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August 19, 2006 On Making Enrollment in a 401(k) Automatic

It is human nature to procrastinate. It is also human nature to decide by not deciding. Both behaviors have conspired to leave many Americans with paltry sums in their company retirement accounts.

Employers and the financial services industry that manages the 401(k) plans for them have joined in the conspiracy. “We made it too complicated and paralyzed the participants with too many choices,” said James D. McCool, executive vice president for corporate and retirement services at Charles Schwab & Company.

The problem starts the moment a new employee is handed a pile of documents on company policies, health insurance options and, oh, yes, the 401(k) plan. (Employees probably won’t find anything about a pension. Those are rare these days and if their company does offer one, the workers should not count on it.) The bewildered employee is usually told to decide whether to join the 401(k), and then decide what percentage of each paycheck should be put into the plan and which funds the money should go into and in what percentages.

“What about automatic enrollment?” a new hire might ask. “Can you give some advice on the funds?” The typical response has been no. Corporate lawyers contend giving advice isn’t legal. They might as well say: “You are on your own. Good luck.”

For many workers, all of it goes into a bottom drawer to be decided later.

The Pension Protection Act, signed this week by President Bush, gives companies no more room for excuses. They will be allowed to stick their employees into a 401(k) and, in many circumstances, offer them some financial advice. But it isn’t clear that the law will set off a wave of more savings unless employees take a bit of initiative.

The law allows companies to enroll employees in a 401(k) plan automatically unless they choose to opt out. Auto enrollment uses the human tendency toward procrastination, inertia or avoidance to the employee’s advantage.

“They have to make the choice that they don’t want to save,” said Jeffrey R. Carney, president of Fidelity Retirement Services, the nation’s largest provider of 401(k) plans.

Study after study show auto enrollment leads to higher rates of participation. A 2004 report by the Investment Company Institute, a trade group of companies that manage 401(k) and IRA plans, found the rate jumped to 92 percent from 66 percent.

It would seem to be a rather obvious conclusion, but one that was nevertheless resisted for the last 20 years. Fidelity, which manages about a quarter of all corporate retirement programs, estimates that of its 12,000 plans, only 195, about 1.6 percent, offer automatic enrollment.

Some companies feared that state laws guarding the garnishment of wages would prevent them from putting employees into a plan automatically. Common sense would suggest that employees who felt that their wages were being garnished could always opt out of the plan, but when lawyers give advice, sometimes common sense is forgotten.

So it should come as little surprise that 1 in 5 Americans nearing retirement don’t have a retirement fund. Those who do, do not have much. Fidelity recommends that a person have enough savings to draw an annual stream of income equal to 85 percent of the salary they made while working. (If your house will be paid off and you are living rent- and mortgage-free in retirement, you may be able to get by on less — unless you get very sick, which happens when you are old.) That means that for someone making $50,000, which is near the median wage in the United States, savings of at least $600,000 would be needed if that person thinks he will live to 90.

Another way to think about it, said specialists at Schwab, is that you’ll need a portfolio approximately 25 times as large as your first-year withdrawal, which is twice as scary.

But the average account balance for people in their 50’s, those people with less than 15 years to plan for retirement, is a mere $129,000. That’s enough to get them comfortably to age 77 if they count on Social Security. Were they able to contribute the maximum amount of $15,000 to their 401(k) from age 50 to age 65, they should make it through retirement just fine. But that is not going to happen. A person over 50 can contribute more to catch up for not contributing when they were young — when the power of tax-free compounding gives contributions a bigger boost — but the money still has to come from somewhere.

“No company would let you procrastinate on health insurance,” said David Laibson, a Harvard University economics professor. A student of behavioral economics, he has found companies could get higher 401(k) enrollments by applying a simple approach to retirement. He suggests that new employees be given a sheet of paper with the question: “Do you want to enroll in the plan? Yes or no. You have 30 days to decide.’’

He calls this an “active decision” that leads to smarter choices of higher-yielding plans.

In some plans sold by the Principal Financial Group, employees get an “Easy Enrollment” card that offers a stark choice of three boxes: one for a 6 percent deduction, one for 3 percent to 5 percent and one for declining, said Monica Kirgan, vice president for retirement and investor services.

Automatic enrollment has other benefits as well. People tend to stay in the plan and they defer a larger percentage of their income into it.

Here is the worrisome part. The Pension Protection Act, all 900 pages of it, is supposed to encourage companies to adopt these plans, but the companies selling the plans don’t expect a surge of businesses requesting them. “A dramatic change? No,” Mr. Carney said. But he expects that companies will gradually adopt the plans. All the while, the clock is ticking.

What is beginning to change, Mr. McCool said, is that companies are now asking, “What are the things we can do to help our employees get to where they need to be for retirement?” They are beginning to see that they have a responsibility that employees do not end up destitute at age 70.

Clearly companies need encouragement. “They should ask, Why are we not doing this?” Mr. McCool said. Indeed, companies need not wait until 2008 to institute auto enrollment, automatic savings increases and defaulting a new participant into a fund other than a low-yield money market fund. Companies can do it right now. “The government is green-lighting this,” Mr. McCool said.

Companies have to do more than just enroll employees automatically. The second step is setting up plans so that the employee who is confused makes the right choice on where to put the 401(k) savings. The default plan on many plans is a money market fund, which has such low rates of return that an employee will never accumulate enough for retirement if the money remains there.

The trend is to make the default one of the so-called life-cycle or target funds. Based on how much time you have left to retirement, these funds adjust the basket of investments, as well as the risk and return. A young person can afford higher risk and an older person would want to preserve capital. About 40 percent of plans offer such funds already, though few offer them as the default.

Meanwhile, employees should sign up for a 401(k) plan if they haven’t already done so. They should contribute as much as they can, but at least as much to snatch the matching contributions that an employer may offer. Anything less and they are leaving their money in their employer’s pocket.

In most cases, put the money in a stock fund, not a money market fund. Stocks will rise and fall, but over the long run, which is the time horizon of a retirement fund, stocks return much more than money left moldering in a money market fund that barely keeps up with inflation.

Finally, employees can agitate. For once, they have two allies against the corporate lawyers who caution for moderation that could leave most people impoverished: the new law and a bunch of hungry financial services companies that want to offer them their services.

Mr. McCool said the motto of the financial services industry ought to be one that encourages the automatic enrollment: “Just Don’t Say No.”

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