Automatic Features: Saving in the Age of Behavioral Finance
By Shane Workman, Consultant, Bronfman Rothschild Plan Advisors
The recent Nobel Prize in Economics for American Richard Thaler enhanced the visibility of behavioral finance – the idea that humans are not rational actors when it comes to their best financial interests. It’s understandable, for example, that someone would rather spend hours researching and planning their next vacation than considering the minute details of their retirement accounts. This person is not irresponsible, they are simply pursuing the activities that bring them pleasure.
Unfortunately, most Defined Contribution retirement plans of today are founded on the opposite idea, that employees will act in their financial self-interest – i.e., make regular, maximized contributions to their employer sponsored retirement plan. Thankfully, many companies are adopting features like those encouraged in the work of Dr. Thaler, which mitigate the natural irrationality of humans and their money. The international attention that is now being paid to behavioral finance should hopefully reinforce the benefits that many are already reaping from incorporating automatic strategies into retirement savings.
Automatic Features Mitigate Irrationally Low Participation, Contribution to Retirement Plans
You may have heard financial wonks get excited about Thaler’s Nobel Prize. Economic theory has traditionally been supported by the idea that individual consumers are inherently irrational, and thus, that financially rational employees will responsibly figure out how much to save for retirement on their own and demonstrate the financial self-control to dutifully implement the plan month-after-month until retirement. Thaler disagrees, having said that “the assumption that everybody will figure out how much they have to save and then just implement that plan is obviously preposterous.”
Thaler’s research focuses on the intersection of economic and psychological analyses of individual decision making. Recognizing the natural tendency for the average human to not pay particular attention to distant financial matters, such as retirement, Thaler has championed the idea that employees must be “nudged” into the right plans via automatic features.
Auto-enrollment features automatically sign up employees for company retirement plans and auto-escalation features automatically increase an employee’s savings rate, both of which are designed to boost how much workers are saving. Although an employee can opt out of such features, the key development is that in doing so they are consciously choosing not to save for their retirement goals. Studies show that such features are increasing the average American worker’s retirement readiness.
Automatic Features are Good For Individuals Participating in a Retirement Plan
The narrative about worker stress related to personal finances is well-known. Many Americans are burdened by everyday finances and generally unaware of their precise retirement needs. This is typically a major source of stress to their lives, and surveys have shown that this stress will decrease their productivity at work. Thaler says that “the lesson from behavioral [finance] is that people only save if it’s automatic.” A financial advisor will typically advise setting aside 15% of your salary for retirement saving. Automatic features nudge workers toward this goal. Your plan may start you at a 6% contribution rate, but auto-escalation will automatically increase your savings rate each year until you reach the optimal savings rate.
Retirement plans are most effective when they pair automatic features with financial wellness. When plan sponsors visit company sites to speak with participants, there is great opportunity to increase overall employee financial literacy. In addition to presenting to a large group, plan sponsors offer one-on-one “financial check-ups,” whereby participants can receive personalized financial advice, understand their contribution rate, and adjust their plan as necessary. The combination of automatic features and financial wellness can substantially boost a worker’s chance of retiring with enough income and reduce overall financial anxiety.
Participants Overwhelmingly Favor Automatic Features in Their Plans
If automatic features are so great for plan participants, why aren’t they more ubiquitous among American employers? Surveys have shown that automatic features are overwhelmingly popular among employees, especially auto-enrollment (75%), auto-escalation (74%), and auto re-enrollment (82%). It is therefore concerning that only 25% of 401(k) plans today include automatic features. What gives?
Employers have cited many reasons, including company size, concerns about cost, lack of employee interest, or lack of company or management interest. Many of these concerns are unfounded. While there are generally added costs associated with including automatic features in retirement plans, it is actually in the interest of employers to prepare their workers for retirement. Older workers that delay retirement due to insufficient savings creates a situation in which employers are maintaining an older, more expensive workforce while simultaneously “are left with fewer slots to reward and retain their best young workers.”
Plan Sponsors Have Much to Gain From Offering Automatic Features to Their Retirement Plans
Preparing your entire workforce for retirement is in the long-term interest of any firm, large or small, and today the benefits of including automatic features far outweigh the costs. If you are a manager of a retirement plan and are thinking about including automatic features in your plan, here are some decisions that will need to be made:
- Determine who will participate in auto-enrollment
- Choose default contribution, usually as a percentage of employee salary
- Define employer matching – consider “stretched employer matching” to encourage employees to contribute a higher percentage. For example, instead of matching 100% of an employee’s 3% contribution, match 50% of a 6% contribution. This “nudges” participants to save more.
- Establish annual auto-escalation amounts
- Determine automatic re-enrollment
- Advertise these beneficial features to your employees. In our experience, thorough communication of details to employees is crucial to satisfaction with the retirement plan.
For retirement plan sponsors, including automatic features is in the interest of the company and of the individual. While educating the workforce on the basics of retirement savings strategies and offering them the investment vehicles to reach their retirement goals are a good start, behavioral economics suggests that this is not sufficient for the irrational human worker. Take if from Nobel laureate Richard Thaler himself: “I’m all for empowerment and education, but the empirical evidence is that it doesn’t work. That’s why I say make it easy.” Automatic features make retirement saving easy for the individual and serve the long-term interest of the firm. Consider adding automatic features to your retirement plan today.