Maximizing workplace retirement plans
- Inertia is the dominant force preventing employees from saving for retirement.
- Some 55 percent of employers automatically enroll workers in a retirement plan.
- The Labor Department is studying the option of automating withdrawals at retirement.
People are not entirely rational. If they were, everyone would have fully funded retirement accounts and no debt.
To get around the inherently irrational human brain, employers offering workplace retirement plans engage in a little benign social engineering to make sure workers save for the future.
Tricks of the trade
Everyone knows they need to resist spending all of their money today in order to save for the future. Unfortunately, procrastination is easier.
That reluctance to drop everything to figure out how to save for retirement is known as inertia: the same phenomenon affecting rocks that stubbornly sit in one place.
To beat inertia, some employers enroll employees in retirement plans automatically, requiring workers to take action to opt out, which is more difficult than opting in by doing nothing.
Before automatic enrollment became widespread, "the fraction of workers that opted in tended to be fairly low, in the 30 (percent) to 40 percent range," says Olivia Mitchell, professor of business and public policy at The Wharton School of the University of Pennsylvania.
Automatic enrollment became more widespread after the Pension Protection Act of 2006 became law.
Employers who added automatic enrollment saw plan participation skyrocket, up to 90 percent or 95 percent, according to Mitchell.
"The message there was: People know they should be saving; it is important to think about the future. But they lose their PIN or they think they'll do it later and then they don't," she says.
Today, about 55 percent of plan sponsors automatically enroll employees in their retirement plans, according to a study by Aon Hewitt released in January 2012. Over a third, 34 percent, plan to add automatic enrollment for new employees this year.
Defaults can lead to inertia
Ironically, automatic enrollment in workplace retirement plans increases participation rates but can lower overall contribution rates, a 2012 study by Ariel Investments and Aon Hewitt found. Participants who are auto-enrolled contribute less than participants who sign up on their own, the study found.
Behavioral finance researchers have delved into that issue as well. In 2008, Maarten van Rooij, from the Netherlands Central Bank, and Federica Teppa, from the Erasmus University Rotterdam in the Netherlands, concluded in a working paper that procrastination and financial illiteracy may best explain why people stick with default options.
To combat that, plan sponsors can also add an automatic escalation feature that bumps up the contribution rate annually. About 1 out of 4 plans (26 percent) intending to change automatic enrollments say they're adding this feature as well, according to the January Aon Hewitt survey.
"They might default you in at 3 percent and then you agree upfront to have the saving rate increased every year into the future," Mitchell says.
"It has been found that people know they need to save, they know they need to save more than 3 percent. But somehow it is easier to think about putting it in the future," she says.
A mental sleight of hand makes the present more significant than the future, which is why it's so tempting -- and easy -- to spend now and save later.
"People regard future raises as 'bonus money' and perceive it as less tangible than current salary. So, (they're) thinking today, it is easy to give up that 'bonus money' for the serious goal of retirement income," says Meir Statman, the Glenn Klimek professor of finance at the Leavey School of Business at Santa Clara University.