With stocks dropping, plenty of participants in 401(k) and other retirement plans face steep losses. But the greatest threat to future retirement security may be the behavior of account holders themselves.

Too many participants are saving little or nothing. Of those who do save, millions fail to diversify their assets properly.

A recent study by the Government Accountability Office found that the median retirement account balance for employees aged 55 to 64 was only $50,000, and 37% of employees had no money saved in the plans at all.

To increase retirement accounts, employers are trying target-date funds and other techniques that put savings on autopilot. The idea is to steer employees into saving enough and diversifying their investments. Through trial and error, employers are struggling to implement the new automatic approaches. While there are some signs of improvements, it is too early to know whether the latest generation of retirement plans will present a solution to the massive problems.

The current difficulties began to emerge shortly after 401(k)s were introduced in the 1980s. At the time, some analysts hailed the new accounts as a major step in the evolution of capitalism, encouraging companies to replace expensive pension plans with flexible 401(k)s

Under the old-style system -- known as defined-benefit pensions because they pay fixed amounts -- corporations set aside money for everyone in the plan. In contrast, 401(k)s rely on voluntary enrollment. To participate, an employee must typically fill out paperwork and elect to have money withheld from paychecks. From the beginning, a large percentage of potential participants decided not to enroll.

To encourage participation, companies began using automatic enrollment, a system proposed by academics, including Shlomo Benartzi of UCLA and Richard Thaler of the University of Chicago. Proponents of a discipline known as behavioral finance, the academics claimed that many employees didn't join plans because of simple inertia.

Under the system proposed by Benartzi, companies would make it easy to participate in plans, and relatively hard to avoid participating. Employees who did nothing would be automatically enrolled. If employees did not want to have money withheld from paychecks, they would have to make an effort, filling out paperwork.

As the academics envisioned, automatic enrollment works. According to a survey by consultant Hewitt Associates, 90% of employees join plans under automatic enrollment, compared to 68% who participate when enrollment requires filling out forms.

So far, only a minority of companies use automatic systems. Will all plans eventually use automatic enrollment? Not likely. The problem is that signing up more people can be costly. Employers must pay administrative fees. More importantly, many companies match employee contributions. When an employee sets aside 6% of his paycheck, an employer may kick in an additional 3%. That is expensive, and many companies don't want to take on the burden.

Along with automatic enrollment, companies have been turning to funds that function on autopilot. These aim to provide employees with proper investment strategies. The investment problems became a concern in the 1990s when academic researchers began noticing that typical employees couldn't necessarily manage investments as effectively as the sophisticated professionals who ran traditional corporate pension plans. In a common pattern, millions of 401(k) participants put most assets in the stock of employers. But putting a retirement fund into a single stock is a recipe for disaster.

Target-Date Funds: Reliable or Risky?

To ensure that employees spread their bets, employers have begun offering target-date funds. These automatically maintain diversified portfolios of stocks and bonds. The funds are designed to serve savers who plan to retire near certain dates, such as 2020 or 2040.

As the saver nears retirement, a fund's allocation to bonds steadily increases. The idea is that older savers must be more cautious, since they have little time to recover from losses. The allocation changes automatically and requires no input from investors. In theory, an employee can sign up for the fund -- and forget about it for decades.

But employees who blindly buy a target-date fund could be in for surprises. According to a study by Financial Research Corporation, there are 58 providers of target-date funds, and their allocations are all over the map. While Wells Fargo Advantage 2020 Fund has 51% of assets in equities, Fidelity Freedom 2020 has 69% in equities, and Oppenheimer Transition has 90%.Not only are there a bewildering range of choices, but some funds have been abruptly changing their allocations to equities. According to Financial Research Corporation, the average target-date fund had 68% of its assets in equities in 2007, up from 55% five years before.

Fund companies say that they are increasing stock holdings to provide growth for retirees. But analysts speculate that funds are raising equity allocations to outdo rivals in increasingly competitive markets.

"I am concerned that there is a race to become more aggressive," says Tom Idzorek, director of research for Ibbotson Associates, an investment advisory firm that tracks target-date funds.

Traditional Pensions vs. Payout Funds
The fickleness of some funds is troubling. In contrast, many traditional pension plans devise an asset allocation and stick with it. The steady strategies have long track records for producing reliable income.

While the target-date approach represents an improvement for many investors, the funds offer little help for another big concern: withdrawals. Studying shareholders in its retirement plans, Fidelity Investments found that the average participant was withdrawing assets too quickly -- taking out 9% of assets annually. According to academic research studies, investors who withdraw at that rate could exhaust their savings in a decade or two.

To provide an automatic approach, fund companies have introduced payout funds. These can send regular checks to retirees. For example, Russell LifePoints 2017 fund aims to pay out 7% of assets annually for 10 years.

The payout funds may prove helpful, but investors must be aware that the portfolios are invested in stocks and bonds. So fund prices fluctuate along with the markets, and there is no guarantee that the checks will arrive.

The payout funds appear relatively shaky compared to traditional pensions, which provide guaranteed income for life. But in an era when corporations must cut costs to survive, 401(k)s will continue replacing old-style pensions. Automatic features may help to ensure that current employees receive at least some income when they retire.