In South Africa, inflation complicates the setting of the increment. An aggressive increment, such as 2%, increases the chances of real take-home pay falling, while small increments may fall short of the contributions required.
In the case of individual need, research suggests that individuals with lower incomes tend to be less likely to opt out of a default – in other words, make a choice different from the default11. Yet, it could be these very individuals who can least afford higher contribution rates, and have the greatest need for take-home pay. So we need to ensure that individuals receive proper advice and communication around the impact of such defaults before they are implemented.
Another challenge with auto-escalation is in industries or companies with high employee turnover. If employees change jobs frequently and the firms that they join all use auto-escalation, they may be perpetually enrolled at the minimum contribution rate. Or worse, they may transfer into a fund without auto-escalation and the net effect of a low starting contribution rate with one employer together with an only average contribution rate with the next employer could also result in the individual being underfunded.
To avoid this, the starting contribution rate under an auto-escalation structure could be set by age. In standard auto-escalation, any new employee, whether 25 or 40 years old, would start at the minimum contribution rate. If the strategy is set around age, then a 25-year-old would start at the same rate as a model 25-year-old enrolled in the strategy, say 10%, while the 40-year-old would start at the same rate as a model 40-year-old, say 18%.
Given that as people age, their salaries tend to rise in real terms (up to a point), this still retains the benefits of auto-escalation. If the increase in contribution rate is structured to be a fixed annual increment, it does raise significant risk of take-home pay falling at some point. Because it is a default, individuals could choose to opt out of the structure at this point. However, as this is more likely at older ages when individuals become more aware of retirement, employees may be willing to stick with the strategy.
Despite its shortcomings, auto-escalation may work well in bargaining council funds, where members may remain within a single fund over their lifetime even though they may not always have the same employer.