Automatic 401(k)s Lower Retirement Savings

Last Updated Jul 12, 2011 9:05 AM EDT

401(k) plans today are the main way for workers to save for retirement. But as popular as they are, there are several 401(k) plan downsides. 401(k) plans require workers to make four very important decisions: when to enroll in the plan, how much to contribute, how to invest contributions and how to manage the account. The problem is that a lot of folks don't take the steps to join these plans at the earliest opportunity and they fail to diversify and manage their accounts. These failings cost workers thousands of dollars in reduced savings for retirement.

The good news is that more employers have made changes to their 401(k) plans to help their workers. The biggest change to hit 401(k) plans is the Opt Out 401(k) , where enrollment into the plan is automatic as soon as an employee becomes eligible to join. This simple change takes advantage of the power of inertia. Newly hired employees are automatically enrolled into the 401(k) plan and they have to take an action to "opt out" to discontinue contributing if they do not want to enroll. Automatic enrollment into 401(k) plans has proven to increase the number of employees who participate in plans with this feature.

One would think that 401(k) plans should have always worked this way. But many employers had been reluctant to automatically enroll employees into their 401(k) plans due to concerns over potential fiduciary liability they would have for the investment decisions they would make for the automatically enrolled employees. But that concern was addressed when the Pension Protection Act was signed into law a few years ago. The PPA included provisions that protect employers from liability when they automatically enroll employees into their 401(k) plans.

But a recent Wall Street Journal article points to an Employee Benefit Research Institute study which found that about 40% of new hires at companies with automatic enrollments are socking away LESS money than they would if left to enroll voluntarily. The reason they found is that more than two-thirds of companies set auto-enrollment contribution rates at 3% of salary or less, unless an employee chooses otherwise. That's far below the 5% to 10% rates participants typically elect when left to enroll on their own.

Typically the way auto enrollment works is that as soon as an employee is eligible to join the plan, the employer will begin a deduction from the workers pay at an initial rate of 1% to 3% of pay. The amount will vary by employer. Some plans will automatically escalate the initial contribution rate by increasing it by one percentage point each year until it reaches a specified percentage, such as six percent. The contributions are invested into a default investment fund, which is typically a single diversified fund that includes cash, stocks and bonds.

The most important thing to know is that these are default settings are a good starting point for many people, but there is much more that you need to do to help your 401(k) plan grow to become a meaningful retirement benefit.

Check back in a few days when I'll write about the specific things folks should do to their 401(k) account after they have been auto enrolled.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.