For some, automatic 401(k) enrollment eases pain of saving

Getting Started

Your Money

April 24, 2005|By CAROLYN BIGDA

Retirement plans seem about as relevant to people in their 20s as Viagra. Only 45 percent of eligible workers in that age group participate in 401(k) plans, according to Hewitt Associates, a human resources outsourcing and consulting firm.

These low participation rates have led employers to automatically enroll workers in defined-contribution plans, investing 3 percent or so of their paychecks even if they don't elect the withdrawal.

There are two main reasons for this. First, the Internal Revenue Service requires that low-wage and high-wage earners save about the same percentage of their salary, referred to as a deferral rate, in their 401(k)s. Broadly speaking, the difference between earning groups cannot exceed 2 percentage points.

Second, there's growing concern that workers are not saving enough for retirement.

In a study by Boston College's Center for Retirement Research, workers age 35 to 44 who started contributing to a 401(k) at age 30 had accumulated a median balance of $24,000 in 2001. However, their potential savings was $58,500 when factoring in a 9 percent contribution (including the employer match) and nominal rates of return. But even at that level, a 30-year-old's savings would total little more than $350,000 by age 62, with the sum declining precipitously for workers in their 40s.

Similarly, a study released this month by the Employee Benefit Research Institute found that most workers are behind schedule in saving for retirement, blaming daily living expenses, child-rearing costs and medical bills.

Younger workers especially prioritize immediate goals, such as paying rent or buying a car. With an entry-level salary and retirement 40 years away, they are reluctant to spare cash for retirement savings.

An automatic 401(k) plan, however, overrides these barriers by making saving the default option. And thanks to the inertia and procrastination that stall participation in the first place, we tend to stay put in the plan, even with the choice to opt out.

"It makes our worst characteristics work for us instead of against us," says Stephen Utkus, principal for the Vanguard Group's Center for Retirement Research.

Although surveys show that fewer than 20 percent of companies automatically enroll employees, the number is expected to grow. If you find yourself in a plan, first test whether you can manage without the cash.

Most contribution rates start at 3 percent, which for a $35,000 salary is $40 every other week. But, because the money is taken out before taxes, you'll notice only a $30 difference every other week on your paycheck's after-tax total. You'll save about $260 a year in taxes at a 25 percent rate.

Also, check how your money is being invested. Traditionally, contributions were placed in a money market or stable value fund. The expectation was that workers eventually would take an interest in their growing balance and elect more appropriate investments.

However, studies show that deferral rates actually drop with automatic enrollment because participants stick with the initial 3 percent rate and the conservative funds, which preserve capital but offer minimal returns.

Consequently, some plans automate even these decisions, raising your contributions by a percentage point each year and rebalancing the stock-to-bond ratio according to your investment time horizon.

Otherwise, if you don't increase your savings rate or miss out on higher returns over the long term, you'll sacrifice thousands of dollars.

And remember that you can always elect options different from the default.

If your 401(k) is not on cruise control, mimicking automatic plans can help ease the pain of saving.

Start out with a minimal deferral rate, 3 percent to 4 percent of your salary.

Elect a balanced fund, which maintains a set ratio of stocks and bonds. Even better, opt for a target-date fund or lifecycle fund, which move from aggressive to conservative allocations as you move along your investment timeline.

And every year increase your contribution level by 1 percentage point.

If a 25-year-old worker put aside 3 percent the first year and increased the contributions by 1 percentage point each year after, he would be saving 10 percent of his salary (not including the employer match) by age 32, far more than that age group's median contribution rate of 6 percent.

In surveys, workers have often said they could not afford to contribute 10 percent of their salary to a 401(k). However, after a few years of gradually increasing the deferral rate, many contributed 10 percent with no problem.

E-mail Carolyn Bigda at

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