Using Lessons from Behavioral Finance for Better Retirement Plan Design

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1 Plan advisor tools Using Lessons from Behavioral Finance for Better Retirement Plan Design Today s employees bear more responsibility for determining how to fund their retirement than employees in the past. Since company defined benefit plans have continued to give way to defined contribution plans, the vast majority of today s employees must calculate how much they will need in retirement and decide how to invest their savings to meet that need. Unfortunately, most employees are ill equipped to make these kinds of decisions and have completely unrealistic expectations for their likelihood of meeting retirement needs. As a matter of fact, a recent Gallup poll found that 28% of Americans believed it likely they would become rich someday, with those under age 30 the most confident: almost half found it likely they would be rich in their lifetime. 1 Many economists and pundits make the underlying assumption that the employee to whom this responsibility is handed is a well-informed economic agent who acts rationally to maximize his or her self-interest. 2 Unfortunately, the field of behavioral finance has found this is simply not how people make economic decisions. The following tables show several retirement savings behaviors, examines why employees behave this way, details the results of these behaviors, suggests how to create a plan design to address the behavior and the intended result of these plan design actions and their benefits to the participant and the plan sponsor. Undesirable Retirement Savings Behaviors Not saving or not saving enough Inertia and procrastination Gap between desire and action Poor investment allocation decisions Reliance on past performance to decide what to choose Investment choice overload Overweight to company stock Intended for use by investment professionals and institutions. Not intended for use with the public. A white paper from RidgeWorth Investments September 2012

2 Behaviors Not saving or not saving enough Inertia and procrastination Gap between desire and action Reasons for the Behavior Two Minds at work Individuals employ two different minds in decision making, an intuitive mind that makes snap decisions based on intuition and known information and a reflective mind that uses careful consideration and data analysis to arrive at a studied decision. 3 Status quo bias An irrational cognitive bias for what is currently perceivable. Leading to the belief that whatever you will be doing later will not be as important as what you are doing now. Hyperbolic discounting People place a lower value on future benefits (which are abstract) and overvalue the present (which is concrete); therefore, the near-term discount rate is much higher than the long-term discount rate. Heuristics When confronted with difficult decisions, people tend to adopt mental short cuts, based on experiential techniques and readily available data that simplify complex problems, such as accepting the default option (e.g., taking the path of least resistance or the simplest thing to do is nothing ). Framing effect Individuals are often highly influenced by how a question or default choice is posed or presented. 4 Result of the Behavior More than half (56%) of U.S. employees have not calculated how much they will need to retire, onethird have not saved anything for retirement, only 17% feel very confident about having enough for retirement, and 10% do not know how much they will need to retire comfortably. 5 After a 401(k) seminar, all employees in one company s plan who were not participating said they would. Over the next six months, though, only 14% actually did so. 6 Approximately half of participants made no changes to their plan over a 10-year period, 7 and nearly one in ten (9%) have never rebalanced their portfolios. 8 Participants are most likely to choose their plan s match ceiling (the amount of salary that a participant needs to defer to maximize employer match) than any other deferral rate. 8 A group of investors were offered an option of an annuity with a $650 monthly payment until death. When the annuity was framed as guaranteed monthly income, 70% selected the option; however, when it was described as an investment return in the same amount, only 21% chose it. 9 Plan Design Action Payroll deduction Pay yourself first as a commitment device: payroll deduction plans have four times the participation rate of non-payroll deduction plans. 2 Auto-enrollment with auto step-up or deferral rate A study showed that participation was 88% in plans offering automatic enrollment, an increase of 13% from the previous year, while participation in plans that did not offer automatic enrollment decreased by 1%. 10 Also, many investors are extremely fiduciary focus: better retirement plan design Page 2

3 loss-averse, and households may be resistant to increased contributions; they view these as a cut in takehome pay (or, a loss), but if the step-up takes place during a time of pay increases (annual review, raises, etc.) they are less likely to consider it a loss. 11 Company match Carefully structure the match formula to maximize deferral rates a 50% match on a certain deferral rate can encourage a higher contribution with the same cost to the employer as a 100% match on half the deferral rate (e.g., 50% match on 6% versus 100% on 3%). Benefits to the Plan Sponsor By encouraging rank and file employees to save more, your Highly Compensated Employees (HCEs) can be allowed to save more without worry of failing anti-discrimination testing. By structuring a company match at 50% of a higher percentage of deferral rather than 100% of a lower percentage of deferral, you can encourage greater savings by employees without additional cost to the firm. Benefits to the Participant Employees enter the plan sooner and participate longer. Employees save more and prepare better for retirement. Behaviors Poor investment allocation decisions Reliance on past performance to decide what to choose Investment choice overload Overweight to company stock Reasons for the Behavior Naïve heuristic Investors tend to avoid the extremes and stick to the middle ground. Risk perceptions and optimism about company stock Employees significantly underestimate the risks of their own company s stock and hold too rosy a view of their company s future. Availability heuristic When faced with difficult decisions, participants rely on readily available, and often the most recently received, information, leading to overreliance on recent past performance. Anchoring effect Decision-making is strongly influenced by starting values (e.g., the initial allocation decision, no matter how arbitrary that decision was). Prospect theory Individuals experience losses more acutely than gains. Loss aversion Investors who experience portfolio declines react negatively and experience psychological pain, which can lead to paralysis. 12 Decision paralysis Faced with complex investment choices, some participants do not make any decision at all. fiduciary focus: better retirement plan design Page 3

