Why automatic enrollment in 401(k)s might not always be for the best

In August 2006, Congress passed the Pension Protection Act of 2006, which included a provision to allow automated enrollment in 401(k) plans (as well as similar plans like 403(b) and 457 plans). With nearly 30% of employees failing to sign up in 401(k) plans, many Americans are failing to adequately prepare for a pension-less retirement and often even missing out on ‘free money’ in the form of employer matches. So a law that allows companies to automatically enroll employees at a pre-set level (say, 3%) and then may (or may not) increase that contribution over time. The employee can usually opt-out within 90 days of being enrolled and get that money back.

So why would this be a bad idea?

  1. Automated enrollment gives people a false sense of confidence. Because of the lack of financial education in this country, a lot of people may not be aware that saving 3% of their income will not be enough to fund their retirement. If an employee who’s generally unaware of finance issues is told that there’s a default rate of withholding for the 401(k) program, I think they would be likely to “let it ride” and assume that 3% was a reasonable amount.
  2. Too many companies don’t offer an automatic increase. Currently only 17% of companies offering automatic enrollment also increase the rate of savings, usually by 1% per year. Since companies typically match some or all of the contribution up to 6%, I consider that a cynical move to “do something” but not to go the extra mile.
  3. Automatic enrollment forces some people into an arena they don’t know much about, the market. While many companies will use lifecycle funds or index funds for their 401(k) programs, others offer company stock or expensive managed funds. I have seen some terrible choices offered in 401(k) programs, with annual fees up to 3% (compared to the sub-1% fees charged by most Vanguard funds). An employee who isn’t fully educated on the effect of fees and who doesn’t understand how that could eat up gains is likely to take a quick, 5 minute glance at funds and throw money at the one with the highest return – which is almost never, ever shown net of fees. No-one expects you start betting your life savings on a poker match if you don’t know how to play poker, so why should you expect yourself to bet your life savings on investing if you don’t understand the market?
  4. Automatic enrollment continues our nation’s long-standing (and bad) habit of requiring employer-specific remedies for individual problems. My personal opinion is that an employee’s savings should be completely separated from an employer’s control. If the employer isn’t willing to take the responsibility to set up a pension program and pay for your retirement, why should they have control over where you invest your money? Wouldn’t it be simpler to eliminate 401(k)s and increase the amount anyone can contribute to an IRA, tax-free, to $20,000 per year? Then you could control where your money was held, what it was invested in and when you invested it. Most IRAs allow you a very broad range of investment options, and some even let you go outside the stock market and use IRAs for real estate or foreign currencies if you desire. A 401(k) typically locks you into a very limited set of choices determined by the employer or the employer-chosen plan administrator. Once you leave that employer, you can roll your money out into an IRA, but as long as you stay with that employer, your investment choices are determined by your employer, not you.

The solution is, as with any investment problem, simple but requires self-motivation. If your employer offers a 401(k), either automated or not, how should you approach it?

  1. Calculate how much money you’ll need for retirement on your own. Don’t rely on your employer’s default rate. At a minimum, you should always contribute enough to receive an employer match, if it’s offered. If possible, you should max out your contributions, particularly if you’re in a high-tax area.
  2. Study your choices, and not just the literature they give you. If your plan offers you a choice of funds, study them all. Go beyond the historical returns, which don’t tell you much about future returns. Consider the fees, particularly, because although the returns may vary, those fees won’t! If a fund charges a 3% fee, you’re going to be charged that whether the fund return is 28% this year or -8%. Go to Morningstar or use Yahoo! Finance to study the funds.
  3. Diversify. If your fund offers company stock, don’t put all of your eggs in one basket. You have already locked up a significant portion of your net worth – YOU – by being an employee of that company. Use the same approach you would use if you were moving a large set of china plates. Would you pile everything in one huge box and hand it to the movers, so if they drop it you lose the whole set? Probably not – you’re going to put it in several smaller boxes, well padded and light enough to carry easily.
  4. Monitor your investments. I am as guilty as everyone else in this category – I check the accounts I “control” such as my IRAs and brokerage accounts on a regular basis, but I tend to let my 401(k) ride. If you are enrolled in an automated plan, you are doubly required to carefully watch your money – what is the contribution rate, where is it being put, how much matching money are you leaving on the table, what are your returns? Be careful, and don’t automatically assume that your employer is watching out for YOU.

Just remember that whether or not a 401(k) is automated, you should always consider investing in a 401(k) before almost any other form of investment for this reason: it takes money away from you before you ever see it (the “pay yourself first” concept), it is tax-advantaged and typically gives you “free money” in the form of a contribution match by your employer. Just make sure that you keep an eye on automated investments, and don’t let this be one more thing that you let your employer control for you rather than with you.