More Savings, More Debt
Do you participate in a 401(k) plan at work? If so, were you automatically signed-up by your employer? A new study suggests that if you were auto-enrolled in the plan, you may be accumulating more debt – but that may not necessarily be a problem.
Whatever... Just Sign Me Up
Policymakers have been trying for years to find ways to boost America's dismal retirement savings rate, with only limited success. A 2016 study by the Economic Policy Institute (EPI) found that as of 2013, almost half of American families had no retirement savings at all. Given those results, it's no surprise that a separate study from The Center for Retirement Research at Boston College found that over half of American households are at risk of failing to maintain their standard of living upon retirement.
Auto-enrollment in 401(k) plans has been touted as a way to boost savings by taking advantage of human nature – if people are auto-enrolled in a program and have to opt out instead of opting in, they are more likely to stick with the default option rather than take the time to change.
The plan seems to be working. Since 2007, the percentage of large employers adopting auto-enrollment has doubled to reach 68%. Meanwhile, 401(k) plans with auto-enrollment maintain a higher participation rate of 85% as compared to the 65% retention rate of plans without automatic enrollment. Sometimes inertia is a good thing.
However, 401(k) inertia can also lead to spending inertia. As a greater percentage of a paycheck is diverted to retirement funds, families don't always adjust spending to reflect the lower take-home pay, and greater debt follows unwittingly.
On the surface, this seems like a negative development – but the study reveals some underlying positives.
Good Debt vs. Bad Debt
While auto-enrolled employees are incurring more debt, their credit scores are not dropping as might be expected. It appears that the debt is directed more toward mortgages and other debt with lower interest rates and lasting asset value.
Credit-card debt is still a concern for American households, as are other forms of high-interest debt such as installment loans. However, the study found no evidence suggesting that auto-enrolled 401(k) participants accumulated more of this type of debt than 401(k) participants that opted in to their plans.
The study compared the 401(k) savings and corresponding debt of participants at the four-year mark from the initial hire. Auto-enrolled employees acquired an average surplus of $3,237 in their 401(k) account compared to those who opted in, but they also acquired an average $4,131 in debt during that time. With mortgage debt removed, the greater average debt of auto-enrolled participants fell to $1,563.
This economic tradeoff appears to be worth the effort. Auto-enrolled employees are accumulating more debt, but are generally using that debt wisely – and with a bit more work on lowering consumer debt, the average debt could be brought below the level of average savings.
Make the Most of Your 401(k)
Whether you were auto-enrolled in your 401(k) plan or opted in, you can take a few simple steps to get the most out of your retirement plan. Consider these four tips:
1. Optimize Your Contributions – Don't just accept the auto-enrollment default amount. Make the largest 401(k) contribution that your monthly budget can allow, and max out your 401(k) to the contribution limit if possible. For 2018, the limit is $18,500 with an extra $6,000 available if you are age 50 or above.
At the very least, contribute up to the limit of any matching program that your company offers. Otherwise, you are essentially turning down free money. Note that default contribution limits are not necessarily the same as matching contribution limits.
2. Review Your Investments Periodically – Most 401(k) plans feature a range of investment options, providing various levels of risk and potential reward. Your company's default investment option may not be the best for you. Make sure that your plan's investment matches your current needs, and make adjustments as your needs change. (If you aren't sure what you need, seek help from a qualified financial professional.)
3. Don't Borrow From (Or Cash Out) Your Plan – There are circumstances where you can borrow from your 401(k) plan, but these should only be used for emergency situations. You could apply a 401(k) loan to pay off high-interest rate debt – but, even if you pay the loan back promptly, you can't recover the lost interest income and long-term positive effects of compounding. Don't look at your 401(k) as a glorified checking account.
In case of a job loss, try to avoid cashing out your 401(k) for living expenses. You will take a substantial tax hit by doing so, as well as eating into your future nest egg. So do all that you can to avoid this drastic step.
4. Adjust Spending Appropriately – Re-balance your budget (in other words, spending) to account for lower take-home pay – and, if you must incur debt, direct your spending as much as possible away from high-interest credit card debt and toward asset-based debt.
In essence, whether you opted-in or were automatically enrolled in a 401(k), you must take an active role to get the most out of it.
The Takeaway
It's difficult to intentionally lower your take-home pay for any reason. However, the payback in contributing to a 401(k) plan can far outweigh the short-term gains of more cash in hand today.
Like any fiscal decision, planning and discipline are the key to getting the most out of your 401(k). If done correctly, a 401(k) can make it easier for you to accumulate suitable retirement funds while helping you rebalance your spending and establish fiscal discipline. However, keep in mind that a 401(k) can't entirely overcome insufficient funding, starting late, or poor spending habits.
401(k) plans are one of the best financial tools available to the public – but like any tool in any field, a 401(k) can't help if you ignore it or don't know how to use it correctly.
This article was provided by our partners at moneytips.com.
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