Exposing the downside of auto-enrollment for 401(k)s

Saving for retirement and thinking about the long-term future is difficult for many workers. Some companies and a number of states, like NY and CA, have decided to create and mandate auto-enrollment features for their 401(k) or retirement plans to encourage workers to save more. Additionally, under the Secure 2.0 Act, all new retirement plans will mandate auto-enrollment at 3% of pay on a pre-tax basis under federal law. While this, in theory, sounds like a great way to encourage plan participants to save for their future, in reality there are several drawbacks to auto-enrollment that can hurt someone’s long-term financial security. The primary concern with auto-enrollment is that it diminishes the importance of having a proactive role in financial planning and retirement saving. A passive approach can be detrimental if savers aren’t fully involved and educated on their options around contribution rates, asset allocation and whether or not to use a Roth option.

How much to contribute?

The auto-enrollment contribution rate tends to start very low: roughly 3-4%. While this can be a good starting point for individuals early on in their career who don’t feel they have a lot of money to spare each paycheck for retirement savings, it also doesn’t give employees the opportunity to choose a higher contribution amount. Since employees don’t have to take any action with auto-enrollment, they may just accept what’s being done for them without looking into it further.

For example, what if they wanted to save 8% of their income, but then it was easier to just default to whatever the automatic enrollment features were? This could result in a big miss on savings over a 40-year period.

In addition, with auto-enrollment contribution flat rates, workers may not be increasing their contributions on an annual basis or when they get a raise. This lack of participation could be a difference-maker for retirement security. Being an active participant in retirement savings is essential for building adequate retirement savings and growing assets as they grow in their career. 

What’s the asset allocation?

Typically, when enrolling in a retirement plan the participant works with a plan advisor to select their own asset allocation based on their risk tolerance and their time horizon to retirement. This process helps the participant to understand the potential ups and downs in their portfolio.

However, if automatically enrolled in a plan, the participant’s asset allocation will most likely be selected based on the employee’s time horizon to retirement, which may not align with how they’d like to invest their funds.

For example, if an employee new to the workforce is worried about market volatility and more risk-averse than the average 20-something worker and they are given a 80/20 portfolio mix, they may get spooked out of the market during a market rout. This could further inhibit their savings or even cause them to pull investments while the market is down, capturing a loss. 

To Roth or not to Roth?

Retirement plans now offer the option for a Roth version, which allows workers to pay taxes on their funds now and withdraw them tax-free come retirement. A Roth can be a great option for workers early on in their career and is a smart move for many under 40 years of age. When earning less money and in a lower tax bracket, investors benefit by paying taxes at a lower rate now when saving, versus paying taxes at a higher rate when it comes time to draw down on their retirement funds. However, when automatically enrolled in a retirement plan, the default is for a regular, pre-tax savings account which doesn’t maximize each employee’s savings potential.

There are two sides to every story. And the question of whether or not employees should be automatically enrolled in a retirement plan posits two lines of thought. Should employers take the position that their employees retirement security warrants their attention and involvement?  Conversely, should the employee confidently assume their employer has created an automated savings structure that will ensure their retirement security?

Ultimately, employees need to be active participants in the retirement savings process in order to create a secure financial future. Encourage employees to stay updated and educated about your company’s retirement plan, and the options available to them.

While automatic enrollment may be well-intentioned, it can ultimately hinder employees’ likelihood of being involved in their future financial plans and accumulating maximum savings for their golden years. 

Don Hughett AIF, is a partner and wealth advisor at Octavia Wealth Advisors.