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Behavioral Economists and the 401(k)

October 1, 2004
Related Topics: Retirement/Pensions, Featured Article, Compensation
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It would seem like a no-brainer. Through 401(k) plans, employees are offered the opportunity to invest in a secure retirement with matching funds from their employer. Yet human resources executives and plan providers have been increasingly frustrated in recent years by low participation as well as lackluster saving rates and indifferent account management by those who do participate.

    This puts the long-term success of many 401(k)s in jeopardy, causing headaches for companies that rely on secure retirement packages to help recruit and retain the best workers. It causes another problem, too. When, as frequently happens, low-wage workers save at a substantially lower rate than their more highly paid colleagues, the 401(k) sponsor may be in danger of flunking the nondiscrimination test. At the very least, workers who earn less act as a drag on the amount that their better-salaried colleagues can contribute to their own funds.

    Altruism may figure in, but make no mistake: it’s a bottom-line issue. "As anyone in a human resources department knows, the biggest cost to a company is employee turnover," says Paul Bracaglia, human resources partner at PricewaterhouseCoopers. "Retirement plans are part of the marketing of a position, and attracting high-quality people and retaining them. The match is going to cost less than the turnover cost."

    "In the 1990s, employees wanted more choice," says David Wray, president of the Profit Sharing/401(k) Council of America. "They wanted the opportunity to invest in the most aggressive funds possible. Then the market came down, and a lot of uncertainty entered the minds of people who thought investing yourself was risky. The message then became, ‘We need help.’ This has led to more employers, with the support of their employees, taking a more paternal role than they had previously."

    The fact is, for fear of making a bad decision, many employees who lack confidence in their investing savvy simply don’t do anything. That can be the worst decision of all. And according to experts, the fear factor has become more pronounced in recent years, as market conditions have grown volatile.

    That has sparked a fundamental shift among plan sponsors and providers, leading to innovations in the way plans are administered. Much of the inspiration stems from research by two behavioral economists, Richard Thaler of the University of Chicago and Shlomo Benartzi of UCLA. While the language of behavioral economics can be dauntingly arcane, Thaler and Benartzi zeroed in on two proclivities of human nature that require no explanation: inertia and procrastination. Advocating a more paternalistic role for sponsors administering 401(k)s, the two scientists have ventured to turn negatives into positives. The basic premise: father knows best. Make wise, informed decisions for your participants, and inertia and procrastination will work in their favor.

    "A lot of it is common sense, but most good ideas are," Thaler says. "We simply found that if you make it easy for people to save more, then lots of people will change their behavior."

    In more and more cases, making it easy means making it automatic. Automatic enrollment, automatic step-ups, life-cycle funds and managed accounts are four primary ways by which sponsors and providers are gently, if not firmly, steering employees to higher savings. In Thaler and Benartzi’s patented Save More Tomorrow plan (otherwise known as SmarT), helping workers increase their savings starts with "negative enrollment," by which employees are automatically enlisted in a 401(k) unless they specifically opt out. Similarly, automatic step-ups tie increased deferrals to pay increases, mitigating worries about diminished disposable income. Life-cycle funds are preselected by professional investment advisers, calculate individual risk tolerance and generally calibrate a plan’s aggressiveness according to targeted retirement date; in other words, the closer you are to getting your gold watch, the more conservative your investments will be.

    While Thaler and Benartzi did patent their formula, they’ve invoked a sort of file-share approach to its use; any provider is free to use the research, in exchange for data. "We decided early on not to make this proprietary," Thaler says. "Our goal was just to get the idea out there and as widely distributed as possible. So we’ve been willing to work with these people like Vanguard and Fidelity. The only agreement we’ve asked for is that companies that use our idea give us data on what happens. And so far everybody’s been good about doing that, at least ones we’ve known about. They tend to want to put their own names on it and have different ideas."

