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New 401k plan rewards you for doing nothing

For those overwhelmed into inaction by the prospect of completing 401(k) enrollment forms, Congress just intervened. With last week’s signing of the Pension Protection Act of 2006 it sanctioned what  is called the automatic plan contribution.
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For those overwhelmed into inaction by the prospect of completing 401(k) enrollment forms, Congress just intervened. With last week’s signing of the Pension Protection Act of 2006, it sanctioned what is called the automatic plan contribution.

While just one item in a sweeping legislative overhaul of pension and savings plans, automating enrollment should boost participation in 401(k), 403(b) and 457 plans along with employees’ chances of actually being able to retire.

Currently the rate of nonparticipation is at least 20 percent, according to The Employee Benefits Research Institute, though the National Center for Policy cites a figure closer to one-third.  Inertia is the most-often mentioned cause for nonparticipation.

The new guidelines allow employers to set default contribution levels for new employees of least 3 percent of compensation and allow for automatic escalation of a percentage point a year up to a minimum 6 percent by the fourth year of participation.  Companies going this route are required to match these contributions — at a rate of at least 2 percent, but not exceeding 3.5 percent annually — and they must provide full vesting within two years. Employees will have 90 days to opt out of automatic enrollment. If they do, any involuntary contributions will be ‘unwound’ and returned penalty-free. Auto-participants may also change the default investment settings selected for them if they choose to remain enrolled. 

“It’s a common sense approach to helping people get over the barrier of inertia and through the twin decisions regarding how much to contribute and what to invest in,” says Mark Iwry, senior adviser to the Retirement Security Project and nonresident senior fellow at the Brookings Institution.

“It gives people a package deal they can choose to go along with, but it doesn’t force anyone into anything,” he adds. That is true for the employers as well.  They are not required to adopt the autopilot option.  However, Iwry estimates close to one in four employers — and over 30 percent of large plan sponsors — currently have the feature.

Congress is basically catching up with the marketplace by providing legal comfort on several points, which should cause other plan sponsors to add the feature.

“We have a number of clients who were waiting for guidance from Congress before setting up a default option,” confirms Pamela Hess, senior retirement consultant at Hewitt Associates, in Lincolnshire, IL, a firm involved with creating and managing corporate retirement plans.  She now expects rapid adoption of the automatic feature.

When Aimee Schnabel first started working as a teacher in New York, she was told a portion of her paycheck would be going right into a retirement account, “I did not know other people had to choose — never even gave it a second thought,” she says.

Spared from making investment decisions
In fact the loss of volition regarding contributions is expected to face little employee resistance. In its 2006 Retirement Confidence Survey, the Employee Benefit Research Institute found two-thirds of its respondents viewed both automatic contributions and automatic escalation of contribution levels favorably. Close to sixty percent welcomed access to default allocations and being spared from making their own investment decisions.

Schnabel has been pleased with her results. As her salary increased along with her account balances, she even increased her contributions well above the default level. 

That is exactly what employers and the government are hoping for—that by forcing employees to save from day one, growing balances will provide incentive to keep them saving and encourage them to save more.

The Retirement Security Project says research shows automatic enrollment boosts participation rates to levels as high as 95 percent.  It also increases participation among those least likely to save such as the young, like Schnabel, but also lower-income workers, minorities and women.

“Where our clients have instituted defaults, they find it sticks,” confirms Hess.  She estimates opt-out rates are maybe 10 percent and mostly driven by an immediate need for money, not a philosophical objection to forced saving.

However, this ‘stickiness’ also represents the downside of switching to autopilot says Hess. “There seems to be a herding effect around the defaults levels and investment selections.  Even people who are actively participating often interpret the default investments as an implicit recommendation by the company.”  This is why the Act requires the Department of Labor to establish further guidelines regarding what acceptable default investments should be — to make sure they provide a decent return.  It is also why the Act opens the door to investment advice.  Participants will now be able to receive individualized advice on how to invest their plan contributions.

While the autopilot feature covers new employees, Hess says many of Hewitt’s’ clients are addressing nonparticipating existing employees by sending out enrollment postcards requesting they check either a ‘yes’ box or a ‘no’ box.  With the ‘yes’ they agree to be enrolled at the same default contribution levels as new employees with contributions going into default investment allocation. 

“It’s all about automation,” says Hess, “and about turning people’s inertia from working against them to working for them.”   Procrastinating retirement savers have clearly met their match, and presumably matching contributions as well, which is not a bad deal.