There is a very nice write-up today on Vanguard’s RSS Feed from John Brennan, Chairman of Vanguard Group.

Vanguard − Chairman’s Corner: A look at the year’s sleeper hit

This is a good overview of some fairly significant changes Congress made this year to the retirement and college savings vehicles available to most Americans.

I want to take a moment to note what is likely the biggest enhancement to the entire “defined contribution” style of retirement plans: the autopilot 401(k).

Let me preface this by saying that, by nature, I am a very strong advocate for self-directed savings vehicles. However, in recent years it has become apparent to me how much “defined benefit” plans, like traditional pension plans, provided for individuals.

In my opinion, more than anything, they provided an automatic way for people to “save” for their retirement, without really knowing they were saving. To participate in a pension, people do not need to understand compounded interest, inflation, “their number”, or diversification between different types of assets.

As we move to a society with more individual responsibility and accountability, we’re learning a lot about the realities of how human beings relate to concepts like long term investment. In fact, there is almost a cottage industry now just advising people on common mistakes people make with their 401ks.

One of the things we have learned is that psychological inertia is a powerful force. The National Bureau of Economic Research does a good job explaining that employees typically follow the path of least resistence.

In a normal 401k plan, a new employee starts at the company, and by default is not enrolled in the plan. They get a lot of material, and they put it aside, planning on “seriously looking at it” sometime in the future.

Years go by, and they are still not enrolled. From a long term saving perspective, with compounding, this is a disaster for their long-term financial well-being.

Now, some of this has to do with the Paradox of Choice. Companies, well intentioned, give employees too many options, too much to analyze. It leads to a state of paralysis.

But, what the National Bureau outlines is that for 401k plans, the biggest issue is psychological inertia. People never enroll, the never increase their contributions with raises, and they end up woefully behind in their saving. Amazingly, this inertia is so powerful, it even overwhelms free money! That’s right, employee matching funds. A free lunch. Enrollment still lags, even with free money, sometimes measured in thousands of dollars, left on the table.

Enter the automatic 401(k).

In this case, the employer automatically enrolls new employees in the 401(k) program when they start. They even automatically increase the contribution percentage every year.

The effect is breathtaking in terms of the financial well-being of the employees. In this case, inertia works for the employee, not against.

Now, in our litigious society, companies had to previously be afraid of automatic 401(k)s – what if the NASDAQ crashes, and employees sue for “automatically” being enrolled.

The Pension Protection Act of 2006 resolves this dilemma, by defining clearly what the US Government considers an acceptable automatic 401(k) program.

The reason I get excited about legislation like this is that it represents not only a growing understanding of how people are irrational with money, but also it represents our progress at designing legislation around the ways that human beings are predictably irrational with money.

People are still in control of their own savings, their own future. But with this minor modification, by default, people are put on the right track.

The US Congress may not have done everything right in 2006, but this is an improvement that is worth noting.