When Auto-Roth Accounts Make More Sense

Automatic retirement plan features have put significant numbers of employees in the U.S. on a path towards retirement readiness, but employers could still do a lot more to overcome participant inertia.

This is according to a new white paper published by Janus Henderson, “Defined Contribution Redefined.” According to Janus Henderson researchers, since the enactment of the Pension Protection Act of 2006 (PPA), automatic features have become common within defined contribution (DC) plans such as 401(k)s, 403(b)s and 457s. In particular, the main trio of automatic features—auto-enrollment, auto-escalation and automatically diversified qualified default investment alternatives (QDIAs)—have helped increase DC assets from $3.0 trillion in 2007 to $5.3 trillion in 2017.

“Now that these automatic and default features have gained widespread acceptance, it may be time to consider additional steps to further enhance participant retirement preparedness,” the white paper says.

Most plans with auto-enrollment offer it to new hires (94.5%), while approximately one-quarter (25.4%) have auto-enrolled existing employees either as a one-time sweep or periodic sweep. According to the white paper, anecdotal evidence suggests the vast majority of auto-enrollment programs fund only pre-tax accounts. This is despite the fact that for younger, lower-income employees, funding a Roth account may be a more appropriate long-term option.

“While contributions are made with after-tax dollars, the earnings can potentially accumulate tax free for many years. Further, younger, lower-paid employees are likely in a lower tax bracket, so the tax advantages of pre-tax deferrals are muted,” the white paper says.

Janus Henderson researchers consider a theoretical 25-year-old in a 20% effective federal tax bracket.

“Contributions of $2,500 a year for 10 years will grow to $32,951, assuming a 6% annual rate of return. If no additional contributions are made, the balance will grow to $189,253 by the time the investor reaches age 65,” the white paper says. ‘Distributions from a Roth will be tax free, while distributions from a tax-deferred account will result in an after-tax distribution of $151,403. In this case, the Roth provides a more valuable retirement benefit, even after accounting for the annual $5,000 tax savings over 10 years ($2,500 x 20% = $500/year).”

According to Janus Henderson researchers, another innovative strategy that employers should consider is linking automatic escalation to retirement income replacement projections. Citing a previous Callan survey, the white paper says approximately 70% of all nongovernmental plans offer auto-escalation, up from 48% in 2014. Further, the number of plans that use an opt-out approach also grew from 52.8% in 2014 to 70.8% in 2017.

“The vast majority of plans automatically increase deferrals by 1% per year (86%), with a median cap of 15% of compensation,” the white paper says. “About half of companies selected their cap because it was likely to be most palatable to participants or limit opt-outs, while one-third felt it would maximize the likelihood participants reach their retirement goals.”

While automatically increasing deferrals annually should help participants accumulate larger balances at retirement, a uniform 1% approach may not help some participants adequately replace their pre-retirement income, Janus Henderson researchers warn.

“For example, older employees have fewer years to accumulate savings. If these employees do not have substantial account balances, they may require both a higher starting deferral rate and more aggressive annual increases to meet their retirement goals,” the white paper says. “Even younger employees may fall short unless prompted by their employer to increase deferrals at a faster rate.”

When it comes to automatic investments, while most plans use target-date funds as their default, 75.2% offer a managed account option. In these cases, the vast majority (92.6%) offer it as an opt-in feature whereby participants must proactively elect to use the feature similar to any other investment decision.

“According to Callan, only 13.3% of sponsors pay for the managed account fee, with the majority assessing the costs directly to the participant or shared by the sponsor and participant,” the white paper says. “Given the sensitivity to the additional cost of a managed account, it is understandable why many sponsors have elected to use a target-date fund as their plan’s default option.”

As the white paper points out, Morningstar and others posit that in some cases, the higher fee associated with managed accounts may be justified, particularly for older participants with significant balances.

“A hybrid or dynamic solution is suggested whereby younger participants are defaulted into the plan’s target-date fund but later defaults participants into the managed account solution upon reaching a specified age,” the white paper says. “Choosing an appropriate age would depend upon each plan’s unique participant characteristics.”

The paper notes that few DC providers currently offer the ability to facilitate a dynamic QDIA approach; however, the marketplace will likely evolve to meet future plan sponsor demand, according to Janus Henderson researchers.