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Automatic 401(k) plans still require decisions

Sometimes you have to be pushed into doing something that's good for you, such as investing in your company's 401(k) plan.

Employees frequently have a lot of excuses for not enrolling in their company's 401(k) program. Some people are spread too thin -- too many bills, not enough money. Others think they're too young to worry about saving for retirement. And then there are employees who just don't care.

That's why some companies have started 401(k) plans in which employees are automatically enrolled unless they specifically choose to opt out.

Studies have demonstrated that the approach leads to far greater participation in the programs.

Pushing people to save
However, experts say, many of the employees need another push. The employees aren't making the best of the situation; and most of the companies aren't doing anything about it.

The problem is that most automatically enrolled employees stay with the contribution rate and investment options selected by the company, called defaults, rather than increasing their contributions and taking on more risk to get a better return on their investment. These defaults are deliberately ultraconservative, and usually not the best choices for a long-term investor.

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A recent study showed that even after three years, half the employees who had been automatically enrolled continued to contribute at the default rate and put their money in the default investment.

Long-term participation in a 401(k) plan is the best opportunity most people have for ensuring they have enough money to last what could be 30 years of retirement. There may be no faster way to build a nest egg, thanks to tax-deferred savings and, in most cases, an employer match.

But investing minimal amounts in money market funds, as default selections often do, won't build your retirement fund very quickly.

Most companies set the so-called default contribution rate for automatically enrolled employees at a fairly low amount such as 3 percent. The default investment option is usually something very conservative such as a money market fund.

"The last thing an employer wants to do is take $20 out of someone's paycheck and the employee looks at their statement and sees their investment is down to $19," says Steve Utkus of Vanguard's Center for Retirement Research.

But Brigitte Madrian, associate professor of economics at the University of Chicago and co-author of the 401(k) study, says companies need to do more than just automatically enroll employees.

"The big problem is 401(k) plans are designed with the assumption that people want to take charge of their retirement savings. Some people want others to make the difficult decisions for them. The plans don't work for those employees.

"Companies need to think about ways to structure their plans so they help employees who don't want to take charge. Investing is complicated. A significant portion of the population doesn't understand which investments are less risky and which are more risky."

About 15 percent of the 1500 companies that use Vanguard to manage their 401(k) plans have automatic enrollment.

Education and encouragement
Utkus says there are two solutions. One, an ongoing educational campaign directed at people in the default rates and investment options, takes time and energy on the part of the employer.

"It's a lengthy and time-consuming process. The employer has to commit to doing it over many years. It's a perpetual problem as new employees come on.

"The other option is on the savings side. Allow participants to automatically have their contribution rate go up by 1 percent every year. It's the "save more tomorrow" concept. You set up a savings plan designed to step up savings over time. We've tested it with a client and we're rolling it out to others," says Utkus.

Utkus also suggests companies choose a different investment default: a balanced fund or lifestyle fund that includes stocks, bonds and money markets, and adjusts the risk allocation based on the age of the participant.

Convenience store giant 7-Eleven automatically enrolls employees on their one-year anniversaries into what amounts to a portfolio of stocks, company real estate and other investments.

"We don't have financial education because employees don't have investment discretion," says benefits manager Margaret Fuller. "But we send them a reminder 45 days before their first anniversary.

"There's a bar chart that shows their projected balance over a period. We also take their last pay check stub and reproduce it to show the actual change to their net pay, because a lot of people hear 3 percent and think more comes out of their take-home than really does."

7-Eleven employees can opt out of the program or they can elect to contribute up to 6 percent of their gross pay. Employees who do nothing are automatically enrolled at 3 percent.

Fuller says the company started automatic enrollment in 1997 and the participation rate in the 401(k) is 72 percent, up from 57 percent prior to automatic enrollment.

Company concerns
While increased participation benefits a company's 401(k) plan in many ways -- it helps the company meet nondiscrimination tests, for example -- employers are also concerned about the cost of automatic enrollment.

"They say, 'What do I do if I end up with all these accounts with 3 percent in them,'" says Utkus. "You create all these accounts, go to a vendor and pay fees on them. There are higher administration fees to pay for all these small accounts."

There's also a question as to whether companies put themselves at risk if the default investment option loses a significant amount of the employees' money.

"Employers perceive there to be a liability risk, but it's more imagined than real," according to Utkus. "But it's the frivolous lawsuit that worries them."

Ironically, it's believed that while automatic enrollment gets more people into the plan, it may actually hurt some employees in the long run financially.

"If the company chooses a lousy default, it works against employees who might have gotten their act together and chosen a better option down the line," says Madrian.

"The vast majority of employees who enroll in a 401(k) choose a contribution rate equal to the company match or higher. If an employee isn't automatically enrolled, it might take them longer to get signed up, but they'd probably pick a higher contribution rate and a more aggressive allocation."

The best thing would be for more employees to become active participants in managing their 401(k). That's a viable option for some workers but not for all, according to Vanguard's Utkus.

"Only about half of the population in a retirement plan has all the characteristics you want -- forward thinking, confident about making decisions and actively interested in managing their money. We're coming to realize that there isn't a single target participant. There should be an option for the participant who makes few decisions, if any. That choice doesn't exist today."

Utkus says he doesn't expect a lot of companies to join the automatic enrollment bandwagon until the economy turns around. Employers who have been battered by the rough economy don't want to be responsible for additional matching contributions.

-- Posted: July 14, 2003
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See Also
FAQ about 401(k) accounts
Employers can now offer more 401(k) advice
Financial advice glossary
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