Opt-Out Plan: What It is, How It Works, Pros and Cons

What Is an Opt-Out Plan?

An opt-out plan is an employer-sponsored retirement savings program that automatically enrolls all employees into its 401(k) or SIMPLE IRA. Companies that use the opt-out provision enroll all eligible employees into a default allocation at a set contribution rate, usually around 3% of gross wages.

Employees can change their contribution percentages or opt-out of the plan altogether. They also may change the investments their money goes into if the company offers choices.

Understanding the Opt-Out Plan

Employers set some of the rules for opt-out plans.

Some allow employees to withdraw their automatic contributions, including any earnings, within 90 days of their first automatic contribution. Some also permit employees to effectively borrow some of their own money and repay it over time in order to avoid tax penalties for early withdrawals from retirement funds.

Employers may also automatically increase the default contribution rate every year that an employee participates in the plan, up to a maximum of normally 10%. This also may be changed by the employee.

Matching Contributions

An employer may offer a matching contribution. This is a substantial employee benefit. For example, the employer may match the employee's contribution dollar-for-dollar up to a certain percentage. A 3% employer match is a common amount, but employers can offer more or less.

Employers need to abide by certain federal rules when offering these types of plans. For example, all employees must be 100% vested after no more than three years of service if cliff vesting is used and no more than six years with graded vesting. Employees need to be offered opportunities to change their investment choices periodically.

An opt-out plan must spell out all rules to employees, provide notifications and disclosures, and execute the plan uniformly among all those who are eligible. 

Pros and Cons of an Opt-Out Plan 

Many workers in the U.S. do not sock away nearly enough for retirement, and some save nothing. Knowing this, some companies enact opt-out plans in an effort to boost the number of employees who save.

Opt-out plans tend to raise participation rates. However, they are set at contribution levels that are too low to meaningfully help the employees in retirement. Employees who don't proactively change their contribution levels may under-invest over the long term. Without a periodic reminder that a 3% contribution, for example, is just a starting point, many may not save enough in the long run. 

While opt-out plans may encourage wider participation in retirement savings plans, they may leave those participating at lower contribution rates. To counter this possibility, some employers raise the employee contribution rate by 1% each year, with 10% being the usual maximum.

There are other ways employers can encourage retirement contributions. Raising the company match is one of them. Most employees who have retirement savings plans know that failing to save enough to take advantage of the full company match is just "leaving money on the table."