Maximizing workplace retirement plans

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People are not entirely rational. If they were, everyone would have fully funded retirement accounts and no debt.

Achieving successful retirement

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.

Defaults and investment decisions

When participants are enrolled automatically in workplace retirement plans, their contributions need a place to go. Typically contributions are defaulted to target-date funds or life-cycle funds, as allowed by the guidelines in the Pension Protection Act.

This can be a double-edged sword as the “fund of funds” structure of target-date and life-cycle funds can be expensive.

Expense ratios for the category range from 0.18 percent to 1.68 percent, with an average asset-weighted expense ratio of 1.02 percent, according to Morningstar.

Once participants are automatically enrolled into default investments, they’re much more likely to stay there, according to the National Bureau of Economic Research.

One possible explanation for the reluctance to move away from default investments could be the number of choices and the complexity of the decision. Research has found that it’s harder to choose from lots of things rather than a few things.

“People like me who come from the behavioral side say, ‘Well, choice is not that great for the people they are supposedly helping.’ You are actually going to make people better off by not having those choices,” says Statman.

In three experiments involving jams, chocolates and extra-credit essays, researchers Sheena Iyengar, from Columbia Business School, and Mark Lepper, from Stanford University, found that while having many choices seemed appealing initially, too many choices could weaken motivation as well as later satisfaction.

In concluding the study, released in 2000, Iyengar and Lepper hypothesized that though people enjoy choosing, they find the responsibility of separating good choices from bad to be something of a burden.

That’s easy to imagine when it comes to making retirement decisions and facing the responsibility of choosing good investments from an array of complex options.

Paternalism vs. shaping behavior

Not all employers want to add automatic features to workplace retirement plans. They can still lure employees to save for retirement using the employer match option.

The design of the match formula can make a big difference, says Marcy Supovitz, president of the National Association of Plan Advisors.

“If a plan offers a match of dollar for dollar for the first 3 percent deferred, the vast majority of employees defer only 3 percent. If you take the same match and instead do 50 cents on the dollar on the first 6 percent deferred, then the vast majority of employees will do 6 percent,” she says.

The Department of Labor is currently investigating the possibility of automating the withdrawal process at retirement, which could come with another set of benefits and pitfalls for individuals.

Similar to buying health and car insurance, saving for retirement is an individual choice that has wider ramifications. Despite the premium placed on individual choice, the government and employers may be increasingly stepping in to shape people to behave rationally when it comes to saving and investing –instead of behaving illogically, like people.