IRAs have played a key role in helping workers save for their retirement for decades. To increase participation and make IRAs easily available to everyone, some believe that having businesses require their workers to make automatic IRA contributions sounds like a great plan. But while such measures may get more workers to save for retirement, it could also cause some to miss out on the IRA's biggest advantage over 401(k) plans.
The pros of automatic IRAs
Proponents of the plan argue that it would encourage more workers to take advantage of IRAs as part of their overall savings strategies. Recent experiences with similar automatic provisions with 401(k) plans suggest that many workers take the path of least resistance with their retirement savings.
They won't sign up for a 401(k) if it takes extra paperwork to do so, but most of them will happily participate in their 401(k) plans if the default choice is for them to make contributions. Although plans give workers complete latitude to change the default savings percentages or opt out entirely from automatic contributions, evidence shows that few workers actually do so.
Clearly, that's good news for those concerned about people's financial stability in retirement. According to some estimates, the plan could result in workers adding as much as $100 billion over the first five years it's implemented.
What could go wrong
The problem with automatic savings provisions like these, however, is in figuring out what the default choices should be. For instance, would such a plan use traditional or Roth IRAs? How much should workers be encouraged to save? Because policy-makers anticipate that typical workers will simply stick with default choices rather than crafting an individualized saving strategy, it's virtually impossible to come up with a single option that makes sense for everyone.
For instance, consider one of the default choices being discussed, the "starter account." Designed for workers who are just beginning to save, the option would put investors into ultraconservative investments such as stable-value funds, CDs, and savings bonds.
Intuitively, it may make reasonable sense to ease young investors into less-volatile investments. But the strategy is just about the worst possible scenario for someone who is 30 to 40 years from retirement. Consider:
- One-year CD rates currently average less than 2%.
- The current earnings rate on Series I savings bonds is 0%. That's right -- investors currently get absolutely no return on their money.
Those investments simply don't do the right job for new investors. With long time horizons, investors can afford to take more chances. Here are two possible solutions:
- Make the default choice a portfolio of conservative blue-chip stocks, such as Coca-Cola (NYSE:KO), IBM (NYSE:IBM), and 3M (NYSE:MMM), that pay dividends and have a long history of stable earnings. Such a portfolio wouldn't be immune from losses, but it would give investors a good chance to grow their assets enough for a comfortable retirement.
- Better yet, give investors access to an investment choice that includes more aggressive stocks, such as Dawson Geophysical (NASDAQ:DWSN) or Agrium (NYSE:AGU). Investors who are just beginning to invest are the ones who can afford to take the most risk with their money, because they have more time to make up for any losses.
Getting investors into the right investments is essential. Without that, no one's experience with an automatic IRA will be a favorable one.
Making it work
To be successful, an automatic IRA plan needs to embrace the flexibility that IRAs offer in customizing each investor's portfolio for his or her own particular needs. Moreover, it could build business for popular brokers such as Charles Schwab (NASDAQ:SCHW), TD AMERITRADE (NASDAQ:AMTD), and Scottrade, which could gather assets and cultivate long-term customer relationships with workers.
As I see it, automatic IRAs can only succeed if they encourage workers to take a more active role in their retirement planning. If workers expect their IRAs to work on autopilot, they'll likely be just as disappointed with them as they have been with their 401(k) accounts.
Done correctly, getting more investors to save through automatic IRAs could get everyone into much better financial shape. Done wrong, though, automatic IRAs could lead investors in exactly the wrong direction.
Take charge of your retirement savings with these articles:
- Seize this chance to retire rich.
- Diversification isn't dead.
- This is how you can tell you've got a great investment.
