With defined contribution plans, individuals have greater freedom to steer their proverbial retirement ship. They can choose how much to save and how to invest, and they’re in the best position to know and pursue their personal opportunities and goals. It is a great system, except for one minor fact—relatively few people take the helm and steer; most leave it to the tides.
Auto-enrollment and auto-escalation, of course, are designed to help people to take action, and they are tremendously powerful tools, but imperfect. If we all had the same optimal contribution rate, auto features would create the perfect system. Who wouldn’t want to have a solid retirement package with minimal (or no) effort? However, we’re different people with different needs, and a one-sized fits all approach isn’t enough. The very biases that make auto-enrollment and escalation effective also limit their effectiveness in the long run. Here are two big reasons why:
Contribution rate inertia—When companies set a default contribution rate, those who wouldn’t otherwise contribute are better off, but some are actually worse. In one study, conducted with three different firms with auto enrollment features, researchers found that 80 percent of the participants stayed with the default contribution rate at 2 percent to 3 percent at the end of one year. That applied both to people who wouldn’t have saved (good) and those who would have saved more (bad). Even if default rates were set higher–a common recommendation and one I strongly support–some participants would still be worse off. In order to fix this, so-called “at-risk” participants would need to engage and adjust contributions for their unique financial situation and preferences.
Present bias—A substantial body of research in behavioral economics has found that people make systematic errors when evaluating tradeoffs between their future and present well-being. Auto-features help mitigate this, but, again, they aren’t enough. Challenges arise, particularly during a job change. Some employees, especially those with small balances, are given the following choice: cash now or save for the future. The big check is tempting and immediate. With our existing roll-over/roll-in system, it’s easy to take the check. According to one study, for every dollar contributed to the DC accounts of savers under age 55, $0.40 eventually comes out before retirement. Auto-features get money into plans, but they can’t keep the money there.
Thankfully, present bias, inertia and other such challenges can be overcome–if we keep the plan participant in the equation. For example, consider what happens when rolling funds into a new plan, or personalizing contribution rates. Simplifying and restructuring those processes can do wonders. A 2011 study compared the effect of providing information about a process versus streamlining it: in this case, with the Free Application for Federal Student Aid (FAFSA). They found that by pre-populating forms with known information, and helping participants complete the form, they could substantially increase submission rates (in fact, college enrollment rates rose by eight percentage points for participants). By contrast, merely providing information about the process had no effect; they want the path of least resistance. Let’s give it to them.
Merve Akbas is a behavioral scientist at Morningstar, Inc.
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.
