Automatic Investment: Improving 401(k) Portfolio Investment Choices

QUICK SUMMARY

Self-direction of investments is a common feature of 401(k) plans, but it is not working as well as it could. Employees frequently fail to diversify their investments or rebalance their portfolios over time One concern is that workers often invest too large a share of their 401(k) savings in their employer's stock, which can prove especially costly: if the employer falls on hard times, workers stand to lose not only their jobs but also their retirement savings. But even when the plan sponsor does not collapse, poor investment choices impose unnecessary risk on workers, threaten the level and security of retirement income, and reduce the public policy benefits from 401(k) tax preferences.

Self-direction of investments is a common feature of 401(k) plans, but it is not working as well as it could. Employees frequently fail to diversify their investments or rebalance their portfolios over time. One concern is that workers often invest too large a share of their 401(k) savings in their employer's stock, which can prove especially costly: if the employer falls on hard times, workers stand to lose not only their jobs but also their retirement savings. But even when the plan sponsor does not collapse, poor investment choices impose unnecessary risk on workers, threaten the level and security of retirement income, and reduce the public policy benefits from 401(k) tax preferences.

Given the prevalence of 401(k) plans, the demonstrated inability or unwillingness of many workers to make sound investment choices is a significant concern: better investment performance could increase plan account balances and reduce the riskiness of participant investments. This policy brief discusses the nature and sources of the problem and outlines a potential solution: “automatic investment.” Emerging evidence shows that the structuring of default choices in 401(k) plans can strongly influence participation and contribution behavior while preserving employees' option to tailor these choices to their individual preferences if they so desire. We suggest a similar default approach for asset allocation and investment options. Under this approach, plan sponsors that offer qualifying automatic investment arrangements would receive a measure of safe harbor fiduciary protection. The proposal addresses both the general problem of poor investment choices made in 401(k)s and the specific issue of
overconcentration in employer stock. The Retirement Security Project is undertaking further research and analysis of this and other ways to improve the design and performance of our nation's retirement savings system.