Breaking Down the Obama IRA

Tucked into President Obama’s financial regulatory reform legislation still being debated in Congress is a proposal to get more workers saving for retirement. The plan calls for employers to set up mandatory automatic-enrollment IRAs, retirement accounts that allow for tax-deductible contributions.

If the measure passes, companies that don't currently offer a tax-deferred retirement-savings plan would funnel employee contributions into IRA accounts through direct payroll deposits. It would also represent the biggest increase in new retirement savers since the creation of the 401(k) in 1980.

Still, for as long as it’s been, the concept is hardly new. Some form of automatic retirement savings has been kicking around the legislature for a couple of years. The model’s roots are in the science of behavioral finance, a field whose findings routinely suggest that people tend to put off doing what they know they should do. For example, rather than choosing a retirement fund from the myriad options available – a daunting task – many people do nothing. They become victims of their own inertia and ultimately come up short when they retire. The Obama initiative is meant to make decisions on workers’ behalf.

Early estimates predict that the plan could direct roughly $100 billion into IRAs over five years and give some of the 75 million workers who don’t have access to an employer plan an opportunity to save, says David John, one of the plan’s designers, the principal of The Retirement Security Project and a senior research fellow at the Heritage Foundation, a conservative think tank. John says he hopes to have a draft of the legislation introduced to Congress within a month.

Many of the details about the automatic IRA have yet to be fleshed out, but here’s a look at how it would work and some of the early benefits and drawbacks.

How it would work
Companies that don’t currently offer a retirement plan, employ 10 or more workers, and have been in business for at least two years would be required to enroll their employees in an IRA. The accounts would automatically deduct money from employees’ paychecks starting with a default deduction of 3%. Employees can choose a higher or lower withdrawal rate or opt out of the plan altogether.

The default IRA portfolio would likely include a basket of conservative holdings. Those assets include I bonds (inflation-indexed savings bonds), money-market mutual funds or stable value funds, John says. “The goal here is to build up a certain amount, say $3,000 to $5,000,” he says, at which point the account would automatically roll over and new contributions would go into a target-date fund, a popular 401(k) investment option. Workers would retain control over their accounts, but the plan would make adjustments over time -- even if the workers did nothing.

Pros
More companies will cover workers. If passed, the legislation would cover roughly 40 million of the 75 million workers who do not have access to an employer-sponsored retirement plan, John says. The National Federation of Independent Business (NFIB), a Washington, D.C.-based lobbying group for small businesses, estimates that 27% of small businesses with fewer than 250 employees do not offer a retirement plan. For businesses with 10 to 19 employees, that number jumps to 50%.

Improved retirement prospects. Any measure to nudge workers into saving for retirement is a positive one, says Brigitte Madrian, a professor of public policy and corporate management at Harvard University’s Kennedy School of Government. Data from automatic enrollment in 401(k) plans suggest this plan would broadly lift employee savings rates. Nearly 5% of workers with 401(k) plans dropped out in 2008, but the participation rate remained flat that year at 74% as many new hires were automatically enrolled in comparable plans, according to a May report by Hewitt Associates, a human resources and outsourcing consultancy that studied more than 2.7 employees who were eligible for 401(k) plans during the last few months of 2008.

Cons
Pushback from small businesses. Small businesses stand to be impacted the most by this reform. Their biggest concern: the administrative burden associated with these plans. Many small businesses don't have in-house human resource departments, and a proposal like this would require some owners to hire an accountant or third-party payroll service to handle the new IRAs. “It’s a new expense,” says Bill Rys, a spokesman for NFIB.

John says the costs imposed on businesses would be minimal and would depend on how they process their payrolls. If a business uses an automatic payroll service provider like ADP, the cost could be as low as $6 to $8 per payroll period, he says. Initially, the IRA mandate would affect only firms with more than 10 employees, he says. Later, once the details are ironed out and businesses and officials watch the plan underway, the threshold could be lowered.

Not aggressive enough. Given the market turbulence that has washed out millions of Americans’ 401(k)s over the past year, the conservative investment approach pegged for the automatic IRAs is understandable. However, caution might not be the best investing tactic, especially for younger workers who have a longer-term horizon. “I’d be more in favor of getting more aggressive investments in there sooner rather than later,” particularly for younger employees, says Ron Rough, the director of portfolio management at Financial Services Advisory, an investment advisory firm in Rockville, Md. “I think if you’re dollar-cost averaging into your portfolio, you want to take advantage of market volatility.”

