If you design it, they will come: Behavioral finance can help sponsors offer better retirement plans
Better retirement plan design means deeper participant engagement and higher savings rates.
Saying that Americans don’t save enough for retirement is a bit like declaring water to be wet. Only 30% of savers say they are very confident that they will have a comfortable retirement, according to the Employee Benefit Research Institute’s 2020 Retirement Confidence Survey. But unlike water and it’s moisture properties, the lack of retirement savings isn’t a foregone conclusion. There’s a lot plan sponsors can do to help workers save and improve their retirement readiness.
The field of behavioral finance provides a lot of ideas about how to do this. Richard Thaler, for example, author of the widely read book “Nudge,” even won the Nobel Prize in Economics in 2017 for his work on ways people can “nudged” into making better decisions. Those findings have been applied to retirement plan designs.
Yet many employers still haven’t been nudged themselves into adopting plan design best practices.
“One of the premises behind behavioral finance is that by and large people are busy and they put off decisions they should make today,” says David Stinnett, head of Strategic Retirement Consulting with Vanguard. “That’s why some of these concepts are so effective.”
It also takes the onus off individuals, says Jon Dauphiné, CEO of the Foundation for Financial Planning and the former senior vice president of education and outreach at AARP. “You don’t want to put all the burden on participants to do everything right,” he says. “You want to default them into good decisions.”
Features such as auto-enrollment and auto-escalation have been shown to improve participation in retirement plans and also encourage greater savings rates. In 2006 Congress passed the Pension Protection Act that provided employers with legal cover for implementing some of them such as auto enrollment and default investment options. Yet 15 years on, only half of small companies have adopted the auto enrollment feature, while 71% of large companies have done the same, Vanguard’s research shows.
“It’s a disgrace that not every plan in the country has an auto default option,” says Frank Armstrong, founder and principal of Miami-based registered investment advisor Investor Solutions.
These features can be simple to adopt as almost every third party administrator offers some form of automation and technical solutions to harness behavioral finance best practices. According to behavioral finance, there are some plan design features that are proven to improve outcomes.
Auto-enrollment
Before auto-enrollment became the default option for many employees, they had to opt in to their retirement plan. Human behavior being what it is, this resulted in only the most motivated employees participating in retirement saving.
But the Pension Protection Act of 2006 changed that, pushing more companies into adopting auto features, so that employees who didn’t want to participate had to opt out. Again, human behavior being what it is, inertia takes over and most people don’t bother opting out. According to the Defined Contribution Institutional Investment Association, the opt-out rate is just 7%.
“You want to design any system, not just retirement systems, so that if [participants] do nothing, the default option is going to leave them OK,” says Frank Armstrong, founder and principal of Investor Solutions, a Miami-based registered investment advisor.
However, in its latest survey, the DCIIA found that only 7% of companies that don’t currently offer auto-enrollment plan to implement it.
Default to a meaningful deferral rate
Most financial planners agree that people need to save between 12% and 15% of their wages if they want to squirrel away enough money for a secure retirement. Yet, the majority of plans still set their default savings rate at 3% or 4%, though almost a quarter of plans set deferral rates of that are at least 6%, according to Vanguard.
“All the plan defaults can be engineered to get them there,” says Armstrong. “It doesn’t matter if you have the world’s best plan if people aren’t using it or not saving enough.”
Plan sponsors should set initial deferral rates high enough that employees are at least able to get the full company match. Then, using auto escalation features helps to save more over time. Plans can be designed to boost participants’ deferral rates by 1% or 2% each year or direct a portion of raises toward retirement savings. Participants may have a hard time stomaching 15% of their salaries upfront, but they may not notice a gradual increase.
Use appropriate investments
Unless plan participants are getting the personalized advice, they probably don’t know what to do with their money once they invest. In the past that money languished in money market funds earning less than 1% a year in interest.
The PPA allowed employers to use some types of funds, such as target date funds, as qualified default investment alternatives
“In an ideal world, everyone would have an experienced fiduciary advisor working with them, but we know that’s not feasible,” says Dauphiné. “”Because of that, we need to automate plans in a smart way like using target-date funds.”
According to Vanguard’s research, 93% of plans use target-date funds. Industry observers say that the growth of the target-date fund market is the direct result of the investment’s inclusion as a QDIA.
More to do
Despite the advances over the last decade and a half, plan sponsors could be doing more to design their plans in ways that increase participation further and help employees save even more.
Re-enrollment: One option is to re-enroll people who opted out initially. There might have been a reason why they chose not to participate the first time around, such as dealing with student loans or medical expenses, that may longer be relevant. “You want to take one more bite at the apple,” says Stinnett of Vanguard.
Target undersavers: Sweep employees with low deferral rates up at least high enough so they get the full company match.
Education programs: Even with automated features, there is still a role for targeted participant education. Sponsors can offer personalized recommendations that make choosing the right actions easy, such as one button at the end of an email that will take participants right to their 401(k) dashboard to increase their contribution amount.
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