Retirement Saving Made Easy

By Mary Beth Franklin
Kiplinger's Personal Finance

Saving for retirement is about to get a whole lot simpler -- so simple, in fact, that in the near future about the only thing you'll have to do to keep your retirement saving on track is show up for work.

What has changed? Landmark legislation that Congress passed last year encourages employers to enroll workers in a 401(k) automatically, increase employee contributions automatically each year and automatically invest the money in the stock market, which offers the greatest potential for long-term growth.

Employers aren't required to offer these savings features. But many already do, and Congress's endorsement will prompt others to follow suit. Saving for retirement could become as easy as it was in the old days, when more workers earned a traditional pension. There's one big difference: Now you're using your own money, in addition (sometimes) to your employer's.

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The new legislation represents the biggest shift in 401(k) plans since they were created 25 years ago, says Chris Jones, chief investment officer of Financial Engines, a leading provider of 401(k) investment advice.

Says Jones: "This is unquestionably a good thing for 401(k) participants."

And its significance can't be overstated now that 401(k) plans, once viewed as supplemental to traditional pensions, are the primary retirement-saving vehicle of 47 million Americans -- more than twice the number of people now covered by traditional pension plans. In 2005, more than half of the nation's $14.5 trillion in retirement assets were held in IRAs and other worker-owned accounts -- surpassing pension-plan assets for the first time.

Young workers such as Ryan Lessner stand to gain the most from automatic 401(k) features because they'll profit from decades of steadily increasing contributions and solid investment returns.

Lessner was automatically enrolled in his employer's 401(k) plan when he was hired five years ago. Now 29, and recently married, he has already accumulated more than $42,000 in retirement savings and is on course to amass about $1.8 million by age 65 -- and that assumes no future raises or increases in his contributions.

Older workers in their forties and fifties will also benefit from the new law, which permanently extends higher contribution levels for 401(k)s and IRAs, as well as catch-up contributions for workers 50 and older. This year, all workers can contribute up to $15,500 to 401(k)s and similar workplace-based retirement plans, up $500 from last year.

Workers 50 and older can kick in an extra $5,000, for a total of $20,500 in 2007. In addition, you can contribute up to $4,000 to a Roth or traditional IRA, plus an extra $1,000 if you're 50 or older.

The new law also makes Roth 401(k) plans permanent. As a result, more employers are expected to offer Roth 401(k)s, which provide tax-free income in retirement.

Not only will you be able to put more money aside for retirement, but you'll also be able to get advice on what to do with it -- if, like many workers, you lack the time, interest or expertise to make those decisions on your own. Starting this year, employers will be encouraged (but not required) to provide employees with investment advice.

Company-provided financial advisers can recommend specific investments within your 401(k) menu -- including mutual funds managed by an adviser's own company -- as long as their fees aren't affected by which investments you choose. They can also make recommendations based on computer models that take into account your age and how much risk you're willing to take.

To make things even simpler, more companies are offering employees one-stop investment options such as target-retirement funds (also called life-cycle funds), which essentially combine advice and investing in one product. The idea behind target-retirement funds is to invest all of your 401(k) money in a single fund geared to your projected retirement date.

Initially, the investments are tilted heavily toward stocks, but the asset mix gradually grows more conservative as you near retirement. At Fidelity, the nation's largest 401(k) provider, 83 percent of its nearly 12,000 plans offered age-based funds in 2005.

That kind of simplicity is a huge selling point. When the union representing editorial staff members at the Boston Globe switched 401(k) providers from Putnam Investments to the Vanguard Group in 2005, participants were given the choice of selecting their investments from a new menu of mutual funds or being automatically enrolled in a target-retirement fund. Two-thirds of the nearly 900 plan members were switched to an appropriate target-date fund by default because they didn't make a selection.

Jim Herndon, a Globe employee and one of the plan's trustees, was amazed at how many participants seemed to prefer a fix-it-and-forget-it style of investing. But Herndon, 43, wasn't one of them.

"I'm slightly more aggressive than the target-date fund, and I'm willing to take the time to monitor my investments," he says.

Herndon puts about 30 percent of his 401(k) money in international funds -- about twice as much as the Vanguard 2025 life-cycle fund -- and directs a portion of his contributions to Dodge & Cox Stock, which is closed to new retail investors.

Although target-date funds with one-stop solutions are becoming increasingly popular, they're not right for everyone. If your situation is more complicated -- because you own a large block of company stock or want to coordinate your 401(k) strategy with outside investments or your spouse's retirement savings -- you may have another easy alternative: a managed account.

Instead of having you choose from your 401(k)'s menu of funds, your plan provides a professional adviser to select and monitor your retirement investments.

For its managed-account program, Vanguard typically charges a fee ranging from 0.2 percent to 0.6 percent (on top of mutual fund fees). So if you had $10,000 in your 401(k) account, you'd pay about $60 a year for professional management -- about the same as you'd pay for a typical target-date fund and much less than fees for managed accounts in the retail market.

And sometimes the peace of mind that comes with having someone watch over your investments is worth the extra cost.

After more than 30 years of working on airplane engines, Harold Tenbrink, 59, thought he'd be retired by now. But benefit cuts by his employer, Delta Air Lines, will slice his pension in half and wipe out his once-promised retiree health coverage. So he's decided to stay on the job and continue contributing 15 percent of his salary to his 401(k).

But Tenbrink, who lives outside Atlanta, was so overwhelmed by the sheer number of fund choices that he decided to turn the decisions over to the investment managers at PMFM Inc. (www.401ktoolbox.com), in Athens, Ga., which offers advice to individuals through large employers such as Delta.