A more stock-heavy investment option might eventually become available, John says.

Shares Up Despite Falling Oil Prices

News at a Glance
Futures Flat: Investors await news from G-8, Alcoa.
Oil slides below $62 as stocks scamble back after open.
Europe Down: Pessimism pushes oil, banks lower.
Asia Lower: Weak oil, metal prices, Japanese economic data drive decline..
The Lowdown
Stocks opened with a mild pop, but it remains a traders' market attuned to negative news and uncertainty.

U.S. markets opened slightly higher ahead of news from the Group of Eight summit in Italy and second-quarter results from Dow component Alcoa (AA: 9.28*, -0.13, -1.38%), which reports after the close, signaling the unofficial start of second-qaurter earnigns season. The Dow Jone Industrial Average rose 38 points to 8183 as of 10:10 a.m. The Nasdaq gained 6 points to 1752 and the S&P 500 opened with a gain of 4 points to 885.

Family Dollar Stores (FDO: 30.54*, +2.79, +10.05%) beat Wall Street earnings estimates for a sharp early rise, news that indicates households remain budget conscious and that a recovery may remain tepid thanks to low consumer spending.

The fate of the dollar as the world's reserve currency is among the subjects world leaders are expected to discuss at the G-8 summit, which will continue despite the departure of Chinese President Hu Jintao. Hu abandoned plans to attend the summit Wednesday after ethnic violence erupted in western China, where ethnic Han Chinese and Uiguhur groups continued their clashes in the Muslim-majority region.

European shares fell as traders showed concern over the prospects for a global economic recovery. Shares of oil producers such as Repsol (REP: 21.09*, -0.36, -1.67%) declined as crude prices slid. Financial firms like Credit Suisse (CS: 42.70*, -0.33, -0.76%) also gave up ground.

Asian stock markets slipped as traders responded to weak oil and metal prices, as well as Tuesday's declines on Wall Street. Negative economic news from Japan also contributed to the downturn. The country's current account surplus fell 34.2% in May from the same month a year ago, and the trade surplus fell 22.1%, according to data released by the Japanese Ministry of Finance Wednesday. Separate data from the Cabinet Office showed core machinery orders fell 3.0% in May from April. Both sets of data suggest the global recession has not waned.

Oil prices continued to decline as pessimism about the economic recovery deepened. By 10:14 a.m., crude had fallen 95 cents to $61.99 on the Nymex.

Corporate News
Google (GOOG: 398.71*, +2.08, +0.52%) is designing a new open-source computer operating system that will be available on netbooks in the second half of 2010, the company announced on its blog Tuesday evening. The Chrome operating system, which will be separate from Google's Android system for cell phones and other smaller devices, is intended to compete with Microsoft's (MSFT: 22.13*, -0.40, -1.77%) Windows.
Alcoa (AA: 9.28*, -0.13, -1.38%) is scheduled to release its second-quarter earnings after the market closes Wednesday. The aluminum producer is expected to post a loss of 38 cents a share, compared to a gain of of 66 cents a share in the same period a year ago. Alcoa is the first Dow component to report, and traders and economists often use the firm's results as an indicator of broader economic health and a harbinger for the rest of earnings season.
Teva Pharmaceuticals (TEVA: 48.86*, -0.40, -0.81%), France's Les Laboratoires Servier and other generic drugmakers face antitrust investigations by the European Union into whether an agreement between the companies hindered the entrance of a generic cardiovascular drug on to the market. The probes come after raids at the companies in November, the European Commission said Wednesday.
The Economy
Crude oil inventories for the week ending July 3 are scheduled to be released by the Energy Department Wednesday at 10:30 a.m. Inventories fell by 3.66 million barrels in the week ending June 26 but remained above the upper limit of the average range for this point in the year.
The consumer credit report for May is scheduled to be released by the Federal Reserve Wednesday at 3 p.m. Consumer debt is expected to have decreased by $8.8 billion after falling $15.7 billion in April.