Employers offering a tax-deferred retirement program can select from three strategies to help their employees retire securely: offer workers financial education and advice, outsource the retirement program to a professional fiduciary and automate retirement program choices.

This article explores features of the last option.

Many employees fail in their retirement planning because they don't enroll, or wait too long to enroll, in their company's tax-deferred plan. Or, once enrolled they don't contribute enough to build sufficient wealth and select irrational investments, and they fail to rebalance their portfolio on a regular basis.

Overwhelming evidence exists describing the financial failings of the average American. The current best explanations for these failures are ignorance and bad decision-making. Recently, the Financial Industry Regulatory Authority commissioned a "National Financial Capability Study" to measure financial knowledge. Five simple questions were asked:

1. Suppose you have $100 in a savings account earning 2% interest a year. After five years, would you have more than $102, exactly $102, or less than $102?

2. Imagine that the interest rate on your savings account is 1% a year and inflation is 2% a year. After one year, would the money in the account buy more than it does today, exactly the same, or less than today?

3. If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?

4. True or false: A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage, but the total interest over the life of the mortgage will be less.

5. True or false: Buying a single company's stock usually provides a safer return than a stock mutual fund.

The average score was a miserable 2.72 correct questions. This result is from a population that self-reports itself to be math proficient (77%) and financially knowledgeable (70%).

Ignorance, however, is only part of the problem. Humans are bad at decision-making. Based on findings from behavioral finance research, employees working under a tax-deferred retirement program often display inertia, think with their hearts instead of their heads, are too oriented toward the present, display status-quo bias (keep things the way they are), procrastinate, and suffer from analysis paralysis and confirmation bias (people accept information that supports their view).

Historically, employers have tried to deal with employee financial ignorance by offering programs of financial education and advice. This strategy is not effective in dealing with employee biases in decision-making. An emerging alternative for helping employees cope with their retirement options is to lessen employee choice through automatic enrollment, automatic contribution increases and automatic portfolio rebalancing.

Auto-enrollment

Automatic enrollment places employees in a tax-deferred plan with a set default contribution rate and asset allocation with an opt-out provision. Evidence indicates that most employees remain in plans in which they're placed. This strategy is particularly effective with younger employees, lower-paid workers, blacks and Hispanics.

Two drawbacks to automatic enrollment are how employees interpret their company's default contribution rate and asset allocation. Studies suggest that employees view default settings as optimal for retirement (they're not), and a majority of automatically enrolled employees never change their employer's default settings.

This has raised concerns about future lawsuits against companies that automatically enroll. One solution offered is to invest contributions from automatically enrolled employees in life-cycle funds instead of the money market funds commonly used.

Using life-cycle funds cures only half the problem associated with automatic enrollment; it doesn't fix low contribution rates. Typically, automatic enrollment programs have a default contribution rate of just 2% to 3%. This is far below the recommended 10% savings rate recommend on pretax dollars if a person is ever to accumulate enough wealth to retire.

Because employees find it painful to increase their level of savings, one tried solution that appears to work is to automate contribution rate increases tied to salary increases. This way an employee never sees a reduction in his or her take-home pay.

An automatic contribution rate increase plan works by first educating employees about the need to increase their savings rate, then asking them to precommit to increasing their retirement contributions out of future pay raises. Evidence strongly supports this strategy for increasing employee savings.

Retirement plan portfolios also need rebalancing occasionally. Assume that a proper investment portfolio for an employee is 60% stock and 40% bonds. Over time, given financial market performance, these percentages will drift away from this setting.

For example, during a stock market boom an investor might discover his or her portfolio to be 70% stocks and 30% bonds. Rebalancing requires that you sell stocks and buy bonds to return your portfolio to its 60/40 breakdown. Most employees fail to do this. Many 401(k) providers now offer this service to employees. Encourage your employees to have their portfolios automatically rebalanced on their birth date.

Shifting your retirement plan into automatic mode helps employees reach their retirement goals by solving two problems: ignorance and biases in decision-making. Next time you're considering offering employees more financial education, try instead shifting your retirement program into automatic; it's more effective.

Contributing Editor Mark Nadler is an economist and professor at Ashland University in Ashland, Ohio. He is a member of the Financial Education Co. and president of Vincuro, a financial stress reduction firm.

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