Tenbrink, who considers himself a good saver but not a good investor, has already accumulated about $300,000 in his 401(k) and hopes to make that nest egg grow to $500,000 over the next six years. That would allow him to withdraw about $20,000 a year in retirement to supplement his pension and Social Security.

Based on a fee of 1.8 percent of assets under management, Tenbrink will pay about $5,000 this year (including underlying fund fees), and that's fine with him. "If I make money, they make money," he says.

Starting next year, employers will be encouraged to enroll workers automatically in their company retirement plan and determine how much of their pay to contribute.

About 17 percent of employers already do that, and a 2006 study by consulting group Hewitt Associates found that automatic enrollment is an effective way to boost plan participation. More than 90 percent of workers participate in a 401(k) at companies that offer automatic enrollment, compared with 68 percent at companies that don't.

The new law even recommends that workers initially contribute at least 3 percent of their salary, and that employers automatically bump that up by one percentage point per year until the percentage reaches at least 6 percent.

"Companies should strongly consider increasing those rates to get workers up to a higher savings rate over time," says Pamela Hess, director of retirement research for Hewitt.

As an incentive, employers that adopt automatic-enrollment plans with annual escalation features will be exempted from cumbersome discrimination tests that can limit how much highly paid workers -- those who earn $100,000 a year or more -- can contribute to a 401(k) plan if lower-paid workers don't participate.

Employees can always opt out of a plan's autopilot features. But if experience is a guide, most won't. Inertia is a strong force in retirement saving -- and the main reason so many workers never increase their contributions or alter their investments once they have made their initial selection.

"Rather than assume people will make the right decisions, we'll let the plan make those decisions for them," says Jones, of Financial Engines.

To that end, the Department of Labor has issued proposed guidelines that would allow target-retirement funds and managed accounts to be used as the default investment options when employees are automatically enrolled in a 401(k) plan. Currently, most plans use money-market accounts as the default, but this ultraconservative choice sacrifices the long-term growth potential you need for retirement savings.

The new law also encourages diversification, requiring employers that match 401(k) contributions with company stock to let workers sell it after three years.

Ryan Lessner's employer, West Bend Mutual Insurance, outside Milwaukee, already offered automatic enrollment when it hired Lessner five years ago. The insurer -- which last year was named by Principal Financial Group as one of the ten best companies for employee financial security -- also bumps up employee contributions automatically.

When he enrolled, Lessner began contributing 5 percent of his salary -- enough to capture his company's 2.5 percent matching contribution -- and he has boosted his contributions every year since. His company also kicks in an additional contribution based on his years of service.

In 2007, Lessner intends to sock away 15 percent of his salary, boosting his retirement nest egg and reducing his federal and state taxes in the process. Assuming a combined federal and state tax rate of 30 percent, every $1,000 in 401(k) contributions saves him $300 on his tax bill.

Leading 401(k) providers recommend that workers aim to save at least 15 percent of their gross income (including employer contributions) in order for their investments to replace at least half of their current salary, adjusted for inflation, in retirement. Social Security benefits would replace another 25 percent or more of your preretirement earnings.

That would bring you close to matching 85 percent of your preretirement income, a figure often recommended by financial advisers. To make up the rest, you could turn to other sources of income, such as a pension, rental income or continued earnings from work.

Of course, how much income you actually need in retirement will depend on your expenses. If you'll continue to carry a mortgage or plan to travel extensively, the 85 percent figure may make sense. If, on the other hand, you intend to move to a less expensive area and enjoy low-cost activities, you may be able to make do with less.

The prospect of tax-free income in retirement is the main attraction of the newest retirement-savings plan, the Roth 401(k). Roth 401(k)s are excellent choices for young, lower-paid workers, who will benefit from decades of tax-free growth, as well as higher-paid employees who earn too much to contribute to a Roth IRA. Unlike Roth IRAs, Roth 401(k)s have no income limits.

Employers have been slow to offer Roth 401(k)s. But now that last year's pension law has made them permanent, they should begin to catch on -- especially because two-thirds of workers surveyed in a study by Transamerica said they'd prefer the tax-free-income feature of a Roth for at least half of their 401(k) savings.

"Employers think there's a lack of employee interest, but the data is shouting that there's a high level of interest," says Catherine Collinson, of Transamerica Retirement Services. "It's up to employees to let their employers know."

John Michel is one employee who has taken all three easy steps to retirement since he joined the ITAGroup, a marketing firm in Des Moines, two years ago.

First, he enrolled in his company's 401(k) plan, initially contributing 5 percent of his salary. Then he opted for the escalation feature that will boost his annual contribution by one percentage point per year. Finally, he invested his money in a target-retirement fund with a date close to his expected retirement.

"As life becomes more challenging and time more compressed, it's a real benefit to have something automatic," says Michel, 39, who has even less free time now that he's been promoted to vice-president of sales. "It's a matter of convenience."

Three new Web tools give you a quick look at where you stand on the road to retirement. With Fidelity's myPlan Snapshot, all you do is provide five facts: your age, salary, monthly savings, how much you've saved so far and your investment style (conservative versus aggressive). You'll see how large a nest egg you can accumulate given your current strategy, or you can adjust the variables to see how much more you could stockpile. Fidelity's more detailed myPlan Retirement Quick Check takes about 30 minutes to complete.

Want to know how you stack up against your peers? Try Nationwide's RetirAbility Check. The tool grades your progress thus far with an "R-score" and gives advice on how to improve your score.

The Pudding Index, as in "the proof is in the pudding," creates a benchmark by comparing your current savings with those of someone of similar age and salary level, and then projects how much retirement income your savings could replace at age 65.

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