    Indeed, various companies have tended to put their own stamp on SmarT, and not all are comfortable taking the reins from participants’ hands to quite the extent that SmarT prescribes. "There’s a continuum," says Steve Utkus of Vanguard, which calls its version One Step. "An employer might say, ‘I’m not ready to go that far and be that paternalistic,’ but they’re experimenting with different aspects. Autopilot is the more extreme version, but others are dipping their toes into various aspects of these plans. And people should know that they retain at every point the right to make their own decisions."


"A lot of it is common sense, but
most good ideas are. We simply found that if you make it easy for people to save more, then lots of people will change their behavior."


    Still, the pendulum is swinging hard toward stronger stewardship. "The traditional model is, Let’s hold educational seminars to motivate people to participate," Utkus says. "The new paradigm is, We’re not even going to educate you; we’re going to put you in a plan and if you want to do something else, tell us. That’s the model where we’ll teach you behavior first, then we’ll educate you. Any psychologist will tell you that the best way to learn something is by doing."

    "There’s a near certainty of failure because of the way most 401(k) plans are administered," says Pete Swisher, certified financial planner at Unified Trust in Lexington, Kentucky, which manages retirement funds for small businesses and individuals. "But a relatively small shift in outlook can change everything. It’s like if you’re at the top of a hill, what’s the best way to get to the bottom? I liken it to a bobsled run. Once you’re on, it’s hard to get off."

    Among those who do participate in retirement plans, stagnant contribution rates are another problem. According to the Employee Benefit Research Institute’s 2004 Retirement Confidence Survey, less than one-third of retirement-plan savers increased their contributions last year. EBRI also found that the average account balance among participants "who consistently held accounts since 1999 declined 7.9 percent in 2002 and 10.0 percent since 1999." And according to research conducted by the Principal Financial Group, a whopping 80 percent of employees are not saving adequately for retirement. Research also showed that a similar percentage described themselves as novice investors at best, with no idea how much they should be saving for retirement, according to Monica Kirgan, vice president of retirement and individual investor services at Principal Financial Group. The remedy: automatic yearly increases in deferrals, an option that the company has branded the Principal Step Ahead Retirement Option. Employees can specify the number of successive years for which their contributions will be increased. In a pilot program conducted last year among 3,000 participants, 25 percent chose to exercise the option, with annual increases averaging 1 percent.

    "People are time starved," Kirgan says. "But if the option is put in front of them, 50 percent will take a positive action toward retirement. With Step Ahead, in four years, you can quickly find yourself on a glide path." An added benefit for employers is that increased contributions among a wide cross section of employees are a good hedge against problems with the nondiscrimination test.

    Still, not everyone is sold on the idea that you can both lead a horse to water and make him drink. "I personally am not comfortable with automatic enrollment and step-ups," says Bracaglia of PricewaterhouseCoopers. "It seems a little too big brother."

    McGrady Gwinn, CFO at Coldwell Banker Caine Co. Real Estate in Greenville, South Carolina, says his company is more than pleased with Unified Trust’s emphasis on assessing risk tolerance in helping participants select funds. (Before the company went with Unified, its 401(k) plan was administered by a stock brokerage firm that was reluctant to make recommendations for fear of liability.) Still, Gwinn approaches the possibility of automatic increases gingerly. "It’s an interesting idea, but we haven’t decided yet," he says. "I’m thinking it would be coolly received. I’d like us to get one year under our belts and then tell people it’s an option."

    The issue of liability has dogged employers for years, swaying many toward a hands-off approach when it came to providing even the most rudimentary investment guidance to participants. This almost certainly contributed to their sensation that they’d been stranded in a hall of mirrors. But recent developments seem to have defanged the specter of liability. "Liability issues are relatively minor," says Vanguard’s Utkus. "The IRS has come out with a lot of endorsements in favor of automatic enrollment. The Department of Labor has come out in favor of using managed accounts. A lot has happened in the past three to five years to encourage the use of such programs."

Workforce Management, October 2004, pp. 88-89 -- Subscribe Now!

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