It's not exactly news: Most Americans are woefully unprepared for retirement. The recently passed Pension Protection Act attempts to address some of these shortcomings, partly by reducing hurdles for companies that automatically enroll their workers in a 401(k) plan. However, this concept of auto-enrollment has raised important questions about the appropriateness of certain investment vehicles. The debate ties directly into one of the biggest mistakes investors make within their 401(k) plans.
A helping hand
Auto-enrollment is a long-overdue concept. It's way too easy to put off signing up for your employer's 401(k) plan. Now, companies can choose to gently nudge their employees toward saving by automatically signing them up for the firm's retirement plan. Contributions are deducted from employees' paychecks, even if they don't proactively sign up for the plan. But how should this money be invested when these employees haven't actively chosen their preferred portfolio? The Department of Labor is struggling with that question right now.
Stable returns aren't enough
The insurance industry is lobbying heavily to include stable value funds among the default investments for 401(k) plans. These funds, only available within retirement plans, generally invest in securities called guaranteed investment contracts (GICs), offering a return marginally higher than most money market funds. Because stable value funds are considered very low-risk, they're a popular option for many investors.
However, the Investment Company Institute (ICI), a trade group representing mutual funds, opposes these funds' default inclusion, since they negate much of the benefit of long-term saving.
Let's say 25-year-old Sally Investor is automatically added to her company's 401(k) plan. All of her contributions go into a stable value fund. In 30 or 35 years, Sally might not lose any money, but the odds that the stable value fund will produce adequate returns to provide for her retirement are slim to none. Sally might even decide to sue her employer for investing her money inefficiently, even though the firm thought it was playing it safe by investing in the lowest-risk option available.
In this case, the ICI is right on track. Stable-value funds shouldn't be default investment options. If auto-enrollment is supposed to save investors from themselves, putting their money into an option better suited to shorter-term investing does them no favors.
Playing it too safe
What about your 401(k) plan? Have fears of losing money kept most of your retirement savings sitting in a stable value fund? No one wants to risk heavy losses, but remember that retirement investing is a long-term game. To achieve competitive returns over several decades, almost all investors need at least some exposure to equities. Quality stocks such as Cisco
Even if you're 50 years old and looking to retire in a few years, your retirement money may have to last 25 or 30 years. To accomplish this, you'll need a limited exposure to growth-oriented investments such as stocks. Sure, at this point in your life, it makes sense to have a good chunk of your money in a stable value fund. But keeping all your savings squirreled away in such investments could cost you better returns. And if you're younger, in your 20s or 30s, you shouldn't have any of your money in them.
Stable value funds are not a bad investment. They're a necessary tool for every investor saving for retirement, and most of us will likely use them at some point. But don't rely too heavily on them for the sake of protecting your holdings. Stay focused on the long term, and always have at least some exposure to equities. It may be too late for Sally Investor, but you can still cross the retirement finish line with a sizable investment portfolio.
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Fool contributor Amanda Kish lives in Rochester, N.Y., and does not own shares of any of the companies or funds mentioned herein. Pfizer is an Inside Value recommendation. The Fool's disclosure policy is both stable and valuable.