It’s America Saves Week, and many people are focused on their financial futures. With regard to retirement planning specifically, too many individual savers and retirement plan participants engage in investing and saving biases of which they’re largely unaware.
In a recent podcast, Schwab executives discussed the cognitive and emotional biases that influence people’s 401k financial decisions and offered strategies to help people improve their financial outcomes.
Default Bias
More and more employers are using defaults when it comes to 401k plans, specifically with automatic enrollment, automatic savings increases (auto-escalation) and default investment selections, but participants shouldn’t necessarily rely on these defaults to be sufficient for them reach their retirement goals.
“Defaults are a great place to start, but there is a bias that leads people to believe that if they are defaulted into something that it’s the right thing for them,” Nathan Voris, managing director of business strategy at Schwab Retirement Services, said. “And that might not necessarily always be the case.
A 3 percent savings rate is a good starting point, he adds, “but for most of us, that’s not going to get us to the retirement that we want. Recognizing that defaults are a starting point, it’s important to do your homework and make sure that your contribution level will ultimately help you meet your retirement savings goals.”
Status Quo Bias
Status quo bias creates a sort of paralysis because sticking with what the participant has is easier than taking action.
There are lots of things they could do, but they end up doing nothing, which means they passively accept a sub-optimal situation.
When thinking about this concept in a retirement context, it’s a reminder of how important it is to regularly monitor the 401k to make sure it still aligns with their financial plan.
“Most people don’t think about the best thing for their 401k until it’s time to change jobs,” Mark Riepe, Senior Vice President, Schwab Center for Financial Research, explained. “Instead of letting your 401k just sit there and gather dust, check it on a regular schedule. You may need to rebalance periodically to make sure your asset allocation is still on target, assuming that isn’t done automatically for you. You should also consider increasing your savings rate every year if your plan doesn’t auto-escalate.”
Finally, he said, if participants were defaulted into a target-date fund, investigate whether the plan offers managed accounts, which will often provide more customized portfolios that can get them closer to meeting individual goals.
Round Number Bias
The third stumbling block is the preference for round numbers. This bias shows up in retirement savings because people often defer to savings rates in multiples of 5 percent, which are large jumps, rather than making incremental increases.
“It doesn’t make sense to restrict yourself to 5 percent, 10 percent, or 15 percent,” Riepe argued. “You should pick a number that makes sense for you. You might be at 5 percent now, but don’t stay at 5 percent because you can’t afford to go to 10 percent. A small jump from 5 to 6 percent is a significant improvement and you should advantage of it.”
Present Bias
Finally, we tend to value future rewards less than immediate rewards.
To a person who feels no connection to their future self, not spending today in order to save for tomorrow feels like throwing money away.
“A recent Schwab survey shows that two-thirds of participants wish they had spent less in the past to save more for retirement, particularly on meals out, expensive clothing, new cars and vacations,” Riepe concluded. “A strategy to overcome this bias is imagining your future self, asking your present self, what are you going to do for him or her? One of the first things you can do is to educate yourself about your plan’s options. Another way of helping your future self is to increase your savings rate to your employer match at a bare minimum. Don’t stick with the default rate if it doesn’t make sense for you.”
With more than 20 years serving financial markets, John Sullivan is the former editor-in-chief of Investment Advisor magazine and retirement editor of ThinkAdvisor.com. Sullivan is also the former editor of Boomer Market Advisor and Bank Advisor magazines, and has a background in the insurance and investment industries in addition to his journalism roots.
