Pitfalls of automated retirement plans

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These days, workers don’t have to do anything to start saving for retirement. Is retirement investing getting too easy?

Employers have increasingly added automation features to their retirement plans since the Pension Protection Act became law in 2006. The law’s provisions aim to boost the rate of plan participation by encouraging employers to automatically enroll new workers in their plans. And it makes it easier for companies to offer target-date funds as a default option.

Currently, about half of companies that offer defined contribution plans — mainly 401(k)s — offer automatic enrollment to their employees. And one-third of those that don’t are thinking of doing so, according to a survey by Towers Watson, an employee benefits consulting firm. Ibbotson Associates reports that assets in target-date funds hit $256 billion at the end of 2009, up 61 percent in one year.

It’s working. Automatic enrollment is boosting participation rates. And target-date funds, which are rebalanced periodically and become more conservative over time, can eliminate dangerous asset allocation errors made by investors, who often tend to stay overweight in riskier equities as retirement nears.

Another encouraging development is employers that introduce automation also tend to increase the matching contributions that they provide to workers — sometimes substantially, according to a study by the nonpartisan Employee Benefit Research Institute, or EBRI.

But if you’re in a plan offering automatic features, don’t assume you’ll reach your retirement goals without some manual intervention on your part.

Override the automated features

For example, most plans featuring automatic enrollment set their initial default contribution rates around 3 percent, according to a survey by Towers Watson. That’s not enough to build real retirement security. Research by Vanguard Center for Retirement Research suggests that most savers need a total contribution rate ranging from 9 percent to 14 percent — including employee and employer contributions — to achieve retirement security.

At minimum, employees should try to set their rates high enough to match the employer’s top matching contribution. Otherwise they are leaving free money on the table.

Another problem is that 23 percent of these automated plans default employees into risk-averse balanced funds, according to Towers Watson. Balanced funds generally hold at least 25 percent of their assets in fixed-income securities at all times, according to Morningstar.

Many believe that’s an inappropriate choice for young investors who have many years to work before retirement and can tolerate a more aggressive approach.

“Automatic enrollment is a pretty good way to get people to start saving, but employers need to be careful how they do it,” says Robyn Credico, senior retirement consultant at Towers Watson. “If (companies) aren’t enrolling their employees at a high enough rate of savings and just use the plan’s default investment options, you aren’t really preparing people very well.”

Target-date funds criticized

Target-date funds have been another trouble spot in the realm of automatic retirement investing. Generally, a target date corresponds to the year in which the investor expects to retire. The fund manager adjusts the asset mix as the target year approaches, reducing the percentage of equities and increasing fixed-income investments to make the overall mix more conservative.

But these funds took heavy fire following the market crash of 2008, when target-date investors suffered large losses. Some funds with an imminent target date fell as much as 50 percent, according to Morningstar, prompting criticisms that the investment mix had been too aggressive.

The controversy prompted the Obama administration to call for target-date fund reforms, including measures aimed at boosting transparency and improving investor education about how these funds work.

“Participants don’t always understand target-date funds,” says Credico. “Employers are doing more now to communicate that target funds don’t offer a guarantee.”

One complication is that investment firms have different philosophies about the optimal equity exposure for retirees. “There are broad disparities among target funds in terms of asset allocation,” says Christine Benz, director of personal finance at Morningstar. “Some funds are far more aggressive than others. If you are in one of these funds, take the time to understand the asset allocation framework being used and how aggressive it is in its positioning.”

Benz adds that investors can get shortchanged because most of the widely available target-date funds are collections of the managing firm’s own funds — and they may not all be top performers within their class.

“Very few firms are equipped to manage all these asset classes well,” she says. “So do your due diligence on how the firm has done managing fixed income, domestic equity and international equity. Fixed income is especially important as retirement draws close.”

Benz recommends looking at the underlying mutual funds in your target-date fund and doing a quick check on their performance, length of tenure of the fund managers and expense ratios. “Equity funds should be charging less than 1 percent, and bonds should be less than 0.75 percent,” she says.