Many economists study the rational man, the person we would all be if we saved exactly enough money for retirement, tracked every penny of spending, ate our leafy green vegetables, and flossed every day.
Other economists, known as behavioralists, study the rest of us. In other words, they try to figure out why humans make the decisions they do, even when they may not always be in our best interests.
The Employee Benefit Research Institute recently looked at the contributions that behavioral economists have made toward understanding workers and their retirement savings. Their findings offer some caveats for virtually everyone with a 401(k).
Keep reading this if you've been automatically signed up for your company's 401(k) savings plan, particularly if the plan makes all the tough decisions for you. Skip ahead to the second part of this tale if you're making active decisions about how much money to save and how to invest.
For those who were automatically signed up for a 401(k) savings plan, you probably think this idea could be the best thing since sliced bread, or at least since Britney decided to ditch K-Fed. You didn't have to do anything, yet you're saving for retirement! Not bad for your average, procrastinating worker bee. In fact, at least one study highlighted by the EBRI found that automatic enrollment increased participation in 401(k) savings plans from 37% to nearly 86%.
Automatic enrollment plans have become one of the most popular trends in 401(k)s, made more so by a recently passed pension law. Among other things, it overrode state laws prohibiting such plans and gave companies some legal assurances that they're doing the right thing.
These plans stand to become even more popular this year. If you've been enrolled in a 401(k) this way, you should be aware of some pitfalls.
These automatic enrollment plans come with default settings. If you don't take the reins and make the decisions, the company will make them for you. That could include setting your initial contribution rate, your automatic investments, and occassionally future increases in your savings rate.
Default settings may not be the best choices for you. For example, a research study found that 70% of workers in one company's plan stayed with the automatic 3% contribution rate and the automatic investment choice, a money market fund. Many continued to stick with this contribution even after they became eligible for a 50% employer match on the first 6% of salary saved in a 401(k).
Think about the potential problems for workers who stick with their default options.
A 3% savings rate almost certainly will not be enough to adequately fund a worker's retirement, yet the automatic contribution rate for almost four out of five companies in a survey highlighted by the EBRI was below 3% or less. The Motley Fool's retirement guru, Robert Brokamp, said in a recent issue of Motley Fool Green Light that retirees will need 10 to 15 times their annual income saved for retirement. Crunch some numbers using these Foolish calculators to see whether you're saving enough.
That same survey found that a significant number of companies make principal preservation the goal for default investments. If your money has been invested only in a money market fund, for example, you're missing out on the potential for long-term growth. Stocks (or mutual funds composed of stocks) should be a portion of every worker's retirement cache. They may be riskier than other savings options, but over time they've provided the best returns to investors with years to go before retirement. Look for a low-cost equity index fund if you're not sure where to start.
Finally, your default contribution may not be enough to get the company's full matching contribution. Make sure you're saving at least enough to take advantage of that perk.
In general, don't assume that the default options set by your plan will guarantee a comfortable retirement. In the parlance of the economist, these default settings are not "implicit advice." In many cases, they just get your savings started. It's up to you to do the rest.
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