Take The Wheel

The Pension Protection Act doesn’t mean you can sit back and relax

Wouldn’t it be great if we could just push an “easy” button, like in the Staples commercials, and create a successful retirement plan? As we know too well, life rarely falls into place that effortlessly. But change is on the horizon.

Last year, the government passed the Pension Protection Act, the most comprehensive retirement legislation in 30 years. In addition to providing multiple benefits and tax advantages, it encourages companies to establish automatic 401(k) accounts, meaning many employees will be automatically enrolled unless they choose to opt out. Simply put, even the most incorrigible procrastinators will start saving for retirement by default.

While the automatic 401(k) sounds like a terrific idea, the Pension Protection Act is actually a mixed blessing. The default investment options and contribution rates for such accounts are extremely conservative. For example, when many of the provisions take effect in 2008, companies can defer 3% of an employee’s salary — a nominal amount at best — into a 401(k) account. Although contributions usually can be increased automatically one percentage point each year, the default contribution is capped at 10%. At this rate, few 401(k) plan participants will come close to saving the maximum $16,000 allowed next year.

What’s more, two of the proposed default investment options are life cycle and balanced funds, which are better long-term choices than a money market fund but still fairly conservative. I fear that too many people, particularly younger workers who have the time to invest more aggressively, will find themselves positioned too conservatively and miss out on valuable long-term equity growth.

Make no mistake, I agree that the Pension Protection Act is an important step toward helping more Americans achieve financial security. Research by the Employee Benefit Research Institute estimates that automatic enrollment accelerates 401(k) participation rates from 66% to more than 90%.

Another benefit is that automatic enrollment improves retirement security for women, minorities, and low-wage earners, groups that historically have been left behind. In fact, one study revealed that automatic enrollment more than doubles female 401(k) participation from 35% to 86%.

Although new Pension Protection Act guidelines provide an important entry point for retirement planning, you cannot just coast on autopilot when it comes to your financial security, you must take the wheel. For starters, I always recommend maximizing 401(k) contributions. But if you cannot afford to set aside the federal maximum, contribute at least enough to be eligible for any match that your company may provide. Research reveals that 78% of defined contribution plans have some type of matching program, which is basically free money for your nest egg. Despite this incentive, studies show that anywhere from 25% to 30% of eligible employees pass on their 401(k). All told, Aon Consulting estimates that workers are forfeiting $30 billion in unused corporate matches.

But electing to defer a portion of your salary to your 401(k) is not enough — you also need to choose your investments wisely and be sure to diversify. In certain market conditions, some of your investments will outperform while others underperform. So I suggest

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