Retirement account balances hit a record high the first quarter of 2017, with the total savings rate for 401(k) participants 12.9 percent, pushing the average balance to $95,500, according to research from Fidelity Investments.
The uptick was fueled in part by a gangbuster stock market, but there’s another factor at work: automatic contribution increases.
“Auto-escalation works to build retirement balances because it plays to human nature,” says Joannie Bozek, head of retirement services at People’s United Wealth Management in Bridgeport, Connecticut. “We don’t always do important things that are good for us in the long run but don’t show immediate results. Auto-escalation facilitates the important goal of increasing retirement savings with no effort on our part.”
Fidelity found that a record 27 percent of 401(k) investors increased their individual savings rate in the last 12 months. While slightly more than 16 percent of Fidelity’s 401(k) plans feature auto-escalation, it’s driving half of the savings increases for workers who raised their savings rate.
Following in their footsteps could put your retirement goals on the fast track.
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Start early. If auto-escalation is an option, use it sooner rather than later, says Mike Kojonen, owner of Principal Preservation Services in Minneapolis.
“For an employee to start auto-escalation right out of college, they’ll most likely reach 10 to 15 percent contribution limits by age 35,” Kojonen says. “Most employees who don’t take advantage of this feature won’t reach that contribution level until their 40s or 50s, losing several years’ worth of compound interest in the process.”
Running the numbers shows how much value auto-escalation can add to a 401(k) over time.
Assume that two 401(k) savers, both age 25 and earning $40,000, each contribute 6 percent of their pay to the plan. Both also receive a 2 percent raise each year and get the same 6 percent rate of return on their investments. But only one of them chooses auto-escalation, with the contribution rate rising 1 percent each year and maxing out at 15 percent of the person’s annual salary. By age 65, the employee not using auto-escalation would have saved approximately $513,000, while the employee using auto-escalation would have more than $1.1 million.
One of the biggest mistakes people make with their 401(k) is choosing the deferral percentage when they initially enroll and never revisiting their contribution amount, says Ronald Weiner, managing director and partner of RDM Financial Group at HighTower in Westport, Connecticut.
“Typically, people defer enough to receive the maximum match from their employer,” Weiner says, without considering how their retirement needs might change. Auto-escalation, he says “takes the thought of increasing the amount saved off the table and makes it happen.”
Choose the right baseline. Where you set your initial contribution rate matters, and the ideal number is different for every person, says Nathan Fisher, managing director of 401(k) solutions at San Francisco-based Fisher Investments.
“Generally, my advice is to save 5 percent of pre-tax at the beginning of your career, 10 percent in the middle and 15 percent as you draw closer to retirement,” Fisher says.
At a minimum, you should contribute enough to qualify for the full company match, if one is available.
“If your company matches 50 percent on the first 6 percent of salary you contribute, that boosts the overall contribution to 9 percent of your salary,” says Tom Foster Jr., assistant vice president of relationship management for MassMutual’s Workplace Solutions unit in Enfield, Connecticut. “That’s a 50 percent return before any investment gains. It’s free money.”
To determine an appropriate contribution rate, review your income and expenses, and remember, Bozek says, you can opt out of auto-escalation if it doesn’t fit your budget.
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Beware the pitfalls. Although a powerful tool for increasing your 401(k) balance, auto-escalation isn’t a perfect solution for everyone.
“The downside of setting up auto-escalation could be if you’re on a pay freeze and are stuck at the same income while your contributions increase,” Kojonen says.
That means your take-home pay continues to shrink, which won’t be sustainable, especially if inflation keeps nudging your expenses higher.
Auto-escalation may also lull savers who make frequent job changes into a false sense of retirement security, Fisher says. Changing jobs makes it difficult to harness the full power of auto-escalation long term so that you may end up underfunding your retirement instead.
Even if you plan to stay put at a company, there are additional downsides to consider.
“One potential drawback is not escalating to a high-enough savings level. Another is forgetting to rebalance your account over time as you approach retirement,” Foster says.
Your age also plays a role. When you’re younger, what counts most is how much you save. By your 50s, the priority shifts to how you invest.
At this stage, Foster says, you should begin thinking about moving to a more conservative mix of investments. With auto-escalation, however, there’s a tendency to set it and forget it, which can cost you if a market correction occurs and your portfolio isn’t balanced properly.
A lack of liquidity is another consideration, says Jeremy Shipp, managing partner of O’Dell, Winkfield, Roseman and Shipp in Richmond, Virginia.
If all your savings are going into a 401(k), you may have to borrow against your retirement to cover an emergency that requires an outlay of cash, Shipp says.
Someone with no savings outside of retirement accounts should lower the auto-escalation rate temporarily and use the difference to build an emergency fund.
Use pay raises to escalate your savings. If your 401(k) doesn’t have an auto-escalation plan, create your own. “Whenever you get a raise, increase your 401(k) contribution level accordingly so your take-home pay remains the same,” Shipp says.
Or, Shipp says, increase your contributions by half your raise amount. The goal is to eventually contribute the maximum amount to the plan. That limit is $18,000 in 2017, with an additional $6,000 in catch-up contributions for people age 50 and older.
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Whether you use your employer’s auto-escalation feature or auto-escalate on your own, make your savings work for you.
“Ask your employer about low-cost investment options and ongoing education to make sure you’re making the best decisions for your age, risk tolerance and overall objectives,” Bozek says.
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Build a Better 401k Balance With Auto-Escalation originally appeared on usnews.com
