Image Credit: Christophe Vorlet
By Jason Zweig | March 29, 2013 7:08 p.m. ET
There is hope for alleviating the retirement-savings crisis. Companies just need to stop believing that “default” is a dirty word.
This month, the Employee Benefit Research Institute reported that 68% of workers in its annual Retirement Confidence Survey said they think they need to save at least 10% of their household income to live comfortably in retirement. Yet only 24% report that they have saved at least $100,000, and just 57% say they are saving for retirement.
When people want to save but can’t bring themselves to do it, their retirement funds need to do the saving for them—automatically.
But designing 401(k) plans that can pull off this trick is harder than it sounds.
“You have to do it right or it might actually backfire,” says Shlomo Benartzi, an economist at the University of California, Los Angeles, who helped pioneer the use of psychological research in designing savings plans.
The key is to harness the most powerful force in the financial universe: inertia.
The only thing people hate more than making decisions is changing them. Consider a 2003 study on organ donation. In Denmark, Germany and the United Kingdom, where citizens had to make an active choice to donate organs, only 4% to 17% consented to do so. In nearby Austria, France and Poland, where citizens were automatically “defaulted in” as donors unless they explicitly opted out, more than 99% agreed to donate.
As those examples show, the status quo exerts a magnetic force on choices. One way to exploit that inertia for a better outcome is automatic enrollment, in which employers default all new workers into the retirement plan unless the workers refuse to participate, which they are free to do at any time.
At companies that use automatic enrollment, an average of 83% of workers are saving, says consultant Aon Hewitt. At companies where workers must actively choose to save, only 65% are contributing.
However, “auto-enrollment wards off one kind of inertia and creates another,” says Dave Tolve, a partner specializing in benefits at Mercer, the consulting firm. “Workers say, ‘I’m in, so I’m all done, aren’t I?”‘
While automatic enrollment has brought millions of new savers into 401(k)s, most employers set the default contribution rate at 3%—and, because of inertia, most workers leave it there.
Auto-enrollment thus makes more people save, but many of them save too little. Patti Balthazor Bjork, director of retirement research at Aon Hewitt, says 39% of auto-enrolled workers don’t save enough to earn the full matching contribution offered by their employers, versus 25% of those who actively enrolled.
Auto-enrolled workers save at an average rate of 6.7%, Ms. Bjork says, fully one percentage point below the rate of those who made an active choice to enroll in the plan.
The solution, according to Mr. Benartzi and other industry experts, is to put savings increases on autopilot as well. Mr. Benartzi and his research partner, Richard Thaler of the University of Chicago, have showed how. Workers are defaulted into a commitment to increase their saving rate later, thus putting off the pain of having less cash to spend. The future rises are timed to coincide with salary increases, so take-home pay doesn’t fall even after those extra retirement contributions are taken out. Workers are always free to choose not to participate.
Still, fewer than half of employers that offer automatic enrollment also offer such an “automatic escalation” feature. Many companies, says Patricia Advaney, an executive at Transamerica Retirement Solutions in Harrison, N.Y., still fear being seen as coercive by their workers. Perhaps as a result, roughly two-thirds of plans that offer automatic escalation require their employees to choose it actively.
Only 8% of 401(k) participants who are offered the active choice of signing up for an annual increase in the percentage of their pay that they save for retirement will do so, says Michael Skinner, head of research at T. Rowe Price Retirement Plan Services. But if that escalation in their savings rate is made automatically on their behalf, 65% of participants leave the increase in place, even though they are free to reverse it at any time.
Donna Norwood, who helps oversee retirement-plan administration at Fidelity Investments, says that at the plans it administers, 88% of workers who automatically saved more in 2012 did so as the result of being defaulted into such programs. This year, she says, Fidelity began offering companies the ability to extend auto-escalation as a default to all workers, not just new hires.
If you are an employer, do your staff a favor and default them all into an automatic-escalation plan. If you are an employee and you are already saving at least 10% of your salary, pat yourself on the back. If you aren’t, demand that your company provide an automatic escalation plan—and go along for the ride.
Source: The Wall Street Journal
http://www.wsj.com/articles/SB10001424127887323361804578390313278109482
For further reading:
Eric J. Johnson and Daniel Goldstein, “Do Defaults Save Lives?” (2003)
Olivia Mitchell and Stephen Utkus, “Lessons from Behavioral Finance for Retirement Plan Design” (2003)
James J. Choi et al, “For Better or for Worse: Default Effects and 401(k) Savings Behavior” (2004)
Gabriel D. Carroll et al., “Optimal Defaults and Active Decisions” (2007)
John Beshears et al., “The Importance of Default Options for Retirement Saving Outcomes” (2009)
Eric J. Johnson et al., “Beyond Nudges: Tools of a Choice Architecture” (2012)
Brigitte C. Madrian, “Applying Insights from Behavioral Economics to Policy Design” (2014)