On Automatic Investments... and Coming Up Short

July 17th, 2011 by 

In 2006, Former President George Bush signed a well-intentioned law which allowed companies to automatically enroll employees in the company retirement program - and to automatically choose the investment in which they were enrolled.  The Pension Protection Act of 2006 authorized companies to automatically enroll new participants and enroll them in three types of funds - lifecycle funds, balanced funds, and managed accounts - while absolving the companies of any financial liability for losses in the funds. Call it the new era of automatic enrollment - from that initial nudge, inertia will kick in and people will save more for their own good.

As expected, the law has effectively increased the rate of participation in company 401(k) accounts and the total amount of funds invested.  That's the good part.

Umm... So Then What's the Problem with Automatic Enrollment?

DeLorean illustrating automatic enrollment.

Automobile, Automatic Enrollment - same thing, right?

First, let me say: there is a problem.

Two thirds of companies have the rate set at 3% or less of salary - a number generally agreed to be insufficient for retirement savings.

Prior to the 2006 law, the majority of self-enrolling participants chose an investment rate of 5% to 10% when self directing their retirement funds.  The study was conducted by the Employee Benefit Research Institute - an oft-cited organization on this site - for the Wall Street Journal.  Finding what the participation rate 'would have been' was done by looking at companies not using auto-enrollment, versus the companies which had enacted the reform.

Seemingly it all boils down to ease of use, and of course, inertia.

The problem with company enrollment, even when bundled with an automatic annual increase (a common plan is starting at 3% of salary and increasing 1 percentage point annually until 6% is reached) is the comfort of the participants in the plan.  If employees feel that everything is being taken care of automatically, they are less likely to increase their participation rates to the higher numbers which are likely necessary to amass enough savings to retire comfortably.

Therein lies the issue with the tinkering!

If companies are more conservative with automatic enrollment than employees are on their own, there is a similar hazard caused by programs like Social Security.  Social Security was never meant to be the sole source of retirement funds but rather as supplemental insurance to be used in addition to other sources of income.  However, large number of retirees rely only on Social Security.  On the other hand, a much higher proportion of retirees have some form of retirement income, as opposed to before the act was signed into law.

Difficult Questions About Automatic Enrollment Percentages

Social Security's "automatic enrollment" and the automatic enrollment in 401(k)s do cause similar distortions to retirement savings.

The difficult question which is raised is thus:

"Is the dependence in workers who would be saving otherwise balanced by the increased participation of workers who would not?"

In terms of raw numbers, on balance, much more money is being put into 401(k) plans on balance than was before the law: 57% of large companies auto-enroll, and participation rates at auto-enrollment companies are 85% versus 67% at non auto-enrollment companies.  From that perspective, automatic enrollment has been a huge success.

But let's conclude: here's some free advice, worth as much as you paid for it (but consider it carefully and ask a pro!): even if you are covered by both Social Security and your company automatically enrolled you in their 401(k), invest in other retirement funds - whether in that same 401(k) or in other accounts, especially if your company is on the conservative end of the automatic enrollment scale.  Also, invest at a higher percentage than 3% - try to hit 10 or 12% for starters, and adjust as you learn more.  As we've also pointed out, saving too much shouldn't be a real concern of yours.

Are we wrong?  Let us know in the comments!



PK started DQYDJ in 2009 to research and discuss finance and investing and help answer financial questions. He's expanded DQYDJ to build visualizations, calculators, and interactive tools.

PK is in his mid-30s and works and lives in the Bay Area with his wife, two kids, and dog.

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