By: Chad Schollaert, AIF, CRSP, Retirement Services
In October, Professor Richard H. Thaler was awarded the Nobel Prize in Economic Sciences. While past winners of the award included groundbreaking works that address large-scale macroeconomic theories and issues that may lack relevance to the average retirement plan participant, Professor Thaler’s work resonates loudly with material implications for both individual retirement investors and Plan Sponsors alike.
Thaler’s work centers on the emerging field of behavioral economics. His thesis establishes that although a large proportion of economic theory is based on individuals acting rationally, in the real world, people are predictably irrational and will consistently act in opposition to the manner economics textbooks predict they will behave. For example, employees know that saving for retirement is important and that social security alone will not be enough but they fail to take action to enroll in a 401k plan even if the employer is offering a company match.
Thaler advocates for the adoption of what he calls “libertarian paternalism”, small changes in policy and structure that nudge participants toward a smarter path and quell their irrational behavior. Some of these plan design options have already become commonplace in defined contribution plans, while others should be considered by Plan Sponsors to further improve participant behaviors and long-term retirement outcomes.
Arguably the most well-known and utilized of these “nudges”, employers automatically sign up new employees to their plans, requiring employees that aren’t interested to opt out. Automatic enrollment leverages participant inertia, the tendency of participants to not make active choices, and utilizes it to encourage better savings behavior. As of the most recent Plan Sponsor Council of America Survey, more than 58% of plans utilize automatic enrollment, up from a mere 8% in 20001. Meanwhile, plans recordkept at Vanguard reported that those with automatic enrollment have an overall participation rate of 90%, compared to only 63% for plans with voluntary enrollment2.
Professor Thaler did not invent the concept of automatic enrollment (though he popularized it), but he did develop the idea of automatic escalation or “save more tomorrow.” Automatic escalation systematically increases participants’ contribution rates by a set increment (Thaler recommends 2% annually). While there is no “magic bullet” that will assure retirement readiness, higher savings rates at earlier ages can help participants become less reliant on rosy investment returns by taking advantage of compounding interest.
To capitalize on participant inertia, Plan Sponsors should consider a more paternalistic approach by defaulting employees to automatically escalate their contributions as another nudge towards better savings behaviors. Automatic enrollment undoubtedly places participants on the right track towards retirement readiness, yet it also can lead to poor savings behavior as the default salary deferral rate under automatic enrollment often begins at 3%, well short of the generally recommended 12%-15% overall deferral rate. Vanguard’s data highlights that most participants save nowhere near this amount, with a median deferral rate of only 5% and a mere 18% of participants saving more than 10%1. In a case study applying the “save more tomorrow” framework, Professor Thaler observed workers in his sample group quadruple their average savings rate from 3.5% to 13.6% after only 4 years of automatic escalation3.
Streamline Plan Entry
For plans that don’t offer automatic enrollment or escalation, another way to reduce the hurdles to participation is reducing the amount of forms needed to participate. Studies show that the more forms a participant has to fill out, the less likely they are to participate in the plan altogether. In our plans we reduce hurdles for participants in the following ways:
- Savings Rate – Participants want a recommendation from an expert. We give participants a recommended goal for saving. If you recommend they save at least 10% and explain why, they appreciate the help and generally go with the recommended rate.
- Roth vs Pre-Tax – Now that most plans allow Roth 401k, this can actually be a hurdle for some participants because they are confused by the difference. To lower this hurdle we recommend that employees over age 55 stick with pre-tax contributions while those under 55 utilize Roth 401k.
- Default Investment – We use target date funds for the default investment based on date of birth. The vast majority of participants don’t know how to invest their money and they want someone with expertise to do it for them. Target date funds are the perfect solution that gets them invested in the right place today and changes with them as they get close to retirement. However, they always have a choice so they can change their investment election anytime they want or we can give them more specific advice if needed.
- Beneficiaries – We use default beneficiaries that cover what most people choose in a sensible order like spouse, children, parents, estate. If they know their spouse is automatically the primary beneficiary they are more likely to participate because you’ve lowered a hurdle. However, they can always change their beneficiary if the defaults are not their preference but it doesn’t inhibit them from contributing to the plan.
While some of these concepts may seem overly paternalistic, Plan Sponsors should remember that the goal of a retirement plan should be to enable participants to successfully retire at a reasonable age. Though this goal may seem altruistic, a participant population with poor retirement readiness can ultimately create a bottleneck of employees who are less engaged, have higher stress and less fulfillment at work due to financial stress, and are more expensive to employ due to higher salary levels and healthcare costs. To not at least consider and evaluate these simple plan design nudges to avoid outsized negative outcomes would be, as professor Thaler would conclude, irrational.
For further information on evolving your plan design and improving participant outcomes, please contact any of the retirement professionals at The Trust Company.
1 Plan Sponsor Council of America. 59th Annual Survey of Profit Sharing and 401(k) Plans. Plan Sponsor Council of America, 2016.
2 Utkus, Stephen P., and Jean A. Young. How America Saves 2017.
3 Thaler, Richard H., and Schlomo Benartzi. “The Secret to Getting Workers to Save More for Retirement.” The Wall Street Journal, 10 Dec. 2017, www.wsj.com/articles/the-secret-to-getting-workers-to-save-more-for-retirement-1512961920?mg=prod/accounts-wsj.