Today, changing employers multiple times over the course of one’s career is the norm. According to Vanguard, the typical U.S. worker will have nine different employers by the time they retire.
Many change jobs in search of better opportunities or better pay. However, a new Vanguard study shows that job-switching can end up costing people money — as much as $300,000 in retirement savings.
It’s one of the downsides to financial automation.
Automatic doesn’t make it right
In one very significant way, the practice of automatically enrolling workers in a company’s 401(k) plan has been beneficial. It has driven up the participation rate in such plans.
However, there are downsides to automation as well. It can give workers a false sense of confidence that the decisions being made on their behalf are the right ones. And, when decisions are made on an employee’s behalf, there may be less ownership of those decisions and, therefore, less of a commitment to let retirement money grow over time.
A low bar
At many workplaces with automatic retirement plan enrollment, the initial contribution rate is low. For example, about 60% of Vanguard-managed plans use auto-enrollment, and the most popular default contribution rate is just 3% of salary. Although many employers then automatically increase that contribution rate, typically by 1 percentage point per year, when people switch employers, they can get off track with their retirement savings.
They may forget to sign up for their new retirement plan if their new employer doesn’t have auto-enrollment. Or, if their new employer does have auto-enrollment, they may get defaulted into the low rate where all new-hires start, even if they had been contributing a higher percentage of salary at their previous employer. (Employees are free to choose a different contribution rate, but most do not.)
Then, after working for that employer for a number of years, and having their contribution rate automatically inch its way upward, they may change employers and start the cycle all over again. According to Vanguard’s research, over the course of a 40-year career, this up-and-down contribution rate pattern can put a $300,000 dent in retirement savings of someone earning average pay.
A Wall Street Journal article about the study explained:
A 25-year-old earning $60,000 who is automatically enrolled at 3% of pay and raises that by 1 percentage point a year to 10% would end up with nearly $800,000 by age 65, according to Vanguard, which assumed a 50% employer matching contribution on the first 6% of employee contributions.
In contrast, someone who changes jobs eight times and whose savings rate falls to 3% each time would have less than $500,000, assuming the same matching contribution and 1 percentage point annual increase in savings rate.
Mixing it up
In automated retirement plans, another potential issue centers on the default investment — typically a target-date fund. Such funds offer a couple of seemingly appealing benefits. First, they come with asset allocation decisions already made. A fund intended for someone with a long time until retirement will be more aggressively invested than one designed for someone who plans to retire soon. Just choose a fund with the year closest to your intended retirement date and you're all set. Second, the fund will then automatically change its asset allocation over time, becoming more conservative as an investor nears retirement. Couldn't be simpler.
However, here too, just because all of this is automatic doesn't make it the best approach. A worker’s investment mix may or may not be appropriate. For example, it’s debatable whether a 25-year-old should have any allocation to bonds. And yet, Fidelity’s 2070 target-date fund has a nearly 7.5% allocation to bonds. Vanguard’s 2070 fund has a nearly 10% allocation to bonds.
If the temptation to trust automated decisions wasn't so strong, and if investment education was more prevalent in the workplace, more employees might choose index funds that enable them to build a portfolio with a more appropriate asset allocation. Or, in plans that provide access to a brokerage window (making a wide variety of fund choices available), more might choose other investment strategies.
Hands off
Here’s one more issue with automated retirement plans. Having made no intentional decisions regarding their participation, contribution rate, or investment selection, some plan participants end up as “unintentional thousandaires” — people who wake up one day and realize they have a lot of money in their retirement plan, and they want that money!
Despite penalties, taxes, or at very least the opportunity cost of missing out on long-term tax-advantaged growth, many participants cash out their 401(k)s when changing jobs. Others sacrifice portfolio growth by borrowing from their nest egg, which is perhaps too easy to do.
A study cited by The Wall Street Journal found that “within eight years of joining a 401(k) plan... automatically enrolled workers withdraw nearly half of the extra they manage to save, compared with workers left to sign up for the retirement plan on their own.”
According to Harvard economist Brigitte Madrian, “We have figured out how to get money into the retirement savings system [using auto-enrollment]. Now we need to think about how to keep that money in the system.”
Again, financial automation can be a good thing. But automation combined with more investment education would be better.
