Why do so many employees leave their contributions in a plan’s default fund rather than set up a more favorable asset allocation? Why would a retirement plan participant with a long time horizon corral their contributions in an overly conservative fund? Why are participation rates not higher in retirement plans even when employers offer a match? These and many other questions are the subject of behavioral finance, a growing academic field that brings psychology and economics together to address impediments to sound financial behavior. The field of behavioral finance seeks to understand human behavior around financial decisions in order to develop solutions that work in concert with our natural tendencies.
Retirement plans that incorporate behavioral finance findings have demonstrated success at not only increasing the number of people participating in their plans, but also increasing the amount people are saving for retirement. Behavioral finance findings provide a pathway to closing the savings gap. While behavioral finance recommendations apply in myriad contexts, Colorado PERA’s Defined Benefit Plan addresses two behaviors that impede effective saving: inertia and present bias.
When in need of an organ transplant, head to Austria, not Germany. Research that highlights a 99 percent participation rate for organ donation in Austria and a 12 percent participation rate in Germany has sweeping implications for removing behavioral barriers to saving for retirement. What accounts for the difference between these fairly similar countries? It is inertia, and its steadfast companion, the unchecked box. Nobody checks boxes. Nobel Prize winning economist Daniel Kahneman and author of Thinking, Fast and Slow explains, “In the economy of action, effort is a cost, and the acquisition of skill is driven by the balance of benefits and costs. Laziness is built deep into our nature.”
Inertia is one of many observable phenomena that the field of behavioral finance has identified to explain why we aren’t saving enough for retirement. Applicants for a driver’s license in Austria check the organ donation box if they do not want to be organ donors, while in Germany, applicants check the box if they do want to be organ donors. The implications of an ample supply of available organs in Austria and a shortage in Germany can mean life and death. While failure to sign up for an employer-sponsored retirement plan may not be as critical for survival as an organ transplant, a lack of retirement savings places people at risk of a substantial gap between the income they will need once they stop working and what is available to live without steady income from working.
This natural tendency toward inertia is the basis for recommendations to implement auto enrollment and mandatory participation in a retirement plan. If doing nothing is the most frequent response from people about saving for retirement, employees should be required to opt out of a retirement plan rather than opt in. Defined Benefit plans like PERA go a step further, and simply require participation. This ensures that participants contribute savings to their own retirement fund. The only opt-out option for PERA Defined Benefit Plan participants is an account rollover or refund when leaving employment.
Defined contribution plan administrators have been slow to adopt auto enrollment despite success in test programs like Save More, Tomorrow. Only 55 percent of the 500 employers surveyed by Aon Hewitt in late 2011 auto enrolled plan participants, and of those who auto enrolled participants, only 63 percent of employers enrolled participants at a level that allowed for the full company match. These 500 employers represent 12 million plan participants. Without the structure of a Defined Benefit plan, individuals enroll at a lower rate and save less when they do enroll.
It is much easier to plan to eat less refined sugar and to exercise regularly next week than it is to avoid the box of donuts in the break room right now or to lace up the tennis shoes for a workout within the next half hour. Economist Robert Strotz in his article Myopia and Inconsistency was the first (1955) to identify the best intentions of a future self. Since then, myriad studies have chronicled our willingness to trade a larger reward in the long term for an immediate, lesser reward.
Save More, Tomorrow program designers Shlomo Benartzi and Richard Thaler seek to address the impediments of present bias when it comes to saving for retirement. Because our brains are wired to favor “near-term gratification at the expense of long-term gain,” our best plans to save tomorrow take a backseat to today’s demands on income. Benartzi explains in a November 2011 Ted Talk that self-control is not a problem in the future, it is a problem now. We have no problem identifying the good behavior that our future selves will do. The challenge is getting the buy-in of your present self to uphold those great ideas you had for the future. In defined contribution plans, auto escalation, or a gradual, automatic increase in the percentage of salary being put away, works in concert with our best intentions for the future and guards against the sabotage our present selves commit.
Using a percentage of pay to begin with and committing to a future increase is the best way to work with present bias to mitigate the adverse effects when it comes to saving enough. All PERA members have the option to enroll in the PERAPlus 401(k) Plan, and some employers also offer the PERAPlus 457 Plan as a supplemental voluntary retirement savings vehicle for their employees. By starting with a percentage of pay as the first contribution, and committing to dedicate future salary increases—even by a single percentage of salary—a supplemental savings account can be used to buy service credit in the PERA Defined Benefit plan, offset the costs of health care in retirement, or for travel, or other purchases in retirement.
Present bias is a worthy adversary and is feeding the anxiety of both defined contribution plan participants and administrators. A quick review of present bias literature outlines the behavior in countless examples, and makes an easy argument for auto escalation in whatever style retirement plan an employer offers.
Organizations exert a great deal of effort to set up and administer retirement plans to round out total compensation. Defined Benefit plans, where contributions are automatic, circumvent some of the toughest challenges plan administrators face when it comes to encouraging people to save. If more plans were set up to work with the natural tendencies of participants, then authentic retirement security would be a possibility.
The field of behavioral finance has a comprehensive and growing body of research specific to retirement that supports adjustments to plan design. The greater recognition participants have about inertia and present bias concepts, the more success they will have in closing the gap between savings and what will be needed in retirement.