The Downside of 401(k) Automatic Enrollment

Employees save less and get smaller employer contributions when automatically enrolled in a 401(k).

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When 401(k) plans automatically enroll participants, more people end up participating in the plan than would sign up on their own. But a recent Center for Retirement Research at Boston College study found that many people who are automatically enrolled in 401(k) plans save less when they are enrolled by default than if they sign up and choose a contribution amount on their own. Plus, some employers with automatic enrollment reduce their 401(k) match or choose a low default savings rate to keep compensation costs constant. Here are some of the potential drawbacks of 401(k) automatic enrollment:

[Read: How to Tell if You Have a Lousy 401(k) Plan.]

Smaller 401(k) match. Automatic enrollment has been successful in getting more people to save for retirement in 401(k) plans. Participation rates are 10 percentage points higher in plans with automatic enrollment (77 percent) than those without it (67 percent), according to the Boston College analysis of Bureau of Labor Statistics data. But, perhaps to offset the cost of higher enrollment, employers with automatic enrollment offer smaller 401(k) matches. Workers in retirement plans with automatic enrollment have a maximum possible match rate of 3.2 percent of pay, compared with 3.5 percent for those in plans without auto-enrollment, a difference that is statistically significant. "Firms with auto-enrollment may offset higher 401(k) participation costs by trimming their per-participant contributions," according to the report. "Auto-enrollment policies are very successful at raising participation rates but may not boost workers' total retirement saving if firms aim to keep their 401(k) compensation costs at a constant level."

Low default contributions. When workers are automatically enrolled in a 401(k) plan, a default amount is withheld from their paychecks unless they opt out. The average default contribution rate for plans with automatic enrollment is 3.4 percent, far less than the average of 5.1 percent of pay these workers would need to contribute to get the full match their employer is offering. "The default contribution rate is well below the rate required to get the maximum match," says Barbara Butrica, a senior research associate at the Urban Institute and co-author of the report. "Among the plans with automatic enrollment, the employer might be setting their default contribution rates low to offset the costs of higher participation." Some plans try to correct this problem by automatically increasing the default savings rate over time.

[Read: 10 Trendy 401(k) Plan Perks.]

A one-size-fits-all default investment. When you are automatically enrolled in a 401(k) plan, your money is invested on your behalf, typically in a target-date fund. This selection may or may not be appropriate for you, and doesn't take into account your individual risk tolerance or how your money is invested outside the 401(k) plan. Target-date funds typically have high equity concentrations for young individuals and gradually invest more conservatively over time. "In most cases, because it is based on their age, it can be appropriate. However, their performance isn't as good as building a portfolio out of the individual funds that could be selected in the plan," says Carey McNeal, a registered investment advisor for Buffington Mohr McNeal in Boise, Idaho. "Target-date funds are usually funds of funds, so there is a management fee on top of mutual fund fees that are internal to the fund."

[See: 10 Target-Date Funds Producing High-Grade Nest Eggs.]

Nudged to save less. Other studies have also found that participants save less when automatically enrolled in 401(k) plans. A recent Vanguard analysis of 2,000 401(k) plans with 3 million participants found that participation was dramatically higher in 401(k) plans with automatic enrollment (80 percent) than among those without it (59 percent). However, the average savings rate was 6.6 percent of pay in plans with automatic enrollment, compared with 7.5 percent in plans with voluntary enrollment. Even people earning less than $30,000 per year saved at a higher rate when they signed up for the plan voluntarily (6.2 percent) than when they were automatically enrolled in the plan (4.1 percent). "Unless the plan has some sort of auto escalation, most people will remain at the default," Butrica says. "For those people who would never have enrolled, it's going to have a hugely positive effect. For those who were already enrolled or would have enrolled anyway, it could, in fact, reduce their retirement savings."