*Hot Topics in Retirement,
Hewitt Associates LLC, 2010.
Summer 2010
Using Behavioral Finance To Help Clients Improve Retirement Plans
Most retirement plans are based on expectations of "logical" behavior. But behavioral finance research shows that human behavior isn't always rational. Instead, inertia and procrastination, expectations of future willpower and a tendency to weigh losses more than gains often add up to employees who are unprepared for retirement. As you work with clients and prospects, applying behavioral finance concepts to plan design can help encourage employees to join the plan and to save more.
Overcoming Behavioral Roadblocks
Here's an overview of behavioral roadblocks and ways to help overcome these issues to increase participation and contributions in a 401(k), 403(b) or 457 plan.
- Risk aversion – Employees may be reluctant to enroll if they see contributing as an immediate loss (from their paycheck), versus a long-term gain (more money in retirement). Overcome this tendency by communicating in positive terms and through automatic enrollment and auto-escalation of contributions.
- Status quo bias – It’s easier to leave things alone than to research something and decide to act. Overcome this bias through ongoing communications, using stories that help people relate to their future selves. Automatic enrollments/contribution increases put inertia to work in favor of savings.
- Lack of self-control – Because what we want now has more importance to us than what we want in the future, employees may lack the foresight to join the plan and/or increase contributions. Overcome this lack through auto-enrollment and auto-escalation.
- Unrealistic optimism and hyperbolic discounting – Faced with uncertainty, we tend to avoid making a decision. We rationalize by believing that things will work themselves out and by discounting the importance of the future. Overcome these tendencies through ongoing education using real-life examples of people who did and did not save enough.
- Anchoring – We base decisions on a familiar starting point. It’s easy to make the leap from a 3 percent contribution to 6 percent, and not so easy to go from 0 to 6 percent all at once. Overcome this limitation by thoughtfully setting the default contribution rate, and by increasing contributions incrementally each year.
- Availability – Risk seems higher when the outcome of the risk is easily called to mind. An obvious example is recent stock market declines, which may cause potential participants to view joining the plan as too risky. Overcome objections through communications, using examples of peers.
- Representativeness – People see patterns where none actually exist and believe that they will continue, leading them to chase stock market returns. Overcome this limited reasoning by showing that consistent contributions can help create more wealth over time. You can also recommend appropriate target date funds or managed accounts as Qualified Default Investment Alternatives (QDIAs).
- Choice Overwhelms – Contrary to what we might think, increasing the number of options in the retirement plan can lead to choice avoidance and prevent employees from enrolling. Overcome confusion through careful plan design and fund selection.
- Framing – A fact can be perceived differently depending upon how it is framed, either positively or negatively. “Your pay will be lower by $125 each month” sounds negative, while “You will have contributed $1,500 by the end of the year” sounds positive. Overcome by reframing statements to encourage savings. Shift the focus from payroll deductions to annual contributions. Reframing to focus on monthly retirement income versus asset accumulation can also help make goals seem more relevant and attainable.
Increased Participation Benefits Executives, Employees And Advisors
Whether and how much employees contribute to their plan has a direct impact on the company owners and highly compensated employees, whose own ability to contribute generally depends on how much the rank and file employees contribute. As an advisor, your compensation may also depend on the plan’s assets.
Applying the principles of behavioral finance can help you and your clients encourage employees to save, thereby benefiting everyone.
To learn more about behavioral finance, view our online webinar, titled "The Science Behind Savings Motivation."
Employers Agree On
Going Automatic*
- Automatic enrollment. 59 percent of employers surveyed already offer automatic enrollment to new employees and 27 percent of the remainder are very or somewhat likely to implement it in 2010.
- Automatic escalation. 59 percent of respondents currently offer contribution escalation. 38 percent are planning to offer this feature in 2010.
- Automatic rebalancing. More than half of the employers surveyed currently offer automatic rebalancing and 46 percent of the remainder are very or somewhat likely to add it in 2010.
- More managed accounts. A quarter of companies indicate they plan to begin offering managed accounts in the coming 12 months, in addition to the 28 percent who already do.