a share of their earnings. Social Security replacement rates for these lower-income workers are high enough that they don’t need to save much for retirement to maintain their standard of living. Moreover, interest rates, net of inflation, have been quite low for more than a decade – and remain low despite recent rate hikes. Thus, the rate of return on any retirement saving is quite low, which tilts the balance in favor of spending money while young. We show that lower-income workers begin to save in middle-age and accumulate low levels of wealth.
If fully rational young workers were automatically enrolled in a retirement plan, they’d opt out immediately. But the whole premise of auto-enrollment is that people aren’t fully rational – and indeed, research shows that a large fraction of young people who are automatically enrolled do not opt out. To quantify the harm done to these young workers, we consider a 25-year-old who is automatically enrolled in a retirement plan and passively sticks with it for five years. Following that period, the worker “wakes up,” cashes out of the account, and then begins to save in accordance with the life cycle model. We show that these workers would need to receive an extra 27-37 percent of their annual salary, upon waking up, to compensate them for the lost consumption during those five years.
Automatic enrollment has been gaining steam over the past two decades. Federal legislation passed in 2006 incentivized employers to adopt automatic enrollment in their 401(k) plans, and the bipartisan SECURE 2.0 Act might, if passed, mandate automatic enrollment for new employer-sponsored retirement plans.
To be clear, nothing in this research suggests that we should have no policies to boost retirement saving. On the contrary, such policies could benefit middle-aged workers. But the idea that more retirement saving is always better – regardless of age and circumstance – needs to be challenged.
Sita Nataraj Slavov is a nonresident senior fellow at the American Enterprise Institute and a professor at the Schar School of Policy and Government at George Mason University.