4 Results of the Behavior Participants, given the choice of an equity fund and a bond fund, chose an average equity allocations of 54%; those offered an equity fund, balanced fund and a bond fund chose an average equity allocation of 73%; those offered a balanced fund and a bond fund chose an average equity allocation of 35%. 13 Participants who first enroll during a bull market will continue to allocate more highly to equities than those who first enroll during a bear market, regardless of current market conditions. A key psychological factor in investor paralysis is loss aversion. Investors are even more averse to the prospect of future losses when they have experienced loss in the recent past (e.g., as during the recent financial crisis and downturn). 14 Participants future forecasts are often overconfident and excessively optimistic, but they are also loss averse to the point of holding on too long in hope of recovering losses. 8 Plan Design Action Simplified investment core-plus menu design Communication resources should be devoted to educating participants about a limited menu of core options, with additional options for more sophisticated investors segregated from the main menu. Present investment decisions and past performance in multiple ways Many participants lack well-formed investment preferences and those with preferences can be easily influenced by the way the choices are framed for them. Utilize plan s financial advisor to formulate an advice plan 70% of workers want their employer to make professional advice available to them. 15 Also, studies have shown that participants with access to professional advice achieved a higher rate of return than those without an advice plan 87% of the time. 16 Benefits to the Plan Sponsor Demystifying investment jargon and concepts will serve to empower participants and can make a huge difference in their investing behavior. By improving participant investing behaviors, you can ensure employees are invested prudently and lessen the chance of 404(c) violations for the plan. Benefits to the Participant Employees make more appropriate investment allocation decisions. Employees save more and prepare better for retirement. fiduciary focus: better retirement plan design Page 4

5 Conclusion Research into behavioral finance can offer insight into retirement plan design and help participants save more and save smarter to secure their financial future in retirement. Behavioral research shows employees do not behave as rational, autonomous micro calculators who exercise independent and unbiased judgment 2 when it comes to saving for retirement. Plan design can drive participant decisions, both in how much to save and in their investment choices. Offering too much choice is counterproductive to encouraging retirement saving, and a great deal depends on how the default contribution arrangement and investment menu is designed. Sources: 1 Gallup Poll: Public Opinion, May Mitchell, Olivia and Utkus, Stephen, Lessons from Behavioral Finance for Retirement Plan Design, Pension Research Council, The Wharton School, Benartzi, Shlomo, Behavioral Finance in Action, Allianz Global Investors Center for Behavioral Finance, Brown, Jeffrey R.; Kling, Jeffrey R.; Mullainathan, Sendhil; Wrobel, Marian V., Why Don t People Insure Late-Life Consumption? A Framing Explanation of the Under-Annuitization Puzzle, The American Economic Review, EBRI data, Choi, James, et al, Defined Contribution Pensions: Plan Rules, Participant Decisions, and the Path of Least Resistance, Ameriks, John and Zeldes, Stephen, How do Household Portfolio Shares Vary with Age?, Retirement Income Survey by Charles Schwab, Brown et al, Schwab survey, 11/16/2010; Results based on 911 plans and 755,000 participants. 11 Benartzi, Shlomo and Thaler, Richard, Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving, Benartzi, Shlomo, When Volatility Leads to Paralysis, Invest More Tomorrow, Allianz Global Investors Center for Behavioral Finance, Benartzi, Shlomo and Thaler, Richard, Naïve Diversification Strategies in Retirement Savings Plans, Thaler, Richard Johnson, Eric, Gambling with the House Money and Trying to Break Even, Management Science, vol. 35, no. 6, pp , (1990). 15 Schwab/Age Wave study, Rethinking Retirement, EBRI 2011 Retirement Confidence Survey Fact Sheet. Provided compliments of This whitepaper is provided by RidgeWorth Investments for informational and discussion purposes only. This information is general and educational in nature provided as general guidance on the subject covered, and is not intended to be authoritative. All information contained herein is believed to be correct, but accuracy cannot be guaranteed. The views expressed are as of the date specified. This information and general market-related projections are based on information available at the time, are subject to change without notice. This information may coincide or conflict with activities of the portfolio managers. It is not intended to be, and should not be construed as, investment, legal, estate planning, or tax advice. RidgeWorth does not provide legal, estate planning, or tax advice. Laws of a specific state or laws relevant to a particular situation or pensions in general may affect the applicability, accuracy, or completeness of this information. Federal and state laws and regulations are complex and are subject to change. All investments involve risk. Investors are advised to consult with their investment professional about their specific financial needs and goals before making any investment decisions. The opinions provided by the authors and other sources are not necessarily those of RidgeWorth RidgeWorth Investments. RidgeWorth Investments is the trade name for RidgeWorth Capital Management, Inc., an investment advisor registered with the SEC and the adviser to the RidgeWorth Funds. RidgeWorth Funds are distributed by RidgeWorth Distributors LLC, which is not affiliated with the adviser. RF-EABPD-0912