In the beginning, the 401(k) world was easy and fun. Its movement away from the shackles of company-controlled pension and profit sharing plans allowed employees to make simple choices between three obviously different investment options. It was not unlike a three-ring circus. Everyone wanted to go to the 401(k) and everyone had a great time once they got there. They didn't need to memorize reams of investment theory, they just needed an ounce of common sense.
As more service providers saw the lucrative advantages of entering the 401(k) market, Modern Portfolio Theory descended upon the retirement plan world like a dark cloud. Gone was the child-like joy of the three options. Entire the complex paradigm of the style box. Choices multiplied and trying to do well in your retirement plan required the equivalent time and effort of studying for a calculus BC exam. The 401(k) was no longer a three-ring circus you could visit every so often. It was complicated Rubik's Cube you needed to solve every day.
Right around the turn of the millennium, however, a light appeared at the end of the tunnel. This was about the time behavioral finance researchers discovered how useful it was to examine 401(k) decision making.
In the case of too little participation, behavioral finance revealed how opt-out models could be more successful than the standard opt-in model. Employees still had a choice whether to participate or not, but the choice was now reframed. In the old model, a “no-action” decision kept an employee out of the plan. In today's models, based on what we've learned from behavioral finance, a “no-action” decision keeps an employee in the plan.
It gets even better.
Using the advantage of inertia (i.e., “no-action”), plan sponsors have helped address the two next greatest problems of 401(k) participants—not contributing enough and not investing in long-term investments.
In the first case, researchers found employees who increased their contribution rate with every raise benefited. While those who did not increase their contribution rate with every raise found their contribution rate remained the same, those who did increase their contribution rate with every raise saw their contribution rate go up from 3.5 percent to 13.6 percent after four raises.
In the second case, the same two researchers found that by merely limiting the number of fixed-income options in a plan, the amount invested in long-term securities (i.e., equities) increased.
By applying behavioral finance techniques to 401(k) plan design and implementation, plan sponsors have found they can successfully address many of the challenges presented by participant choice plans.
This is something all employees can be thankful for.
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Christopher Carosa
Chris Carosa has been writing a weekly article and monthly column for BenefitsPRO online and BenefitsPRO Magazine since 2011 and is a nationally recognized award-winning writer, researcher and speaker. He’s written seven books, including From Cradle to Retire: The Child IRA; Hey! What’s My Number? – How to Increase the Odds You Will Retire in Comfort; A Pizza The Action: Everything I Ever Learned About Business I Learned By Working in a Pizza Stand at the Erie County Fair; and the widely acclaimed 401(k) Fiduciary Solutions. Carosa is also Chief Contributing Editor of the authoritative trade journal FiduciaryNews.com and publisher of the Mendon-Honeoye Falls-Lima Sentinel, a weekly community newspaper he founded in 1989. Currently serving as President of the National Society of Newspaper Columnists and with more than 1,000 articles published in various publications, he appears regularly in the national media. A “parallel” entrepreneur, he actively runs a handful of businesses, including a small boutique investment adviser, providing hands-on experience for his writing. A trained astrophysicist, he also holds an MBA and has been designated a Certified Trust and Financial Advisor. Share your thoughts and story ideas with him through Facebook (https://www.facebook.com/christophercarosa/)and Twitter (https://twitter.com/ChrisCarosa).
