Automatic Escalation: Helping Employees Save More Over Time

Automatic enrollment gets employees into the plan at a default contribution rate. Without anything to move that rate up, many employees stay at the starting rate for years, sometimes for their entire career with the company.

Automatic escalation, often called auto increase, addresses that. It raises each participant's contribution rate gradually on a set schedule until it reaches a cap, while leaving employees free to change or stop the increases at any time.

How it works

A typical design looks like this:

• The participant's deferral rate increases by a set amount, often 1% of pay
• The increase happens on a set schedule, often once a year
• Increases continue until the rate reaches a cap set by the plan
• Participants receive notice before increases take effect and can opt out or choose a different rate

Why it matters

Default rates such as 3% or 4% are meant as a starting point, not a destination. Many retirement planning guidelines suggest total savings, combining employee and employer contributions, well above those levels for employees who want to maintain their lifestyle in retirement.

Asking employees to jump from 3% to 10% all at once rarely works. Small annual increases are easier to absorb, especially when they line up with a raise.

Behavioral economists Richard Thaler and Shlomo Benartzi popularized this approach with a program called Save More Tomorrow, which asked employees to commit in advance to saving more when they received future raises. The underlying idea is simple: people are more willing to save more later than to save more now.

Design decisions

Sponsors have several choices to make.

Increase amount. One percent per year is common, but plans can choose other amounts.

Timing. Increases can happen on the plan anniversary, on January 1, on each employee's hire anniversary, or at the same time as annual raises. Aligning increases with raises means employees often see little or no drop in take-home pay.

Cap. Many plans cap escalation somewhere between 10% and 15%. A higher cap leads to more savings for employees who stay with the default, while a lower cap may feel less intrusive.

Who it applies to. Escalation can apply only to employees who were automatically enrolled, or to every participant contributing below the cap, including those who chose their own rate. Applying it broadly reaches more people, but some employees who made a deliberate choice may be surprised by increases, so communication matters.

Opt-in or opt-out. Some plans make escalation automatic, while others offer it as a feature participants can choose to turn on. Opt-out designs tend to reach more people.

SECURE 2.0 requirements for new plans

Under the SECURE 2.0 Act, many 401(k) and 403(b) plans established after December 29, 2022 must include automatic enrollment with automatic escalation, beginning with plan years that start after December 31, 2024. Those plans must increase the default rate by 1% each year until it reaches at least 10%, with a maximum of 15%. Plans established before that date, small businesses with 10 or fewer employees, and businesses in existence for less than three years are among those exempt.

Safe harbor automatic enrollment plans, known as qualified automatic contribution arrangements or QACAs, also follow a minimum escalation schedule set by the tax code.

Operational considerations

Automatic escalation is only as good as its execution:

• Payroll must apply increases on schedule. Two-way payroll integration with your recordkeeper reduces the chance that increases are missed.
• Notices must go out on time. Participants need advance notice and a reasonable chance to opt out.
• Opt-outs must be tracked. An employee who declined an increase should not be increased again unless the plan design calls for it and they have been notified.
• Errors should be corrected promptly. The IRS correction programs include simplified correction methods for automatic escalation errors that are caught and fixed quickly.

Cost considerations

If your plan includes a match, higher deferral rates can mean higher matching contributions, up to the limit of your match formula. Before adopting escalation, it is worth modeling how many employees are likely to stay with the default and how the increases interact with your match.

Communicating the increases

Employees are more likely to stay with escalation when they understand it. Notices should explain when increases happen, how large they are, and how to opt out. A short reminder a few weeks before each increase reduces surprises on payday and gives employees a natural moment to review their savings.

Want a second look at your plan's escalation design? Brian Williams, CPFA®, of Northshire Consulting LLC | Registered Investment Advisory Firm meets with business owners to review plan design. Call 203-401-6062, email bwilliams@northshireconsulting.com, or visit northshireconsulting.com to schedule a plan review.

Frequently asked questions

Can employees stop automatic increases?

Yes. Employees can opt out of future increases or choose a different contribution rate at any time.

Does escalation apply to employees who picked their own contribution rate?

It depends on how your plan is designed. Some plans apply escalation only to employees who were automatically enrolled, while others apply it to everyone below the cap.

What happens when an employee is already above the cap?

Nothing changes. Escalation only affects participants contributing below the cap set by the plan.

This material is for educational purposes only and is not individualized investment, tax, or legal advice. Advisory services are offered through Northshire Consulting LLC | Registered Investment Advisory Firm.