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Roadblocks Ahead for Auto Enroll? Default Choices, Higher Costs Give Some Sponsors Pause

Automatic enrollment and automatic escalation will be the two most significant developments of defined contribution plans over the next three years, according to 401(k) plan advisers polled by Putnam Investments.

If even just the 66% of employers that Wells Fargo projects adopt automatic enrollment by the end of 2008, that could boost the current $4.07 trillion in DC plans by as much as an additional $90 billion, or 2%, a year. If Spectrem Group's expected 75% of employers combine auto enroll with the power of auto escalation of contribution rates-raising the current average of 3.9% of an employee's salary to 7% or more-that could possibly double those flows.

Given that assets in DC plans have grown by an average of 8% a year over the past 10 years, according to data from the Investment Company Institute, putting these plans on complete auto-pilot stands to boost those growth rates to 10%, 12%-or more.

These are serious dollars.

"All plan providers love the idea of automatic enrollment," said Gerry O'Connor, a director at Spectrem in Chicago. "More participation means more assets under management."

But for all of the excitement over this latest development in 401(k) plans, there are clear challenges ahead.

Many plan sponsors still cleave to guaranteed/stable value or money market funds as the default option, with 59% telling Spectrem they prefer such principal-protection choices. Others are skeptical about target-date funds, citing their short track record and high fees.

Some 401(k) consultants say putting investors in target-date funds discourages them from reviewing their holdings, which, despite the "set-it-and-forget-it" philosophy of target-date funds, is an exercise investors should nevertheless practice on a quarterly basis.

Others still aren't sure of the safe haven the Pension Protection Act is supposed to provide to sponsors that adopt auto enroll.

And finally, some companies balk at the idea of boosting participation in their 401(k)s since employees today expect matching contributions, which means higher plan costs.

"I have mixed feelings about age-based plans," said Jan Dahlin Geiger, a certified financial planner with Financial Network Corp. in Atlanta. "They vary from the very good to the very crummy. Some are ridiculously conservative and some offer great service, but come with an extra layer of fees.

"You're always better off designing your own portfolio if you have the time and know-how, but fewer than 20% of people are capable of doing it," Geiger said.

Geiger reiterated that portfolios should be revisited annually. "For most people, doing it once a year is a chore," she said. "If you told them to revisit quarterly, they would probably throw their hands up in the air and give up."

Thomas F. Wallach, a certified financial planner and principal of Wallach Financial Planning of Chester, N.J., also has reservations. "Target-date funds lack a track record," he said.

Wallach said investors have different time horizons, different levels of risk tolerance and unique needs. Target-date funds can address these needs for some people, but not for everyone.

"Auto enrollment is a great thing, but an investor has to make some effort," Wallach added. There is a lot of planning software out there that can help someone devise a decent, diversified portfolio in a matter of minutes, he said.

That's why Wells Fargo of Minneapolis believes helping employers shepherd investors into the right default option is critical. Eighty-eight percent of retirement plan participants make no change to their portfolio in a year, and a higher percentage is likely to leave it untouched indefinitely if it's put on auto-pilot, according to Wells Fargo.

"Employers are taking a step back and considering how to invest their employees' money," said Laurie Nordquist, head of Wells Fargo's institutional trust services. "If you're younger, you want to take advantage of the upside of the equity market. When you get older, you want retirement preservation."

Wells Fargo found not just target date, but also target risk, balanced and managed accounts as the types of diversified investments sponsors are considering, with 56% of them now offering one or all of these as the default, up from 27% in 2006.

O'Connor said target-date funds are beneficial for idle participants because the fund has an investment manager who handles the reinvesting.

For now, although the Department of Labor has indicated target-date funds may be one of its default recommendations, it has not finished the final rule yet, according to Bradford P. Campbell, assistant secretary for the DOL's Employee Benefits Security Administration.

So all of the debate over target-date funds may be a moot point.

"We have received more than 100 detailed comments from individuals, employee benefits practitioners, trade groups, financial institutions and members of Congress," Campbell said. "We are considering all of the comments and are making significant progress on the final rule. We are working hard to publish the final rule as soon as possible, consistent with the legal requirements of the regulatory process."

Nonetheless, O'Connor said that if the DOL heads in the direction he thinks it will, the industry will see predominately target-date or asset-allocation approaches.

Nordquist agreed, noting that Wells Fargo found that the percentage of companies that enroll new employees automatically in their retirement plans increased nearly 70% over the last year to 44%.

Target-date funds have already gone to the top of the list, Nordquist said, with 40% of plans now defaulting to them and another 42% looking to change.

"I wouldn't be at all surprised," Nordquist said, "if we see target-date funds default as the top of the list, 60%-70%, by 2008.

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