A Nobel Prize-winning 401(k)
Imagine winning the Nobel Prize for the best 401(k) plan design.
The notion may not be farfetched as Richard Thaler, an economist at the University of Chicago’s Booth School of Business, won the Nobel Prize in economics recently for his insights into behavioral economics. His work has direct implications – and many would argue a hugely positive impact – on 401(k) savings.
The findings from Dr. Thaler’s seminal study, Save More Tomorrow1, co-authored by Shlomo Benartzi of the University of California, may be put to good use by financial advisors when designing 401(k) and other defined contribution retirement plans. The study shows how behavioral economic principles such as inertia, myopia and loss aversion can be used to motivate workers to start saving and even save more. Those behaviors form the general foundation of 401(k) plan designs and features such as automatic enrollment, automatic escalation of savings and target date funds.
Take inertia or humans’ innate bias towards inaction. If you automatically sign employees up for a 401(k) instead of asking for volunteers, Dr. Thaler reasoned, then 90 percent will not only start saving but will continue doing it. Slowly increase the rate of savings over time and not only will they save more, they may even save sufficient amounts to retire. Who knew inaction could be so effective?
Most humans are also terrified of loss. That fear often discourages people from saving or taking sufficient risks over time to accumulate the retirement savings they need, according to Dr. Thaler. Target-date funds are aimed at solving this problem, putting suitable investors in a highly diversified portfolio of stocks, bonds and cash calibrated to the investor’s time horizon to retirement. The assets are then automatically reallocated over time as he or she creeps closer to retirement.
Most of us also suffer from myopia or the inability to see the future2. Given the choice of investing money for tomorrow or spending for a good time today, most humans will quickly jump on the next flight to a tropical island. Helping people envision what their life in retirement might be like is a first step at overcoming this behavioral shortcoming. It’s especially so if they see themselves retiring to their dream destination.
Dr. Benartzi estimates that at least 15 million people in the U.S. are saving more for retirement thanks to this research.
New research by Dr. Benartzi and John Beshears of Harvard Business School pushes the boundaries of Dr. Thaler’s work. Drs. Benartzi and Beshears found that employees can be defaulted into 401(k) plans at salary deferral rates above 6 percent without them bailing3.
Participants in the study were randomly assigned savings deferral rates from 6 percent to 11 percent of salary and could default at any time to zero. What the research found was that those with default savings rates higher than 6 percent were no more likely to stop saving than those who were assigned smaller percentages. It shows that despite some reticence on the part of employers, savings default rates can be set at higher rates than the 1 percent to 3 percent levels that are common.
Dr. Thaler and other behavioral economists have pioneered new frontiers for America’s retirement savings. Their work is opening new possibilities to help workers better prepare for retirement, simply by making the most of their human shortcomings.
Advisors who apply the same principles can go a long way towards helping create more effective retirement plans and helping more people realize their retirement dreams. Based on Dr. Thaler’s experience, doing so just might be a noble as well as a Nobel endeavor.
E. Thomas Foster Jr. is head of strategic relationships for retirement plans for Massachusetts Mutual Life Insurance Co. (MassMutual).
1 Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving, Richard H. Thaler,
University of Chicago and Shlomo Benartzi, University of California, Los Angeles, 2004, http://faculty.chicagobooth.edu/richard.thaler/research/pdf/smartjpe.pdf
2 The Effect of Myopia and Loss Aversion on Risk Taking: An Experimental Test,
Richard H. Thaler Amos Tversky Daniel Kahneman Alan Schwartz, 1997, https://academic.oup.com/qje/article-abstract/112/2/647/1870948/The-Effect-of-Myopia-and-Loss-Aversion-on-Risk?redirectedFrom=PDF
3 How Do Consumers Respond When Default Options Push the Envelope? Voya Behavioral Finance Institute for Innovation, 2017, https://www.morningstar.com/news/pr-news-wire/PRNews