Organizations make significant investments in the funding, design, communication, and administration of their retirement savings plans so employees can enjoy a well-timed and comfortable retirement. Keep in mind too that retirement is meant to be a mutually beneficial arrangement between employers and employees. Despite the best efforts of employers, studies consistently show that unless “auto” features that make decisions about enrollment, contribution amounts, and investment choices on behalf of employees are in place, employees will often fail to take action or make decisions that are in their best interests.
So why aren’t employees responding as expected and taking advantage of their retirement savings plans? And what can you do about it? The answer lies in knowing a bit more about human behavior and what the field of behavioral economics tells us.
Behavioral economics is becoming increasingly more important these days as employers modify their benefit plans and employees assume a greater role in making their own health, wealth and career decisions. Its insights can help employers understand why employees make decisions that may not be in their best interests. These decisions can even be considered irrational from a pure economic standpoint. Behavioral economics can also help employers revise and reframe traditional thinking to develop new approaches that are more effective and result in greater employee accountability and engagement. So how does this apply to decisions people make about saving for retirement? Let’s look at five ways that behavioral economics can explain some of the contributing factors to the retirement readiness crisis.
- Choice Overload – When faced with too many options or choices, people tend to freeze or shut down and not make a decision. When it comes to saving, not making a decision can mean not saving. This can occur when employees are given too many investment fund choices. Presenting too many fund choices can cause confusion and result in indecision and inaction. Employees may end up abandoning the savings plan enrollment process altogether or opting out. This is one of the reasons why automatic features, such as auto enrollment and auto investment, can be so important.
- Endorsement Effect – This effect is very powerful and occurs as a result of the influence a person (such as a celebrity) or an organization (such as an employer) can exert because of their status or prominence. This is why advertisers use celebrity spokespersons. People will pay attention to and follow the spokesperson’s message, even if it’s not in their best interests to do so. The same holds true for organizations. If an employer auto enrolls employees in the company’s retirement savings plan at 3% and auto invests their money in a stable value fund, most employees will readily comply and not opt out. They believe the employer has their best interests at heart and has put them in a position where they should be to reach their retirement goals. After all, the employer knows best and usually a lot more about the retirement savings plan than they do. They would be foolish not to accept this decision the employer makes on behalf of them, right? Well, that may not be true in a number of cases. Studies show that most employees need to contribute a total of 10-15% of their pay to their retirement savings plans over the course of their careers to maintain their standard of living in retirement. A 3% contribution is going to leave most employees woefully short of their retirement income goals even with a 100% employer match. Communication and education become very critical in this situation. There is no guarantee, however, that the messages and guidance will result in good decisions.
- Hyperbolic Discounting – Hyperbolic discounting is the tendency for people to heavily discount the importance of future events in favor of immediate action (or inaction). This behavior results in people putting off things, even when those things are clearly beneficial. Hyperbolic discounting helps explain a prevalent and regretful behavior: procrastination. Not starting to save for retirement is a great example of hyperbolic discounting. Employees will tend to procrastinate because they discount the value of tax advantages and future investment gains, not to mention the need for future income. This is why plan features such as auto enrollment are so important and effective.
- Loss Aversion – Loss aversion is the tendency for people to be more motivated by avoiding a loss than achieving a gain. This manifests itself in two ways when it comes to savings: employees decide not to join the retirement savings plan, because they don’t want to risk losing their money and they invest all or too much money in less risky investments since they don’t want to lose money. What employees fail to grasp, however, is that not investing or selecting investments that are too conservative will inhibit them from reaching their investment goals.
- Status Quo Bias – The principle of inertia – a body at rest tends to stay at rest – holds true when it comes to savings. Studies consistently show that the best way to get employees to start saving is to auto enroll them in the retirement savings plan. The same holds true for increasing savings. Auto escalation is the most effective tactic to get employees to save more. Unless employees are nudged, they will tend to stay where they are and do nothing. What may be even more profound is that when employees are nudged via auto enrollment and auto escalation, an overwhelming number accept it and don’t stop or try to undo the change. They readily adopt the new status quo and adjust accordingly.
As the traditional, defined benefit pension plan became unsustainable for many organizations, they began adopting the defined contribution approach. This transferred various financial risks – savings rates, investment choices, and the risk of outliving retirement funds – from professional pension committees and sponsors to the individual participants themselves. Now they’re suddenly pension plan managers, without the education, tools, and time needed to do it effectively.
Since saving for retirement is primarily in the hands of the individual, and savings rates and account balances are well below the adequate targets, we need a solution that breaks down the barriers and gets people to start saving responsibly for retirement.