Fixing Our Broken Retirement System with Opt-out Retirement Accounts

Social Insurance originally began in the late 1800s in Germany, and by the time the U.S. adopted its Social Security program in 1935, about 20 countries already had similar programs in effect. The basic idea behind social insurance is to work hard during able years to insure against the hazards of sickness, accident, involuntary unemployment, and old age. Whether someone wants to work or not, sometimes there are circumstances beyond one’s control that prohibit working. The system has worked and has served people well over the years. Looming fiscal crisis aside, the program has been successful.

However, while Social Security has been successful, it’s not enough. Most people are not able to delay gratification on their own. And I think we can all agree that having poor old people is not in any way a benefit to society. Having a bunch of poor old people will just cost us more money down the road. And if you don’t think that having poor old people is likely, just check out some of the statistics. Of people aged 50-65, more than 60% have less than $6,500 saved in their retirement accounts. At the age of 24, my fiance and I have as much saved for retirement as about 75% of people ages 50-65. Now, that is scary.

Investing for retirement is just like anything else in life. While some people can do it on their own, most people need a professional to handle it. Investing is like repairing a car. Many of us could learn to do it, but we don’t. Some people spend a lot of time research car repairs, reading car repair forums, and they repair their own cars well. It’s just like personal finance. Some people read personal finance blog and forums, and can invest for themselves. However, for most people, this clearly is not the case.

So, if low and middle-income earnings are not saving enough, what’s the solution? I think that automatically-enrolled accounts similar to IRAs are the answer. When employees begin working with an employer they should automatically be enrolled in a savings/investment account that would function much in the same was as a Roth IRA. Here are a few of my thoughts for this proposed account:

  1. The account would be opt-out. That means that all employees would be automatically enrolled. This would significantly boost the percentage of participants. Consider the organ donor program. In the U.S., you have a fill-out an additional paper at the DMV to become a donor, which results in about a 25% opting-in. In countries that utilize an opt-out system, such as Austria and Sweden, the percentage of people who have consented to donating organs is above 90%. An opt-out investment account would allow anybody who doesn’t want to participate to opt-out, it would just remove the barriers from opting-in, and thus result in more people saving for retirement.
  2. There are a lot of investment options out there to fit anybody’s financial profile. I think that it would be best to be conservative with the automatic investment and then allow investers to tweak their risk profile. A good starter investment would be a target-date retirement fund that starts with a higher-than-typical allocation to “safe investments”. For someone young, this might be 60% equity, 40% bonds. For someone aged 50, this might be 40% equity, 60% bonds. The key here is that the person is investing as opposed to not investing. That’s the first big step.
  3. I’d hazard to guess that most high income earners would rather self-direct their investments, and would choose to opt-out. However, low to middle-income earners are less likely to opt-out of the investment plan. And they’re the ones that need the most help saving for retirement.
  4. To further encourage use of this account and to offer similar benefits to an employer match, I think that 50% of any amount up to $3,000 should be a tax credit to lower and middle-income families. People with good jobs and employers who offer 401(k)s typically get employer matches, why should poor and middle-income people be excluded?

I’m not the only one that thinks this would work. Senators in California are currently working on SB 1234. Although I don’t think the bill is aggressive enough, it’s absolutely a step in the right direction. Employees who are not offered retirement accounts through their employers would be automatically enrolled in a low-fee, low-risk retirement savings plan. Unless employees opt-out, an automatic 3% of earnings would be contributed on their behalf. The funds would be pooled and likely managed by CalPERS. This makes sense, as it’s been proven that pooling funds decreases administration costs, and these reduced fees and result in a final nest egg about 30% greater than funds that are not pooled. The proposal is for a 50-50 stock-bond portfolio. I think this offers enough safety while still getting the upside from investing. If someone wants a different allocation, they can always opt-out. In all likelihood, the plan would offer some type of guaranteed return, which would be underwritten by insurers to insure that tax payers would not be footing the bill if actual returns were lower.

I think that California’s opt-out retirement plan is a huge step in the right direction and it’s something I’m excited about. Yes, it’s nerdy to get giddy about a bill proposing a new investment account. But that’s what I do. I think that, if implemented well, this could benefit a lot of people (those who participate, as well as those who do not) and this could lay the framework for a national policy involving out-out retirement accounts.

Target-Date Retirement Funds: Great Beginner Funds

Young investors are being hammered with information about investing early. Everybody in their 20s has heard of the benefits of compounding in some form, and that’s a very good thing. The benefits of compounding are real and there’s no better time to take advantage of them than when you’re young and have the longest time horizon to invest. However, many of these young people know that they should be investing, but they don’t necessarily know how to invest.

Target-date retirement funds bag of moneyLuckily, there’s a popular trend in the investing community that can help with this. Target-date retirement funds are built on the premise that an investor generally should hold riskier investments when young and over time shift toward safer investments. To do this, a younger person would hold a greater percentage of stock versus bonds when young, and over time sell some of those stocks and purchase bonds. Target-date retirement funds will automatically do this for you as the specific target date draws nearer. For example, a 2020 target-date retirement fund will have a great portion of its portfolio in bonds than a 2040 target-date retirement fund.

But simply re-allocating between stocks and bonds is not all that these funds do. These funds provide diversification within them by investing in a diverse portfolio of index or mutual funds, holding domestic and international stocks, with the potential for real estate holdings (REITs) as well. Because of their simple, hands-off approach to investing, it’s easy to see why target-date retirement funds have become popular amongst investment planners. They’re a quick and easy way to get someone’s retirement investing on track.

However, investing is never as simple as a general rule of thumb might suggest. While target-date retirement funds are great for most people, you can’t simply rely on that designation to determine whether it’s the right investment for you. Frankly, there are too many target-date retirement funds that invest in actively managed mutual funds and don’t do a good job of controlling costs. For example, let’s say that I start investing at age 25 in a 2050 target-date retirement fund within my Roth IRA and I contribute $5k per year until I’m 65. If I invest in a target-date fund from Vanguard, I’d have low fees and let’s imagine I end up with an average return of 9% after fees. At age 65 I’d have approximately $1,841,000 in my Roth IRA. Now, if I am investing in a fund that takes just 1% more each year, then I am earning a net 8% on my investments. Over that same period, with the same contributions, I’d only end up approximately $1,399,000. That’s more than a $400,000 difference due to the 1% higher fee taken by a different fund.

If you’re looking to invest your money, but don’t want to spend the time or effort to determine your own optimal portfolio, then I absolutely recommend looking into target-date retirement funds. SmartMoney has published a good guide on the best target-date funds here. In it’s article, SmartMoney notes that Vanguard’s funds are 5 times cheaper than average, and they were one of just two funds that was using mostly index funds to construct its target-date funds. You can also check out MorningStar’s rankings of target-date retirement funds, where it lists Vanguard as the top provider. If I were going to point a friend in a single direction to make their retirement planning simple, I’d tell them to check out their appropriate target-date retirement fund from Vanguard.

(Photo: 401K)