When looking for answers about the savings crisis in America, look to loss aversion, the idea that we “hate losing more than [we] even want to win.” Loss aversion has a profound effect on retirement security, and it deserves our attention.
Americans aren’t saving enough, in part because we see a paycheck deduction and think of it as a loss, rather than as a future payoff. According to behavioral finance pioneers, people experience a greater sensitivity to a decrease in wealth than they do to an increase of the same amount. Choosing not to enroll in, or to underfund, one’s retirement plan is a way of avoiding the feeling of having to give up something. Unfortunately, the tradeoff is retirement security. That is, unless an employer makes retirement plan participation mandatory, as is the case with Colorado PERA’s defined benefit plan.
Luckily, the PERA defined benefit plan will comprise participants’ core income in retirement, proportionate to the years spent contributing. However, everyone agrees that individual savings are a key factor in boosting retirement security. When a participant postpones opening or underfunds a supplemental plan, loss aversion is at play. But the effects of loss aversion can be mitigated to some degree with mandatory participation.
The Endowment Effect
A core feature of loss aversion is the endowment effect. Simply put, individuals place greater value on things they already own compared to items they have yet to obtain. Some experiments show that this value placed on things already owned can be as much as twofold.
Implications of the endowment effect come in several forms. If well-intentioned savers set up a savings plan without realizing how high its fees are, the endowment effect leaves them in danger of staying, even when they realize high fees are eating away at their balances. Similarly, the endowment effect also explains why investors may be unwilling to part with underperforming or high-cost investments simply because they already own them.
As a low-cost provider in both its defined benefit plan and defined contribution plans, Colorado PERA helps its members avoid these concerns. PERA’s defined benefit plan operates at $51 per member per year, $9 below the average among its peers. The PERA hybrid defined benefit plan provides more retirement security to its members at a lower cost than other plan designs.
Colorado PERA’s defined contribution plans also offer a low-cost option (and peace of mind about fees) for individuals who wish to manage their own mandatory contribution, or set up a supplemental account in the form of the PERAPlus 401(k) or 457 Plan.
These low-cost defined contribution plans have expert advice tools built in at no additional charge, and are designed to help a participant avoid making bad investment decisions. Participants can set up and follow an asset allocation strategy or choose a target retirement date fund that offers a hedge against mistakes participants might make if they were to pick individual stocks or pay for advice.
Furthermore, Colorado PERA’s defined benefit investment portfolio is guided by an asset allocation strategy set by the Board of Trustees. Investment decisions are informed by that strategy and executed by a team of experts who weigh the risk and return tradeoffs of a diverse universe of investments.
As long as individuals make financial decisions that seek to avoid loss even if it means a future gain, defined benefit plans, where participation is required, will be a successful avenue to retirement security.
Hybrid defined benefitPERA’s Defined Benefit (DB) Plan is “hybrid” in that it combines features of a traditional DB plan with some of the features of defined contribution (DC) plans, such as portability.Defined benefitAlso known as a pension, this is a type of pooled retirement plan in which the plan promises to pay a lifetime benefit to the employee at retirement. The plan manages investments on behalf of members, and the retirement benefit is based on factors such as age at retirement, years of employment and salary history.Defined contributionA type of individual retirement plan in which an employee saves a portion of each paycheck (along with a potential employer match) and invests that money. The employee’s retirement benefit is based on their account balance at retirement. A 401(k) is a type of defined contribution plan.Asset allocationAn investor’s mix of stocks, bonds, and other investments. PERA’s strategic asset allocation is set by the PERA Board of Trustees.
