Plan Design Can Improve 401(k) Savings Rates
By making relatively minor and inexpensive changes to the design of defined contribution retirement plans, employers can significantly improve participation and savings rates among employees, according to a recently published study on the behavioral economics of retirement savings habits.
Written by behavioral economists Richard H. Thaler of the University of Chicago and Shlomo Benartzi of the Anderson School at UCLA, the study concluded that most workers attempt to cope with the complexity of retirement and other forms of financial planning by adopting simple heuristics, or rules of thumb. In their report, the authors examined simple heuristics that can lead to counterproductive biases in workers' savings behaviors, including decisions about whether to participate in retirement savings plans, the size of plan contributions, and asset allocation. They also looked at whether interventions by plan sponsors could be successful in changing negative savings behaviors.
Thaler and Benartzi cited research showing that participation rates in the 401(k) plan of one company rose substantially among new employees after automatic enrollment was introduced, from around two-thirds to nearly full participation within 36 months of starting employment. However, the authors observed, studies uniformly showed that new enrollees in defined contribution plans have a strong tendency to choose their plan's default asset allocation and savings rate options, which are generally far too conservative to meet the retirement savings needs of most people.
In addition, the authors cited research that examined the prevalence of certain heuristics that tend to impede, rather than facilitate, optimal savings outcomes. These include the common strategy among 401(k) plan participants of contributing only the minimum necessary to get the full employer match or failing to adjust their deferral rates to take advantage of changes in the tax laws that would allow them to save up to 100% of pay.
Similarly, Thaler and Benartzi noted that studies of 401(k) plan participants' decisions on asset allocation indicate that most employees do not base their investment choices on an accurate assessment of their individual needs, but on the types of choices they are offered and the way in which they are presented. For example, one experiment showed that employees are more likely to invest the majority of their assets in equities when most of the funds offered are equity funds, but they demonstrate the opposite tendency when most of their choices are fixed-income funds. Other studies found additional evidence of naïve diversification behaviors, such as a tendency to divide assets equally among the funds selected.
Discussing what plan sponsors can do to help participants overcome these types of potentially self-defeating behaviors, Thaler and Benartzi warned that the usual approach of providing financial education and detailed information about savings choices has been shown by a number of studies to be largely ineffective. Instead, the authors recommended that employers alter their plan design to include automatic enrollment features, target maturity funds as the default investment option, and a program of automatic escalation that asks participants to commit in advance to increasing their saving levels each time they get a pay raise.
