How Your Employer's Automatic 401(k) Enrollment Could Hurt You

If you're a 401(k) slacker who always meant to start contributing to your company's plan but never got around to it, the trend toward automatic enrollment in employer's 401(k) plans sounds like a good thing.

And for the most part, it is. But there is a way it could trip you up.

Since the summer of 2006, employers have been allowed to automatically enroll staff in 401(k) plans provided the employees have the ability to opt out. That's the reverse of the traditional opt-in method, which -- though widely recommended as a primary means of saving for retirement -- many potential participants ignored.

The problem arises because many employers, absent instructions from the employee, are enrolling people in "target date" funds. Those are mutual funds that try to find an optimum mix of risk and return assuming retirement in, say, 2020, or 2040. The farther away retirement is, the more the fund will invest in riskier equities, since there's time to ride out a downturn. As the target retirement date draws near, the fund shifts to bonds and other less risky, more predictable assets, so that a stock market downturn just before retirement shouldn't have much impact on the 401(k).

There's nothing wrong with that at all. The potential problem is that your employer could make an incorrect guess as to your planned retirement date. If you plan on working longer than they think, you'll be enrolled in a too-conservative plan; conversely, if you have a plan to retire early, you don't want your employer putting you in a plan with undue risk.

Here's an example of what could happen if you plan to retire earlier than you "should." Take a look at what happened to two Barclay's target date funds during the downturn in the early part of this decade. The more aggressive 2030 fund (in red) started off faster and fell farther. The 2010 fund (in blue) fell too, but not as dramatically. If you had planned on retiring in 2002, but were in the wrong target date fund, you'd have been much worse off than if you'd paid attention to where your money was.

(source: WSJ Fund Screener. Click for larger version.)

So on the early retirement side, the risk is in the timing. But if you plan on retiring later, or not accessing your 401(k) until you're 75, the problem is opportunity cost -- the gains given up because you've been put in a too-conservative fund. For instance, here are the ten year returns of Barclay's Lifepath Class I funds. They're a good example because the funds have a longer track record than most target date funds. As you'd expect, the funds with the closer target date have a lower average return:

The average annual return increases about 0.5% for each fund, with the exception of the 2030 and 2040 ones, which are so far out that their asset weighting is probably quite similar.

0.5% per year doesn't sound like much? If you're in the wrong plan by a decade, today's $50k 401k balance will be too low by about $60k in thirty years. And that's real money.

While automatic 401(k) enrollment is a wonderful thing, it doesn't mean you're absolved from all responsibility. Do you really want your retirement in the hands of your company's HR department?

Didn't think so. So check out what you're invested in, and whether it matches your plans -- not their assumptions.

---
A good overview of target date funds is "Right on Target" at financial-planning.com. Other useful articles are "Pick the right target-date fund or risk missing goals" at DowJones Marketwatch and "Tips for Targeting Target-Date Funds" at the Wall Street Journal Online (subscription probably required).

Technorati Tags: 401(k), 401k, target-date-funds