Riding the Contribution Rate Escalator to Retirement
Automatic Contribution Increases Can Have a Big Impact on Savings
Have you ever had good intentions to take action on something important in your life but you never got around to getting the job done? If you said “yes” you are not alone! I’ve had those good intentions to start a new workout regimen for a few months but have simply been unable to keep things going with any consistency. In the real world, this lack of action is often labeled as procrastination, forgetfulness, present bias, or good ole fashioned laziness.
Behavioral finance experts refer to this as inertia.
Lack of action or “inertia” is not an option if you ever want to achieve a sense of true financial independence or what most financial planners refer to as “retirement”. There are no shortages of personal finance articles and blogs out there to encourage us to contribute to a retirement plan. A growing body of academic research has identified that the majority of Americans are at risk of not being able to maintain their current standard of living during retirement (see the Center for Retirement Research). Confidence in our own retirement preparedness is also pretty low. According to Financial Finesse, only 19 percent of workers believe they will be able to reach their retirement income goals.
While most of us understand the need to save more for retirement, the problem we run into is often related to the fact that it is hard to balance other priorities in life that are competing for our same hard earned dollars.
It’s also easy to tell ourselves that we will save more in the future only to see the days pass by with no real change being made.
Fortunately, retirement plan providers have helped make it easy to automate the process of increasing our contributions to 401(k) and 403(b) plans. The concept is rather simplistic by design but can have a significant impact on your long-term retirement outlook.
The contribution rate escalator feature (also referred to as “automatic rate escalation”) allows retirement plan participants to control the amount and timing of future contribution increases.
Many companies automatically enroll new hires into retirement plans with the ability to opt-out of contribution rate escalation. But it is often a smart idea to stick with those automatic increases for your contributions to the 401(k) or 403(b) plan. If you didn’t automatically enroll in a retirement plan at work recently you should review your current plan to see if you have contribution rate escalation available.
Here Is an Example of How It Works:
Holly is 25 years and recently finished graduate school with an MBA. She understands the need to save for retirement but has student loan payments and other debt obligations creating a tight cash flow situation. She worked with us to run a quick retirement estimate and determined that she would need to save 17 percent of her salary to meet her goal of becoming financially independent by the time she reaches 55. The problem is that she is only saving 4% of her salary today which is exactly how much her employer will match. With a "set it and forget it" approach she may still be contributing 4 percent a decade later.
However, let’s assume Holly elected a contribution rate increase of 2 percent a year that coincides with an annual pay increase. After 8 years of giving her contributions a boost, she would have gradually increased her 401(k) contributions from 4 percent of her pay to 20 percent.
The original plan didn’t have a horrible outcome — assuming her income is 50k per year, paid bi-weekly with 2 percent annual increases, in 10 years she will have accumulated approximately $59,000 by age 35 and $405,000 by age 55 assuming 6 percent average annual returns. However, those 2 percent annual contribution rate increases for the next 8 years would result in approximately $60,400 of extra retirement savings in 10 years and over $626,000 in 30 years, making up the shortfall she needed. Because her increases coincided with annual pay increases she never really felt any major changes in her take home pay.
Estimate the Benefits of Automatic Rate Escalation
There are a variety of retirement calculators that help you estimate the benefits of participating in a contribution rate escalator program. Here are a few helpful tools to consider:
CalcXML: What is the impact of increasing my 401(k) contributions automatically?
Retirement Account Contribution Accelerator (contribution accelerator calculator from Prudential)
The best part of contribution rate increases within retirement plans is that they help automate smart savings behavior. They also provide flexibility. If your financial situation changes throughout the course of the year, most retirement plans allow you to make changes at any time. You have the flexibility to change your contributions by increasing or decreasing them. Most retirement plans that offer an automatic rate escalation feature also allow you to stop participating in the program at any time.
Be sure to check with your employer to find out more details about important features of your 401(k) or 403(b) plan such as the contribution rate escalator. If you do not have a retirement plan at work you may need to take a few extra steps but the same concept works with individual retirement accounts. Just set reminders on your Smartphone or calendar reminding you to increase Roth or traditional IRA contributions.
Saving enough for retirement doesn’t have to be a mission impossible scenario. A few small changes today can result in big changes later on in life. So don’t let inertia rule the day and make your retirement savings automatic!