The law of unintended consequences strikes again. A few years ago, in 2006 to be exact, legislation enabling automatic employee enrollment in 401ks was passed in order to boost retirement savings. An article in the Wall Street Journal suggests that automatic enrollment might be having the opposite effect.
Under the law, companies are allowed to automatically enroll workers in their 401(k) plans, rather than require employees to sign up on their own. The measure was intended to encourage more people to bulk up their retirement nest eggs—a key goal in a country where millions of people aren’t saving enough.
But an analysis done for The Wall Street Journal shows about 40% of new hires at companies with automatic enrollments are socking away less money than they would if left to enroll voluntarily, the Employee Benefit Research Institute found.
More people were getting enrolled in the plan, but the initial contribution rates were set at lower levels than new enrollees typically selected on their own!
More than two-thirds of companies set contribution rates at 3% of salary or less, unless an employee chooses otherwise. That’s far below the 5% to 10% rates participants typically elect when left to their own devices, the researchers said.
Some of the plans have automatic escalation, but even these plans did not seem to go far enough.
An October study by EBRI and the Defined Contribution Institutional Investment Association found that, depending on their incomes, 54% to 73% of employees would fall short of amassing enough money to retire if they enrolled in their companies’ 401(k) plans at the default-contribution rate and were auto-escalated by 1% a year to a maximum of 6%.
The net result has been a mixed bag. Enrollment rates have climbed from 67% to 85%, but contribution rates have dropped!
Among plans Aon Hewitt administers, the average contribution rate declined to 7.3% in 2010, from 7.9% in 2006. The Vanguard Group Inc. says average contribution rates at its plans fell to 6.8% in 2010, from 7.3% in 2006. Over the same period, the average for Fidelity Investments’ defined contribution plans decreased to 8.2%, from 8.9%.
Vanguard estimates about half the decline “was attributable to increased adoption of auto-enrollment.”
Obviously, it’s not the auto-enrollment itself that’s the problem. It’s simply that most of the plans have the automatic enrollment savings rate or the top escalation rate set way, way too low—and Big Brother underestimated inertia.
The study found that if people were auto-enrolled at 3%, they were just too lazy to proactively change it to 10%, or whatever. If you are in charge of auto-enrollment at your firm, the obvious fix is to start it at 6% or so, and escalate it 1% annually, up to 15% or so. A few more people might opt out due to the higher initial rate, but—again, due to inertia—most people would leave it alone and thus have a chance at a decent retirement.
Don't let inertia get the best of you
Financial advisors, on the other hand, know all about inertia. Advisors have to fight client inertia all the time. Inertia is closely related to the behavioral finance construct of fear of regret. Clients don’t want to make a mistake that they will regret, so they take no action at all. Philosophically, of course, taking no action is also taking an action, but clients tend not to see it that way, despite the fact that in the long run, opportunity cost usually dwarfs capital loss.
Markets offer infinite opportunities for error and regret (much of which is unfortunately actualized by the typical retail investor) but you can’t let a little thing like that dissuade you. That’s why one of the most important functions of a financial advisor is to get clients to do the right thing at the right time. Disciplined use of relative strength can often be a big help in that regard.