By Randy Neumann
Defined benefit pension plans, those fully paid for by an employer, went out with “your father’s Oldsmobile.” Today’s defined contribution pension plans, mostly paid for by employees, are the new normal.
The Pension Protection Act (PPA) passed by Congress in 2006 enabled employers to automatically enroll employees into their 401(k) plans. To take it a step further, chances are good that you will be automatically enrolled in your company’s plan.
A 2010 study of 120 large U. S. companies performed by Aon Hewitt, a human resources firm, found that 60 percent of the companies surveyed automatically enrolled their employees in defined contribution retirement plans such as 401(k)’s. In Aon Hewitt’s 2006 survey, only 24 percent of the companies surveyed had bothered to do so. Auto enrollment is not the same as being sent to a Gulag—an employee has the choice of “opting out.” However, in most cases, opting out would not be a good idea.
Well, with company pension plans now a thing of the past, and Social Security, Medicare, and Medicaid in the headlines daily with funding problems, perhaps we should help to secure our own retirement. The following retirement plans are similar to one another and get their names from the Internal Revenue Code: 401(k)—private sector plans, 403(b)—not-for-profit plans, and 457—government plans. These plans provide the most efficient way to fund retirement savings.
On the front side, you get an income tax deduction for your contributions. Along the way, taxes are deferred; therefore, you do not pay income tax on gains within the plan. You only pay tax when you take withdrawals, and, generally, you will be in a lower tax bracket (retired) when you do. But what if you don’t want to pay taxes on withdrawals? Many companies are now offering Roth plans in addition to traditional plans. With a Roth, you don’t get a deduction for your contributions, but you get a deferral on the taxes, and you don’t pay taxes on withdrawals (nor do your heirs).
So, for retirement planning, “4” plans are the way to go.
Does automatic enrollment lead to plan participation? It seems to greatly encourage it. The Aon Hewitt study found that 85.3 percent of auto-enrolled workers were participating in the retirement plans, bringing overall defined contribution retirement plan participation to 75.8 percent of the workforce.
Further, auto-enrollment seems to encourage “growth” investing. When you auto-enroll in a 401(k), you are often presented with a suggested asset allocation including target-date funds (a hybrid that automatically resets assets—stocks, bonds and cash—according to a hypothetical investor’s needs).
Younger plan participants seem to be embracing this choice and ramping up their ownership of equities. A new Vanguard study shows that equity allocations for the typical 20-year-old plan participant went from 40.7 percent to 84.7 percent between 2003 and 2010, and there was also a notable increase in equity ownership for plan participants aged 20-30 in that period. Last year, 61 percent of Vanguard plans offered workers default investment choices—89 percent of these plan sponsors picked target-date funds as the default choice.
Well, if a teaspoon of medicine is good, wouldn’t a gallon be better?
In 2010, President Obama proposed requiring any employer in business for more than two years with 10 or more employees to sponsor direct-deposit Roth IRAs, with 3 percent of their employees’ salaries going into the accounts. The National Small Business Association (NSBA) called the idea “unfair” to small businesses and “very problematic.” No momentum seems to be building for its revival.
Given the job situation, would this promote or inhibit job creation?
So, is automatic enrollment “the answer?” Since workers need to save more for retirement, auto-enroll 401(k) plans at least force them to be acquainted with the awesome potential of these retirement savings vehicles. The Aon Hewitt study seems to show a path from enrollment to interest to investment.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for the individual. Randy Neumann CFP (R) is a registered representative with securities and insurance offered through LPL Financial. Member FINRA/SIPC. He can be reached at 600 East Crescent Ave., Upper Saddle River, 201-291-9000.