Ray Martin's 401(k) Advice

Ray Martin gives advice on how to deal with your 401(k).

The Opt-Out 401(k) — What to do if you are "auto enrolled"

Today, 401(k) plans are the main vehicle workers have to save for retirement. But these plans have several disadvantages: They require workers to decide when to enroll in the plan, how much to contribute, how to invest contributions and how to manage their accounts. The problem has been that a significant number of workers don't take the necessary steps to join these plans at the earliest opportunity and they improperly diversify and manage their accounts. These failings cost many employees thousands of dollars in reduced savings for retirement.

But more employers are making changes to their 401(k) plans to address these problems. The biggest change to hit the 401(k) plan landscape is the opt-out 401(k). Enrollment in 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 in 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 have been reluctant to automatically enroll employees into their 401(k) plans and a selected investment fund due to concerns over potential fiduciary liability they would have for the investment decisions they would have to make for the automatically enrolled employees. But that concern was addressed when the Pension Protection Act was signed into law last August, which included provisions that protect employers from liability when they automatically enroll employees into their 401(k) plans.

Now, many employers are taking steps to make enrollment into their 401(k) plans automatic. According to Hewitt's "Hot Topics in Retirement 2007" report, 36 percent of employers have adopted automatic enrollment, up from about a quarter of plans last year. And of the employers who do not currently automatically enroll employees into their plan, about 55 percent said they were somewhat or very likely to automatically enroll all newly hired employees beginning in 2007.

But what does auto-enrollment mean for a typical individual who will be enrolled into their 401(k) plan this way? Typically auto-enrollment will mean that as soon as an employee is eligible to join the plan, the employer will begin a deduction from the worker's pay at an initial rate of typically 1 to 3 percent of pay — the amount will vary by employer. Some plans will automatically escalate the initial contribution rate by increasing it by 1 percentage point each year until a set rate, such as 6 percent, is attained. 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, which are a good start for many people, but there remain some important steps to take for improvement.

Increase Savings

For most workers, their employer's 401(k) plan provides employer-paid matching contributions when employees contribute, typically up to 6 percent of pay.

People who are automatically enrolled should immediately increase their contributions to an amount at least enough to get the full matching contributions from your employer.

But even this is not enough savings for most workers today — particularly those who are covered solely by a 401(k) plan. Most workers in this situation need to save and contribute at least 10 percent of their gross income into their 401(k) plan account, according to a report on national savings rate guidelines published earlier this year. The advice for folks who cannot afford to immediately increase their savings to 10 percent is to set your contributions to automatically increase each year to reach a contribution rate of at least 10 percent. If your finances get tight in a particular year, at the very minimum, always contribute enough to collect your employer's matching contributions.

In 2007, the maximum annual contribution a worker under the age of 50 can make to their 401(k) plan account is $15,500. Workers age 50 and over in 2007 can contribute an additional $5,000, for a total contribution of up to $20,500 each year to their 401(k) plan accounts. But these folks need to know that when they change jobs and are automatically enrolled in their new employers plan, these additional catch-up contributions will not be activated automatically — they will need to take an action to activate these additional catch-up contributions.

Personalize and Diversify

The default investment election for folks who are auto enrolled is a single fund that is typically a balanced fund, a target date retirement fund or a lifecycle fund. These funds are diversified and include cash, stocks and bonds all inside one single fund. Additionally these funds automatically rebalance the allocation and may gradually reduce the exposure to stocks and increase the allocation to cash and bonds as you near retirement. But folks who are automatically enrolled into one of these default funds need to know that these are not personalized for your specific situation or needs. For example, if you want to increase your allocation to foreign stock funds, these default funds would not allow you to make this adjustment. Also, if you wanted to maintain a higher allocation in stocks even as you near retirement, these funds would not provide for this either. If you want to personalize your investment allocation or attempt to increase your returns, you will still need to select from the other funds available in your employer's 401(k) plan.

Alternatively, some plans may hire a professional investment manager to allocate and manage the accounts of auto-enrolled participants until they elect to take over the management of their account on their own. This approach does allow for personalization and adjustments while having the oversight and management of a professional investment manager.

The typical 401(k) plan today offers 12 to 18 investment options, which include diversified funds that focus on stocks of large, mid-size, small and foreign companies. Since younger workers will typically have a long period of time until retirement they should consider an allocation of their 401(k) savings primarily in stock funds, because over long periods of time (15 years or longer) stocks have provided higher returns versus bond funds and stable value funds. Also, since a younger worker will have a smaller 401(k) plan account balance, the primary factor towards increasing their account balance will be contributions, and investment risk, or the up and down volatility of market values, will have a greater chance of working in their favor as they make contributions.

But just allocating your account to a few of the stock funds that recently had the best performance is not proper diversification and doing so can lead to poor results. From 1995 to 1998, large company stock funds had the best returns of all stock funds, but since 1999, small and foreign stock funds have outperformed large company stock funds — the lesson being that you should not only diversify between stocks and bond funds, but also diversify within the asset category, holding large, mid, small and foreign stock funds. Here is a typical allocation that may be suitable for younger workers who are being enrolled in their 401(k) plan account: