The trend toward automation is significantly affecting 401(k) and other workplace retirement-plan participants.
An increasing number of employers now automatically: (1) enroll new hires into their retirement plans; (2) choose how much of an employee’s pay will be contributed to the plan; (3) increase how much employees contribute over time; (4) choose investments for new participants; and, (5) sometimes even change the investments chosen by participants to investments plan administrators deem to be more appropriate.
Automation has undoubtedly led to higher plan-participation rates, but is there a downside? This article explains why you need to be wary of some aspects of automation if your plan is set on autopilot.
Nudging has become the norm
University of Chicago Economist Richard Thaler didn’t coin the term “nudge,” but his 2009 book by the same name certainly popularized it. A nudge, he explained, refers to anything that influences people toward better choices. It’s what school cafeterias do for students when they put healthier foods within easier reach than less-healthy choices.
Applied to workplace retirement plans, the first widely adopted nudge was automatic enrollment. Standard practice used to be that new employees had to choose to participate in their employer’s retirement plan (they had to “opt in”). Now, it’s becoming more common for new hires to be automatically enrolled. If they don’t want to participate, they have to opt out.
In 2003, only 1% of companies with defined-contribution plans, such as a 401(k) plan, had auto-enrollment. Today, according to a survey by benefits consultant Aon Hewitt, 70% of such companies have it. According to a Vanguard study, the widespread use of auto-enrollment has had a noticeably positive impact on participation rates, especially among younger workers. In 2003, about half of workers age 18-34 participated in available 401(k) plans. Ten years later, the participation rate in voluntary-enrollment plans grew to 60% — but in auto-enrollment plans it spiked to 87%.
With so many of today’s workers ill-prepared for retirement, getting more people to participate in a workplace retirement plan via auto-enrollment is very positive. However, the typical automated contribution amounts and investment choices may still leave participants underprepared for retirement.
Automatically missing out?
Among employers that automatically enroll workers in retirement plans, the most common contribution rate is 3% of an employee’s salary, according to Vanguard. That is less than the amount that workers in voluntary enrollment plans tend to contribute, and it is far below what most workers need to contribute to adequately prepare for retirement. It is also less than the amount needed to receive all of the matching money offered by most employers that provide a matching contribution.
Although workers can change their contribution rate at any time, a Bureau of Labor Statistics report noted, “enrolled employees tend to remain with the default options of their plans.”
To encourage more savings, some employers are now using “auto-escalation,” which over time automatically increases the percentage of pay their workers contribute. At some companies, auto-escalation is built in. At others, it’s an option employees can sign up for. Still, most plans escalate only so far, capping contributions at a percentage that’s still lower than what most employees need to be saving.
Automatically off target?
Within most automatic enrollment plans, target-date funds are the default investment choice. Under a process known as “re-enrollment,” some companies are even switching people out of investments they have chosen and moving them into target-date funds! The reasoning is that many employees lack the knowledge to make appropriate asset-allocation decisions on their own.
Target-date funds have become popular because they require so little of investors, providing a built-in asset allocation plan that automatically shifts the portfolio to a more conservative stock/bond allocation as investors near retirement age. While the appeal of target-date funds is understandable, it’s important to understand a fund’s specific approach. Different fund companies may have widely varying asset-allocation models for funds that target the same retirement year.
The danger of blindly accepting a target-date fund’s design was seen in 2008 when some 2010 target-date funds, designed for people on the cusp of retirement, suffered huge losses. While some target-date fund providers have since changed their “glide paths” to make their asset allocations more conservative, others remain surprisingly aggressive.
Judging the nudge
If you work for an employer that automates aspects of its retirement plan, be sure you understand the decisions being made on your behalf. Recognize that the default contribution rate may not be sufficient to meet your retirement savings goals, and the default investments may not be the best options. Just because your employer is nudging your retirement planning down a certain path doesn’t mean you can’t take the reins and start going in a better direction.