Target-Date Funds Riskier Than You Think

To encourage participation, companies began using automatic enrollment, a system proposed by academics, including Shlomo Benartzi of UCLA and Richard Thaler of the University of Chicago. Proponents of a discipline known as behavioral finance, the academics claimed that many employees didn't join plans because of simple inertia.

Under the system proposed by Benartzi, companies would make it easy to participate in plans, and relatively hard to avoid participating. Employees who did nothing would be automatically enrolled. If employees did not want to have money withheld from paychecks, they would have to make an effort, filling out paperwork.

As the academics envisioned, automatic enrollment works. According to a survey by consultant Hewitt Associates, 90% of employees join plans under automatic enrollment, compared to 68% who participate when enrollment requires filling out forms.

So far, only a minority of companies use automatic systems. Will all plans eventually use automatic enrollment? Not likely. The problem is that signing up more people can be costly. Employers must pay administrative fees. More importantly, many companies match employee contributions. When an employee sets aside 6% of his paycheck, an employer may kick in an additional 3%. That is expensive, and many companies don't want to take on the burden.

Along with automatic enrollment, companies have been turning to funds that function on autopilot. These aim to provide employees with proper investment strategies. The investment problems became a concern in the 1990s when academic researchers began noticing that typical employees couldn't necessarily manage investments as effectively as the sophisticated professionals who ran traditional corporate pension plans. In a common pattern, millions of 401(k) participants put most assets in the stock of employers. But putting a retirement fund into a single stock is a recipe for disaster.