Image Credit: Christophe Vorlet
By Jason Zweig | Oct. 13, 2017 12:13 pm ET
“Default” is normally a bad word in finance; ask anyone who’s ever owned a bond that missed an interest payment. But another sort of default can be good for retirement savers.
Inspired by research from Richard Thaler, an economist at the University of Chicago Booth School of Business, and other scholars, companies automatically enroll employees into a 401(k) retirement plan. That way, workers participate by default, rather than having to sign up in order to save. Prof. Thaler won the Nobel Prize in economics this past week, partly for studies that led to such insights.
Defaults can wield huge influence over human behavior. In countries where people are automatically cleared to donate organs unless they register not to, an average of about 90% end up donating. In countries where people must actively choose to donate organs, roughly 15% become donors, on average. Decisions can function like adhesives: Whatever hits first tends to stick.
If you default new workers into a retirement account, meaning they are automatically enrolled to save unless they opt out, more than 90% participate — even though they are free to choose not to. If you default them out, so they must make a deliberate choice to register in order to participate, fewer than half sign up.
There’s a dark side, though: While defaults lead more people to save, those who do save less.
About 40% of new workers at companies that automatically enrolled them in a 401(k) ended up saving less than they would have if they had signed up voluntarily, the nonprofit Employee Benefit Research Institute estimated in 2011.
Many employers set the initial contribution rate at 3% of pay — partly to cut costs, partly out of concern that a higher rate might painfully pinch many workers’ take-home pay, discouraging them from participating at all.
Because inertia is one of the most powerful forces in financial physics, workers who are defaulted into saving 3% are inclined to leave their contribution rate right there.
Those who make an active choice, however, tend to think through the problem of how much they can afford to save from scratch. They may also be more motivated by receiving the maximum matching contribution from the company — which often applies on the first 6% that employees set aside.
On average, newly hired workers who opted in voluntarily to a 401(k) plan chose to save 5% of their paycheck in 2016, while those who were automatically defaulted in saved 4.1%, according to Vanguard Group.
Nearly half — 44% — of 401(k) plans using automatic enrollment default workers in at a contribution rate of 3%, says Vanguard. Only about 20% of such plans default employers in at saving rates of 6% or higher, according to Vanguard and the Plan Sponsor Council of America.
About one-tenth of workers will stop saving regardless of whether the contribution rate is 3% or 6%, says Jean Young, senior analyst at the Vanguard Group’s Center for Investor Research. Yet many employers remain worried that workers will stop saving entirely if 6% or more comes out of their paycheck.
A new study led by John Beshears of Harvard Business School and Shlomo Benartzi of the University of California, Los Angeles, shows that employers can probably default workers into 401(k) plans at rates above 6% without scaring them out of saving.
From November 2016 through this July, the researchers studied 10,000 employees enrolling in 1,500 retirement plans served by Voya Financial, Inc., the fifth-largest 401(k) provider in the U.S.
The employees were randomly selected to view a default saving rate of 6%, 7%, 8%, 9%, 10% or 11%. (They could reduce the rate in increments all the way down to zero simply by clicking a button.)
Were those who saw default saving rates above 6% significantly more likely to drop out? No, the study found: Roughly one in 10 participants quit saving, irrespective of how much would come out of their paychecks.
Something else happened: Those with default contribution rates above 6% ended up saving 0.2 to 0.5 percentage points more.
The difference in saving 6%, versus 6.2% to 6.5%, might sound trivial, but it isn’t. Stretch that over decades and it can add up to tens of thousands of dollars — as much as an 8% increase in total retirement savings, says Prof. Benartzi of UCLA.
Many Americans aren’t saving nearly enough — and often don’t even realize it. Getting people to save 6.2% instead of 6% “isn’t going to solve the undersaving crisis by itself,” says Prof. Beshears of Harvard. “But we shouldn’t let the perfect be the enemy of the good or the better. Every little bit counts.”
Source: The Wall Street Journal, http://on.wsj.com/2zm87xY
For further reading:
Richard H. Thaler, The Winner’s Curse: Paradoxes and Anomalies of Economic Life
Richard H. Thaler and Cass R. Sunstein, Nudge: Improving Decisions About Health, Wealth, and Happiness
Richard H. Thaler, Misbehaving: The Making of Behavioral Economics
Definitions of BEHAVIORAL ECONOMICS, IRRATIONAL, RISK, in Jason Zweig, The Devil’s Financial Dictionary
Jason Zweig, Your Money and Your Brain