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Investing on Autopilot Can Crash Your Portfolio

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Millions of workers who should invest for their future don't. Five years ago, a new law sought to change that, making it easy for new employees to participate automatically in their 401(k) plans at work. But as with many things, the law has had unintended consequences that may actually prove detrimental to your retirement security.

Making it automatic
In 2006, the Pension Protection Act put in motion a sea change in the way that many workers sign up for their employer-sponsored retirement plans. Before then, many people never went to the bother of signing up for a 401(k) account in the first place, thereby leaving them out of their retirement plans entirely.

The law allowed employers to set up default provisions for signing up newly hired employees for retirement plans at work. Because the law addressed potential liability issues for doing so, new "Opt-Out 401(k)" provisions became commonplace. Instead of having to sign up to participate, these Opt-Out plans required workers to affirmatively tell their HR departments if they didn't want to participate. Among large companies, 57% have automatic enrollment, up from just 24% in 2006. And participation rates are higher -- 85% for plans with auto-enrollment versus 67% for those without it.

But a recent study from the Employee Benefit Research Institute found automatic enrollment often results in less retirement savings. That may seem counterintuitive, but the reason lies with the default choices that most employers make.

Overcoming inertia
Specifically, most automatic enrollment programs, including those at Computer Sciences (NYSE: CSC  ) and Medtronic (NYSE: MDT  ) , use a default savings rate of 3% or less. Yet researchers found that when workers have to choose their own deferral percentage, they typically choose a much higher rate between 5% and 10%.

The result has been a decrease in overall retirement savings. Both Aon Hewitt and Vanguard have seen average contributions fall by about half a percentage point since 2006, and Vanguard blames about half of its drop on automatic enrollment.

How you can buck the trend
Automatic enrollment is a reasonable way to make sure that unsophisticated investors put aside at least some money for their retirement. But to get a real grasp of your finances, you need to take charge of your retirement savings.

In particular, make sure you do the following:

  • Get the match. Many companies specifically cited lower costs of employer-matching programs as a reason not to implement higher default contribution rates. You should make sure that you contribute at least enough to get the full benefit of any matching program your employer offers. With Southwest Airlines (NYSE: LUV  ) matching up to 9.3% of pilot contributions and ExxonMobil (NYSE: XOM  ) adding 7% if you contribute 6%, a 3% contribution wouldn't get you everything you're entitled to.
  • Boost your savings. Regardless of matching, 3% is rarely going to be enough to get you to your retirement goals. Most financial planners suggest 10% to 15% as a reasonable goal to set for retirement savings.
  • Save in the right place. 401(k) plans can leave you with inferior investment choices. You may be able to save both in a 401(k) at work and an IRA of your own, giving you maximum investment flexibility.

Moreover, keep in mind that your investment choices within your employer's retirement plan may not be optimal for your particular investing strategy. Although default investments have typically moved away from all-cash funds to balanced funds that have a mix of stocks, bonds, and cash, the particular allocation often won't be right for you.

In addition, you may need to fill holes in your employer's offerings. For example, if the best option in your 401(k) is a low-cost S&P 500 index fund, then take it -- but be sure to balance your overall retirement nest egg with other investments. ETFs can be the easiest way to get diversification here, with options like the small-cap focused iShares Russell 2000 (NYSE: IWM  ) , international fund iShares MSCI EAFE (NYSE: EFA  ) , and emerging-market ETF Vanguard MSCI Emerging Markets (NYSE: VWO  ) .

Don't crash and burn
Autopilot investing can do some people a lot of good. But an autopilot won't get you to the right place if it isn't programmed specifically for your needs. You'll do yourself a big favor by taking steps to take control of your own retirement money, rather than counting on default investments to work for you.

ETFs can play a big role in successful retirement investing. Here at the Fool, we've found three promising ETFs that could help give your retirement savings a nice boost. Click here to receive our free special report to learn more.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.

Fool contributor Dan Caplinger took enough pilot lessons to get himself into trouble. He owns shares of all three ETFs listed above, but none of the companies mentioned in the article. The Motley Fool owns shares of Vanguard MSCI Emerging Markets ETF and Medtronic and has created a ratio put spread position on iShares Russell 2000 Index. Motley Fool newsletter services have recommended buying shares of Southwest Airlines and shorting iShares Russell 2000 Index. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy keeps you flying the friendly skies of investing.


Read/Post Comments (1) | Recommend This Article (9)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 14, 2011, at 3:23 PM, Gregeph wrote:

    The first step to becoming a good investor and/or to prepare for your retirement is to educate yourself.

    You'll need a rational framework and the discipline to control your emotions. Value investing is way to go given its track record of wealth creation.

    Here's a simple blueprint to consider.

    1. Search Broadly and Continually for New Investment Ideas.

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    If you want more details this may be of interest: http://gregspeicher.com/?p=164

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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