This 401(k) plan hums along on autopilot
If you’re lucky enough to have the newest kind of 401(k) plan, experts say you’re off to a good start even if you don’t lift a finger.
The hot trend in retirement savings plans is making the 401(k) run on autopilot. Employees are enrolled automatically. The plan decides how much you should contribute and simply takes the money out of your paycheck.
How your money is invested is also decided for you. And your contribution amounts and investment allocation automatically change over time. You can tweak those decisions -- as you can with a traditional 401(k) -- or even opt out of the plan entirely. But if you don’t do anything, you’re still probably better off than if you didn’t enroll.
“These plans are designed to make a lot of the right decisions for the worker,” said Jon Dauphine, director of economic security strategy at retiree group AARP in Washington. “Even if inertia rules and the employee doesn’t do anything, they’ll still be in a plan that gives them a good outcome.”
Until last year, few employers had automatic 401(k)s because companies were afraid they could be held liable if workers didn’t save enough or invest well enough to meet their retirement needs. The Pension Protection Act of 2006 changed that by creating “safe harbors” -- guidelines for automatic 401(k)s that employers could use to help protect themselves from liability.
As a result, 40% of employers that don’t yet have automatic 401(k)s say they plan to implement them, Dauphine said.
The plan guidelines are widely considered to be a good start for workers who otherwise would not have participated.
Companies that offer automatic enrollment rave about it for a variety of reasons: It vastly increases participation rates, with more than 85% of all eligible workers -- sometimes more than 95% -- enrolling compared with about 70% in plans that use traditional “opt in” enrollment. Workers in automatic 401(k)s also are more satisfied with their plans and are likely to save a higher percentage of their pay, according to a survey.
Plus, participants in automatic 401(k)s are now more likely to have an appropriate mix of investments in their accounts. Before the 2006 pension law was enacted, if you didn’t decide how to allocate your assets in an automatic-enrollment plan, your money was likely to go by default into a super-safe but low-yielding fixed-income investment such as a money market fund -- not the best place for your savings if you have a ways to go before retirement.
Companies that employ automatic enrollment are encouraged by the law to use “target date” retirement funds or “asset allocation” funds to better diversify workers’ assets. (Target date funds allocate assets among stocks, bonds, cash, real estate and other investment categories based on the date that the participant intends to retire. Asset allocation funds are used to give the employee a mix of investments consistent with his or her risk profile; a conservative investor would have more in bonds and less in stocks than an aggressive investor would.)
The features of an automatic 401(k) plan can make a big difference in how much money you end up with in retirement.
That’s because the biggest mistakes employees typically make in saving for retirement are starting too late, saving too little and investing too conservatively. An automatic 401(k) can solve those problems.
Consider these two fictional examples:
Joe Average, who earns $51,000 annually, starts saving in the 401(k) when he’s 45 -- 20 years from retirement. (That’s when most people start thinking about saving.) He’s nervous about his retirement prospects, so he contributes 15% of his pay, the maximum his employer allows, which amounts to $7,650 a year. Because he figures he can’t afford any investment losses on the nest egg he is building, he invests it in bond funds, earning an average of 5% a year. When he’s 65, he has $252,954, enough to pay him a monthly stipend (assuming a 5% rate of return) of $1,371 a month for 30 years.
Rachel Oblivious, meanwhile, goes to work for a company that provides an automatic 401(k) when she’s 25 and earning $30,000. She ignores the 401(k), so the company automatically enrolls her, contributing 3% of her earnings, or $900 annually. The after-tax cost of this $75-a-month contribution is only about $50, so she barely notices the money is gone.
The next year, she gets a raise to $31,000 and the company boosts her 401(k) contribution to 4% of pay, or $1,240. The following year, the contribution rises to 5% of $33,000 in pay, or $1,650. In her third year at the company, the plan claims 6% of pay, which is now $35,000.
After that, the company doesn’t raise her contribution percentage rate, but Oblivious’ contributions continue to rise along with her pay. By the time she’s 45, she’s earning $51,000, the same as Joe Average. But she’s still contributing only 6%. Meanwhile, the company invests her money in a target date retirement fund that will mature when she’s 65. It earns about 8% a year on average.
What does Oblivious have when she retires? Even assuming that she never got another raise after hitting that $51,000 level, she’d have more than $600,000 -- enough to provide a monthly income of $3,256 for 30 years. That’s more than double what Joe Average ends up with.
“These plans are designed to work with the way that real people behave,” Dauphine said. “When you design a system that way, it tends to be very powerful in helping people save.”
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Kathy M. Kristof welcomes your comments but regrets that she cannot respond to every question. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com. For past Personal Finance columns, visit latimes.com/kristof.
