One of the most interesting things about working with retirement plans is that, for the most part, participants get to make their own decisions. Plan sponsors, with the help of consultants and other service providers, strive to create a plan that enables participants to make good decisions and likewise, difficult to make especially poor decisions. Plan sponsors can do this through a variety of different services and plan design choices.
As defined benefit (DB) plans waned and defined contribution (DC) plans began to dominate the market place, a key difference between the two was that investment selection and contribution level decisions were shifted from the plan sponsor (in DB plans) to the participants themselves (in DC plans). This obviously has pros and cons for participants. On the one hand, a participant is most familiar with their savings and investing goals, as well as how much they can afford to save and how much they spend now and may spend in retirement. On the other hand, participants may lack the financial and investment literacy necessary to make the most appropriate choices to reach their goals.
I was recently in a room with several personal financial advisors discussing behavioral finance and strategies to overcome cognitive biases in their clients. I couldn’t help but compare those tactics with the ones we see employed in the retirement plan business. Below I detail a few common cognitive biases and explore how plan sponsors may use plan design features to take advantage of, or overcome, those biases.
Status Quo Bias – people facing an array of choices are predisposed to select whichever option extends the existing condition.
Generally, when participants enroll in the plan is when they are the most engaged. The asset allocation and contribution rate a participant selects at that time is likely going to stick with them for quite a while because of this bias. This bias contributes to a lack of rebalancing by participants, as their asset allocation becomes skewed or their needs and risk tolerances change. It also means they may not update their contribution amount as needs and ability to save changes.
On the other side, plan sponsors are relying on this bias whenever they use defaults within the plan, and especially with automatic enrollment. Study after study has shown that participation rates go up when automatic enrollment is used precisely because participants stick with the status quo and do not opt-out of contributing to the plan. Additionally, one of the reasons we often recommend target date funds as the default investment is that they are generally well-diversified investments which de-risk over time, which is often a good option for a large portion of participants. Therefore, when participants stick to the status quo, at least they are in a vehicle which is likely to be appropriate for them.
Anchoring and Adjustment Bias – when given an initial default number, an “anchor,” which must then be adjusted up or down to reflect new information, a person biases towards the anchor and fails to move up or down as much as is appropriate.
We see this most often in the retirement plan world with contribution rates. Anchor contribution rates can be created in a variety of ways: default rates for automatic enrollment, the rate which attains the full match, or an example rate on enrollment materials. This again has pros and cons for participants. High anchors may induce people to save more, low anchor weights may keep savings rates low.
One way plan sponsors may work to overcome this bias is through the use of automatic escalation, that is, increasing a participant’s contribution rate by some set rate annually up to a limit. This could be an opt-in program where participants can self-select or an opt-out program in conjunction with automatic enrollment.
Self-control Bias – a person fails to act in favor of their own long-term goals because of a lack of self-control.
At this point, most people realize they should save for their retirement, but we know that many people are not saving at all or saving at lower rate than is necessary to cover their costs in retirement. Some of this can be contributed to lack of access, some to lack of ability to save, but some are undoubtably because people sabotage their future interests for temporary benefits today. Even when a participant is contributing to the plan, you see this focus on today to the detriment of tomorrow when participants take loans from their retirement or cash out their balances when changing jobs.
Plan sponsors can combat this bias through a few different techniques. Defaults, as discussed above are a powerful tool, so the use of automatic enrollment and automatic escalation can help get participants to save more for their retirement. Putting limits on loans or early distributions may stop plan leakage. Additionally, education, advice, retirement planning tools, and savings calculators can help participants think more clearly about their future selves and future needs.
In summary, we all are guilty of some sloppy thinking. Knowing how people come to make irrational decisions can help work towards fixing them. Participants are running the show on their retirement savings, but plan sponsors have tools to help. Carefully considered defaults, plan provisions, and robust tools and education resources can help even the most disinterested participant get on the right track to retire with dignity.
Multnomah Group is a registered investment adviser, registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice.