When investing in a 401(k) plan, many participants are unsure about what percentage of their salary they should contribute.
- Select an amount too low, and they risk not having sufficient savings for retirement.
- Select a percentage too high, and they fear not being able to meet current needs.
However, the reality is that increasing 401(k) contributions by just 1% to 2% will have a minimal impact on take home pay, while making a significant difference in the value of the participant’s account over time.
The Difference A Percentage Increase Makes
- For example, a 35-year old participant earning $50,000 elects to have 3% of her salary invested in her new 401(k) plan.
- Her employer matches 100% of her contribution.
- After 30 years, (factoring in an annual salary increase of 3%), she has contributed a total of $71,363 which is matched by her employer.
- Assuming an average rate of return of 8% over 30 years, the total value of her 401(k) has climbed to $503,444.
However, as the table below shows, if she increases her contribution by 1% to 4% of her salary, she will enjoy an additional $83,907 at the end of 30 years and grow her account to $587,352.
The Impact of Increasing Contributions
| Participant contribution | 3% | 4% | 5% |
| Employer match as a % of contribution | 100% of up to 3% | 100% of up to 3% | 100% of up to 3% |
| Cumulative participant contributions | $71,363 | $95,151 | $118,939 |
| Cumulative employer contribution | $71,363 | $71,363 | $71,363 |
| Total account value in 30 years | $503,444 | $587,352 | $671,259 |
If she increases it by two percentage points to 5% of her salary she could enjoy an extra $167,815 and grow her account to $671,259.
Engaging Participants
When you do the math, it is clear that increasing contributions by even 1% – 2% can reward the participant over time. Encouraging an employee to add an additional percentage every time they receive a raise or bonus is one way to start. Implementing an automatic escalation feature in a 401(k) plan is another.
Automatic escalation increases participant contribution rates by a particular amount each year, such as 1%, until it reaches a predefined maximum. This takes the burden of choosing whether or not to increase contributions away from the participant, making a gradual increase over time automatic and easier to implement.
What to Know About Automatic Escalation
- Plan sponsors are free to choose the maximum automatic escalation contribution percentage for their plan. To determine this cap, they may want to factor in workforce demographics and chose a maximum percentage that will not compromise employee’s current income needs.
- Plan sponsors can select any initial default contribution rate and are not required to tie the rate to the plan’s matching contribution formula in any way. The initial default contribution rate could be less than or more than the plan’s maximum matching contribution percentage.
- Plan sponsors can choose any auto escalation step-up rate, taking into consideration the plan’s goals. While a 1% annual increase is often used as a step-up rate, plan sponsors are free to use a higher rate, depending on the demographics of their workforce.
To discuss ways to encourage and communicate the value of increasing contributions over time to participants, contact your Alliance Benefit Group Representative.
