Make the Most of Your 401(k)

Behavioral research has shown that inertia can be a powerful force, and that's a big reason why many firms have begun automatically enrolling employees in their 401(k) plans. (To learn more about why your company does this, click here). However, if your company auto-enrolls its employees, it's a mistake to assume that you don't need to lift a finger. That's because the default options may not allow you to make the most out of your plan. What follows are some of the common pitfalls associated with automatic enrollment, as well as ways to avoid them.

Default percentages are usually too low.
When you're automatically enrolled in a 401(k), usually 2% to 3% of your paycheck is diverted to the plan. This small amount will not cover the costs of retirement, especially considering many employers are opting to forego offering traditional pension plans. Encouragingly, some plans are starting to implement automatic escalation programs, where the contribution amount is increased each year, usually maxing out around 6%. Still, even 6% will leave most people short of their retirement goals. Morningstar's  Asset Allocator tool can help you determine how much of your current income you should put aside now to maintain your current standard of living during retirement.

You may miss out on matching funds.
In addition, by not contributing more, some employees are losing out on a major benefit of investing in a 401(k) plan: matching funds. Some employers will contribute an additional percentage of each dollar you invest up to a certain percentage of your paycheck. If your employer matches you on contributions up to 4% of your salary and you're contributing only 2%, you essentially lose the extra 2% in matching funds. Some employers don't even offer matching funds until you contribute at a set level. For example, you may need to allocate 5% of your salary to your 401(k) in order to receive a matching payment from your employer. It's therefore important to investigate if your default setting enables you to receive any matching contributions. Aim to contribute at least the amount your employer offers to match; otherwise, you're leaving money on the table.

Default funds are not always geared toward the long haul.
Often, the default option for automatically enrolled employees is a money market or stable value fund. These funds invest in low-risk securities and pay consistent yields, but they're not designed for capital appreciation and therefore would be inappropriate for the young savers who are the most likely to find themselves automatically enrolled in a 401(k) plan. In the current environment, it would be rare to make more than 5% a year investing in a money market fund. This can be easily remedied by changing the asset allocation of the cash in the 401(k) to a more appropriate mix of stocks and bonds. (To read more about how to invest in a 401(k), click here).

Target funds can be off target.
Some plans now automatically enroll employees into target-date funds, which gradually become more conservative over a specific time horizon. That's an improvement over a money market fund but might not be appropriate for every investor. Companies typically use your age as the determinant of which target-date fund to auto-enroll you in, but that fund might not jibe with your goals. For example, if you're invested in a fund geared toward someone retiring in 2030 but you don't plan on retiring until 2040, the investment most likely doesn't have the right mix of assets to help you meet your retirement goals.

The bottom line? Although you may have a 401(k) now, that's not a license for inertia. Automatic enrollment is a way to jump-start employees' retirement savings, but it's by no means a guarantee of a comfortable retirement. You can take steps, like increasing your contribution rate and investing your cash in more appropriate investments, in order to better plan for your future.