Why 401(k) Auto-Enrollment Is Seriously Flawed

In 2006 Congress finally got around to addressing one of the easier-to-confront shortcomings of the 401(k): the fact that about 25 percent of folks eligible to join a plan don't bother. Thanks to the Pension Protection Act, employers now can more easily automatically enroll employees in the plan. That's a major victory for the behavioral finance camp that has been railing for years that opt-out (you must actively make the choice not to participate) is far more effective than opt in (you must actively make the decision to participate). The push for auto enrollment seems to be a success; firms with auto-enrollment report that just 5 to 10 percent of employees opt out.

But the implementation of auto-enrollment is nonetheless seriously flawed.

More than 75 percent of plans that offer auto-enrollment set the initial default contribution rate at a woeful 3 percent and don't include a feature that would raise that rate on a set schedule. Even if we assume every plan provides a generous matching contribution of 50 percent up to 6 percent of salary (a wildly optimistic assumption given the rash of companies that have suspended 401(k) matching contributions during the recession) that's likely to bump up the contribution rate to just 4.5 percent at best. That's less than half the 10 percent to 15 percent we're told we should be saving. It's also far short of the 7 percent contribution rate employees left to their own devices had been choosing prior to auto-escalation.

The whole push for auto enrollment is an acknowledgment that plenty of people won't make the right choices without some guidance, or a well-intentioned Nudge. But this nudge is dangerous. It suggests to the employee that they don't have to lift a finger, because the employer/plan has defaulted them into the "right" features. Once enrolled, the employee settles into his or her well-chronicled inertia and thinks everything is great. Three percent is far short of great.

One More Ding Against 401(k)s
Now I know there are far more egregious shortcomings of the 401(k), and I agree that major overhaul in our retirement saving policy is needed. But this isn't some small nitpick. If history is any guide, it could be years before we see meaningful change in retirement policy; if we see meaningful change. In the meantime are we really going to sit back and let another generation of 401(k) participants (and sponsors) get it wrong?

In a new book published by the Brookings Institution, Press Automatic: Changing the Way America Saves, a couple of retirement policy wonks zero in on the escalation problem:

In the wake of the PPA, much still remains to be done in Congress, the executive branch, and the market to expand and improve the automatic 401(k). Plans that use automatic features need further encouragement to evolve from what we call "first generation" to "second generation" automatic features.
Among the recommendations: set the initial default rate at 5 or 6 percent and add automatic annual escalation of that contribution rate.
Inside Influence It just so happens that one of the authors, J. Mark Iwry, became the first deputy assistant Treasury secretary for retirement and health policy this past spring, as well as getting the title of senior adviser to Treasury Secretary Tim Geithner.

Maybe, just maybe, Washington will indeed step it up and fix this fixable 401(k) flaw.

Self-maintained 401(k) image via Flickr user mujitra, CC 2.0