LAST REVIEWED Feb 20 2023 7 MIN READ
A 401(k) contribution rate (or deferral rate) is the percentage of an employee’s wages deducted from their paycheck and contributed to their retirement account.
Plan sponsors may select default deferral rates for their 401(k) plans, which may positively impact employee savings rates.
Combining automatic enrollment, automatic escalation, employer match, and a strong default deferral rate can help incentivize all types of employees to save more for retirement.
What’s a 401(k) deferral rate?
401(k) contribution rates, or deferral rates, are among the most powerful levers of retirement savings. Deferral rates refer to the percentage of an employee’s paycheck deducted and transferred to their retirement account.
Higher deferral rates may increase the likelihood of a larger nest egg in retirement. For example, imagine someone wants to retire at 65. The individual is 30 years old, has $10,000 in retirement savings, earns $60,000 annually, and contributes 6% of his or her annual salary to their retirement. If income and contribution baselines remain consistent, we assume that the projected value at retirement is $220,405.20. However, if the deferral rate is increased by just two percentage points to 8.3%—which is the average deferral rate in 2021, according to the Plan Sponsor Council of America—the projected value at retirement increases by nearly $70,000 to $290,359.11.
How Human Interest can help
Technology has helped streamline 401(k) plan administration—which is great news for small business owners. Human Interest can help reduce your administrative burden and could drive costs down in the process. That way you can spend less time on back-end work and more time on what matters the most: running your business.
What's a 401(k) default deferral rate in an auto-enroll plan?
If an employer selects automatic enrollment, or auto-enroll, when designing their defined contribution plan, their eligible employees are automatically enrolled in the plan at a set deferral rate described in the plan (unless the employee decides to opt out manually). Auto-enroll is a powerful plan design feature that has been proven to increase participation in 401(k) plans. In a 2021 study from Vanguard, plan participants that had auto-enroll were three times more likely to contribute to their retirement plans than participants that did not have auto-enroll.
Additionally, employers that use auto-enroll may also be able to take advantage of tax credits of up to $500 per year over the duration of three years as a result of SECURE Act 2.0 (more on this below).
What’s a common default deferral rate?
The most popular default deferral rate in 2021 is 6%. Remember, the default deferral rate is the deferral rate that employers set in a retirement plan with auto-enroll. According to the PSCA, the 6% default deferral rate is a significant increase from previous default deferral rates. In 2006 alone, the average default deferral rate was 3%, which is the lowest default deferral rate that can be set with plans with automatic enrollment.
Default rates & matching contributions
A 2021 study found that default deferral rates could have more of an impact on retirement savings than an employer match. The study concluded that when retirement plans have high deferral savings rates, both low and high-income employees benefit because both groups are less likely to change their default savings rates due to behavioral biases such as psychological inertia. Psychological inertia is the phenomenon where people are more likely to stay with the default choice because it doesn’t require manual effort.
The study also found that an employer match by itself can lead to disproportionate savings across low and high-income employees. While an employer match can still be a highly attractive benefit to attract and retain employees, the study concludes that to promote more equal savings across employees of all income levels, it is advisable for employers to provide a high default rate and a high employer match as well.
SECURE Act 2.0 and default deferral rates
Signed into law in December 2019, the SECURE Act was designed to address the retirement crisis in the country through tax credits and other incentives to encourage small businesses to start a retirement plan. In late December 2022, SECURE Act 2.0 was signed into law, which added 90 provisions to the original bill.
SECURE 2.0 requires all new 401(k) and 403(b) plans established after December 29, 2022 have automatic enrollment and automatic escalation provisions in effect beginning with the 2025 plan year.The minimum default deferral rate is 3% (can be set up to 10%) and the annual auto-escalation rate is 1% (up to a maximum deferral rate of 15%).
Benefits of setting higher default deferral rates in auto-enroll plans
Employers have the ability to set the deferral rates for their retirement plans with auto-enrollment and can adjust the deferral rate through a plan amendment process. A higher default deferral rate can reduce employee indecision and nudge them to save more for retirement. With the average default deferral rate continuing to rise year over year, more employees are looking to save more for their futures. That’s why a high default deferral rate, which is typically above 7%, combined with auto-escalation, may help employees to maximize their retirement savings.
To multiply the effects of a strong default deferral rate and auto-enroll, we recommend that employers also utilize auto-escalation. Auto-escalation is a plan feature that incrementally increases the default deferral rate at a set percentage every year. Similar to auto-enroll, auto-escalation features may help encourage less proactive employees to save more for retirement.
Plan administrators should consider designing their retirement plan to include:
At least a 7% default deferral rate
A strong employer match
By combining all of these elements, employees of all types are at an advantage to save more for retirement. According to Human Interest’s estimates, if all plans required auto-enrollment with a 7% deferral rate, Americans could save up to $83 billion in just one year.²
The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.