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. This phenomenon represents far more than just an interesting concept however, as Plan Sponsors who accept and embrace the inherent irrationality of their participants can effect much greater influence on the retirement readiness of their plan population.
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.
Automatic Enrollment
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.
Automatic Escalation
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.
A Streamlined Investment Menu
A robust, style box-driven investment line-up may feel like participants have ample opportunity to successfully plan for retirement, but behavioral economists like Professor Thaler have discovered a trend of “analysis paralysis” among participants. His research shows that too many choices paired with a lack of confidence or knowledge leads participants to delay or ultimately stall when making decisions. Plan Sponsors can combat this in a few ways:
• Emphasize the use of professionally designed and managed portfolios (such as target date funds) that focus on participant retirement objectives and default participants into these options upon enrollment. These portfolios help participants stay invested and counter loss aversion or the tendency to care more about losses than gains which can lead to improper market timing.
• Simplify and streamline the investment menu. Offer participants the building blocks to build an efficient asset allocation, while not overwhelming them with too many competing or overlapping options.
• Embed the complexity of multiple investment managers by using “white label” funds. White label funds typically appear with generic names to participants (i.e. U.S. Equity Fund) but are comprised of multiple underlying investment managers. As a result, participants gain access to funds that are conventionally named and easy to differentiate between, while the design, implementation and management decisions of these funds can be delegated to investment professionals. These funds can offer improved investment opportunities, lower costs and reduced complexity for both participants and plan fiduciaries.
By simplifying the investment line-up, Sponsors can help participants to focus on their savings habits and staying the course, rather than investment-related decisions which many participants may be ill-equipped to make.
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 professionals at DiMeo Schneider & Associates, L.L.C.
