Automatic IRAs present risks, opportunities

Unless workers opt out, contributions to 401(k)s and similar retirement plans are automatically deducted from their paychecks. Now Congress wants to add IRAs, too.

Uncle Sam wants you to save for retirement. And, if a new bill makes it through Congress, he's going to do his best to make sure you do.

The bill, introduced in both the House and Senate, would require most employers to enroll employees in IRAs – automatically deducting money from their employees' paychecks and depositing it into a retirement account, unless workers explicitly opted out. It follows legislation that last year authorized companies to set up automatic 401(k)s for their employees, a practice that previously had fallen into a legal gray area.

But while automatic IRAs have the potential to increase retirement savings for millions of US workers, some say there are also risks.

Lower-income workers may increase their consumer debt to make up for lost income or suffer stiff penalties if a financial crisis forces them to withdraw money from an automatic IRA early.

"Some people end up not saving because of inertia. If you can make it that the inertia [turns into savings], it's a good thing," says Dean Baker, codirector of the Center for Economic and Policy Research in Washington, D.C. But "some people just don't have the money."

About 75 million US workers have no access to employer-sponsored retirement plans, according to a recent study commissioned by AARP. The study predicts that 48 million of these workers could see increased retirement savings if the proposed legislation were to become law.

The bipartisan bill would require companies that are at least two years old, have more than 10 employees, and do not already offer retirement plans to automatically enroll their employees in an IRA, unless individual employees opt out.

While "auto IRAs" are a relatively new idea, other retirement programs – including pensions and, increasingly, auto 401(k)s– have long made automatic deductions from employee paychecks.

But auto IRAs would be fundamentally different from the other programs: Employers will not contribute to an employee's retirement savings. Instead, they will act as the conduit to enable employees to save for themselves.

The bill looks as though it has legs, but details – how it will be administered, how the fee structure will work, what happens when someone switches jobs – may change as the legislation progresses. "I've never seen a bill that isn't amended," says Evelyn Morton, AARP's national coordinator for economic issues.

Studies indicate that automatic-enrollment savings programs effectively encourage retirement savings. The participation rate of workers hired under automatic 401(k) enrollment who had been with a company for three years was 30 percentage points higher than those hired under traditional opt-in plans, says a 2004 study of three large companies written for the National Tax Journal Forum on Pensions.

More companies are setting up automatic 401(k) enrollment systems for their employees. Last year, Congress passed a bill legalizing automatic 401(k)s for companies that chose to have them, superseding any state laws that prohibited the practice. As of this June, 12 percent of the Vanguard Group's 401(k)s automatically enroll employees, up from 8 percent in 2006, says Rebecca Cohen, spokeswoman for the investment-management company.

Marlene Vega, a cashier assistant at a Costco in Queens, N.Y., was automatically enrolled in her company's 401(k) after she was hired last April. She didn't know which of Costco's 10 plans her money was being invested in, but she was glad she had automatically been enrolled. "It's not money you see, so you don't miss it," she says.

But many don't have access to 401(k)s. The AARP-commissioned study says that employees at small companies and lower-income workers are least likely to have access to retirement plans at work. The study says only 44 percent of workers in companies with fewer than 100 employees have access to a retirement plan, compared with 78 percent of workers in bigger companies. And low-income workers are less likely than other workers to have access to pension plans, it says.

AARP, which supports the legislation, says that a worker who saved $1,000 a year over the course of 30 years at a 4 percent real interest rate would accumulate almost $60,000 – which would provide nearly $200 a month in interest income in retirement.

"The key thing is that no matter how small your savings, it makes a big difference in your retirement savings down the road," says Ms. Morton. "We're not saying it's enough, but it's better than not having it."

Indeed, half of people over age 65 live on less than $16,000 a year of income, according to the Current Population Survey. And many have scarcely saved for retirement at all – 34 percent of aged beneficiaries depend on Social Security for more than 90 percent of their income.

But for some, the relatively small amount of additional retirement income may come at a heavy cost. With few exceptions, people who withdraw money early from their IRA will be hit with a 10 percent penalty. CEPR's Mr. Baker recommends having a "modest cushion in an accessible form," especially if you're a parent, before locking money away in a retirement savings account.

Investment fees may also eat into retirement savings. The Senate version of the bill states the "costs of investment management and administration are kept to a minimum," but doesn't set a cap. An increase in fees of 0.5 percentage points on an investment with a 4 percent real return would decrease earnings by almost 10 percent.

And an increase in credit-card debt could quickly wipe out financial gains from saving for retirement. Cardweb.com notes that average credit-card debt for households with at least one credit card is approaching $10,000. "Almost certainly it's better to pay off credit-card debt first," says Baker. Borrowing money at a higher rate than you're investing it at is a "losing proposition," he says.

Despite her credit-card debt, Ms. Vega sees her 401(k) as a good investment. "The more money I have, the more I waste," she says. "As I get older I can do more things with the money."