Saving consistently for retirement is easier when the job is taken out of your hands. Automatic enrollment in an employer’s 401(k), for example, saves procrastinators from themselves.
A 2017 Wells Fargo survey finds the average participation rate for employer-sponsored retirement plans with automatic enrollment is 82 percent, compared to less than 50 percent for plans without that feature. Over the last five years, the number of employer-sponsored retirement plans that enroll employees automatically has increased 40 percent. “On balance, auto-enrollment is a good thing,” says Martin Schamis, vice president and head of wealth planning at Janney Montgomery Scott in Philadelphia. “More people are saving for retirement because of it and investing in balanced portfolios.”
[See: 7 Things That Can Derail Your Retirement Investing.]
Relying on automation can be dangerous, though, if you lose sight of your retirement goals. While micromanaging investments is unnecessary, taking your hands off the wheel completely can hamstring an investment portfolio in more ways than one. You’ll need to find a happy medium.
Underfunding your retirement is the biggest danger. Automatic 401(k) contributions can help you maintain a steady savings pace, but there’s a rub: You may not be saving to your full potential.
According to the Wells Fargo report, the typical default contribution rate for employees automatically enrolled in a workplace plan is 3 percent. Jeff Kletti, head of investments for Wells Fargo Institutional Retirement and Trust in Minneapolis, says that while any amount of saving is better than none, 3 percent probably isn’t enough, especially for savers who got off to a late start.
The report suggests a target contribution rate of at least 10 percent, which includes both employee contributions and the employer match. The problem, Kletti says, is that participants often stay locked in to the same default contribution rate at which they were enrolled. If so, they may not be saving enough to get the employer’s full match.
Assume, for example, that you make $50,000 annually and contribute 3 percent of your salary to a 401(k). Your employer matches 100 percent of those contributions, up to the first 6 percent of your salary. Over 35 years, assuming a 6 percent annual return, not qualifying for the full match could cost your retirement nearly $350,000.
Scheduling automatic annual increases for your contribution rate could help you close the gap. According to Fidelity, auto-escalation helped the average 401(k) balance hit an all-time high of $95,500 through the first quarter of 2017.
But investors must walk a fine line with auto-escalation. “You have to be careful with auto-escalation and make sure you’re not funneling too much money into a pre-tax account,” says Chris Scalese, founder and president of Fortune Financial Group in Dunmore, Pennsylvania. He says pre-tax accounts are a double-edged sword in that you’re able to grow your investments tax-deferred, but you can’t avoid paying taxes indefinitely. Adding after-tax accounts, such as a Roth IRA, to your portfolio “can help limit the tax time bomb later.”
Automated investments may not be a good fit. Automatic enrollment also can result in a portfolio holding that doesn’t meet your investing objectives. In 2016, for example, 88 percent of defined contribution plans adopted target-date funds as their default investment, according to investment consulting firm Callan.
[See: 7 Tips for Finding the Best Target-Date Retirement Funds to Buy.]
Target-date funds have a certain appeal because their asset allocation automatically becomes more conservative as the investor’s target retirement date nears. Scalese says that’s good for people who don’t know a lot about investing or don’t want to be bothered making asset allocation decisions. But “target-date funds aren’t the best choice for people who fall on extreme ends of the risk scale.”
At one end, you have risk-averse investors who want to avoid the market as much as possible. At the other, you have investors who are comfortable investing more aggressively. Target-date funds may not be a good fit for either group.
Andrew Thomas, director of client services for Blooom, an online registered investment advisor and robo advisor for 401(k)s, says the one-size-fits-all nature of target-date funds often makes them too conservative for younger investors who can take on more risk because they have longer to invest.
Morningstar data, for example, shows that the asset-weighted average 10-year investor return for all target-date funds was 5.38 percent through 2016. A recent survey of millennial investors conducted by AMG Funds found that younger investors expect to earn an average annual return of 13.7 percent. Based on historical returns, target-date funds may fall short of younger investors’ expectations.
Cost is another concern. Thomas says target-date funds may have higher fund fees than a similarly constructed allocation using other investments in a 401(k). According to the Investment Company Institute, the average target-date fund expense ratio was 0.51 percent in 2016. By comparison, expense ratios for index equity exchange-traded funds averaged 0.23 percent. If target-date funds are your retirement plan’s default option, higher fees could slowly erode your returns over the course of your career.
Target-date funds could also backfire for investors who are closer to retirement. “That last decade before retirement is the most crucial for growth in your portfolio,” Schamis says. “Target-date funds can pull you out of the market at the exact time when you should be fully invested and taking advantage of equities.” You’re better off making the effort to find other investments for your 401(k) than running the risk that a target-date fund’s allocations will shortchange your investing goals.
Nothing can replace an individual savings strategy. Even an automated savings plan needs to be re-evaluated regularly. That includes reviewing not only your employer’s plan but also any individual retirement and taxable accounts you may hold to see whether you’re on track meeting your financial goals. “The largest challenge facing investors for retirement is saving enough,” Kletti says.
[See: 7 Investment Fees You Might Not Realize You’re Paying.]
Thomas says investors should monitor investment fees and tax efficiency when using automated tools. Investors should also understand how their automated savings fits in with their investment strategy for other accounts, particularly contribution rates and asset allocation. “The main risks are that you’re on autopilot toward the wrong destination, or you’re paying an unnecessary amount of investment fees using the automated options available through your plan.”
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