3 Problems With Automated 401(k)s

Automation of workplace retirement plans has spread rapidly in recent years. But don’t make the mistake of taking your foot completely off the gas pedal if your employer has installed retirement cruise control.

The Pension Protection Act of 2006 (PPA) set the stage for plan sponsors to step up automatic opt-in enrollment for new workers, and it’s resulted in much higher plan participation rates. Growing adoption of other automation features have helped to address the hard reality that most workplace retirement savers pay little or no attention to their contribution levels, rebalancing or mutual fund selection.

But automation comes with drawbacks that can hurt long-term performance of your retirement portfolio. If you’re using default options, it’s time to start paying attention — and watch out for these three potential potholes:

One: Low Default Contribution Rates

More than half of large plans set initial contribution rates for auto-enrolled workers at 3%, according to a survey of large defined contribution plans by the the Defined Contribution Institutional Investment Association (DCIIA), a non-profit industry consortium focused on the institutional retirement industry. This despite the fact that survey respondents acknowledge that the optimal rate is 10% or more.

The disconnect stems from a PPA provision that defines 3% as the contribution rate that provides safe harbor protections for plan sponsors, says Cathy Peterson, director of retirement insights at J.P. Morgan Asset Management and co-author of the DCIIA study. “Many plan sponsors don’t want to be out of line with the industry,” she says. “The 3% rate is viewed as the benchmark.

The economy also plays a role. 18% of respondents said higher initial contribution rates would require them to make higher matching contributions that they can’t afford right now.If you’re only contributing 3%, consider boosting your contribution rate to a level that at least takes advantage of the maximum match offered by your employer.

Two: No Automatic Escalation

The DCIIA survey found that only one-third of companies with auto-enrollment have tied the opt-in default to an automatic increase feature, which bumps up your contribution rate annually — typically 1% — until the maximum is reached. If your current contribution rate is in the 3% range and your plan has an auto-escalation feature, consider adding it to your account if you can’t afford a big one-time bump.

Three: Target Date Funds

Auto-enrollment’s growth has set off a boom in the use of target date funds (TDFs), which invest in a mix of assets and aim to reduce equity exposure as participants approach retirement. TDFs have become the most popular default investment option for plans with auto-enrollment features; the percentage of plans served by Vanguard Group with TDFs as the default investment option hit 80% in 2009, up from 42% in 2005, according to a Government Accountability Office report.

TDFs are a reasonable response to the problem of investor neglect and mismanagement. Numerous studies show retirement savers hurt themselves by trying to time the market, failing to rebalance and making poor fund selections. “The concept behind the target date fund is a good one,” says Adam Bold, CEO of The Mutual Fund Store, a fee-only investment advisory. “You have asset allocation among classes and professionally designed allocation. Rebalancing is going on, and you have tactical changes to allocation based on market conditions.”

“The problem,” he adds, “has been the execution.”

In my next post, I’ll talk about the common problems with TDF funds, and how you can avoid them.