What Nobel Laureate Thaler Told Us About 401ks

We spoke with Thaler about (what else?) behavioral economics

401k, Nobel Prize, retirement, behavioral financeCongratulations to the University of Chicago academic.

Behavioral economics’ impact is primarily felt in retirement plan participation and administration, something famed University of Chicago professor Richard Thaler routinely trumpets. Word arrived Monday that Thaler has won the 2017 Nobel Prize in economics. One of the first scholars to specifically identify and understand the role default options play in successful outcomes, Thaler graced the pages of 401(k) Specialist in our inaugural issue in 2015, an interview we reprint in its entirety here.

University of Chicago behavioral economist Richard Thaler turns his keen eye to football, the faculty lounge and 401ks in his latest book, Misbehaving: The Story of Behavioral Economics. Recounting how behavioral economics went from cute fad to critical thinking, this latest work follows on the wildly successful Nudge: Improving Decisions on Health, Wealth, and Happiness. Thaler sat with 401(k) Specialist for a thorough discussion of the biases that blind us.

Q: Is too much choice a bad thing, is simple “better” or has your research found a happy medium, particularly with the number of 401k investment choices?

A: Too much choice can be a bad thing. It can lead to poor portfolios and delay enrollment, especially if enrollment is not automatic. That is why it is so important to have a well-designed default option. Most employees will take the default, and will do better as a result.

Q: A paper by Eric Johnson and Dan Goldstein finds that two particular European countries have a vastly different percentage of their citizens registered to be organ donors simply because one is opt-in while the other is opt-out. Are we as humans lazy and always looking for the path of least resistance, or is there something more at play psychologically?

A: Yes, defaults are powerful. They work for lots of reasons, not just because we are lazy, although that can be the explanation in some cases. For example, we continue watching the same channel after a show we had chosen is over. One click on the remote should not be a big barrier, but it can be. In the case of 401k plans, the default can also serve as an implicit suggestion from the plan sponsor, so people may choose it for that perfectly sensible reason. That is not to say that all defaults are good ones. Some companies still pay their match in company stock, creating a default to keep increasing holdings in the company they work for. We should have learned the lesson that heavily concentrated portfolios in company stock can be dangerous after Enron, but the same problem existed at Bear Stearns.

Q: 401k auto-enrollment and auto-escalation have been a major boon to 401k participation rates. Is there something similar that policymakers should enact that they’re missing, something that could make 401ks work even better for the majority of Americans?

A: Yes, we need to make it easier for small businesses to offer a payroll-based retirement plan. The Obama administration has proposed a sensible plan but it is stalled in Congress. The state of Illinois has adopted its own plan, and I urge other states to do likewise unless Congress unexpectedly takes action. The plan would impose virtually no costs on any employer that uses a payroll servicing company such as Paychex.

Q: In Misbehaving you reference football. Can you provide a brief description of your findings in relation to NFL draft picks and the mistakes made in how they are chosen? Do the Patriots still rank No.1 in the quality of their picks?  

A: Our chief finding is that the earliest picks are overvalued. Teams can and do trade picks and the first pick in the draft could (in principle) be traded for as many as five or six second-round picks, each of which could be more valuable in terms of the contribution to performance compared to their salary. Teams seem to be slowly learning part of the lesson, meaning that the offers for the first pick may have tailed off slightly, but the teams owning those picks won’t trade down because they are holding out for the previous outrageous prices. This is similar to what happens in real estate markets in a downturn. There are many for sale signs but not many sales. The Patriots do seem to understand the principles of our research better than most teams.

Q: What is hindsight bias and how does it similarly affect decisions in baseball and 401k asset allocations?

A: We all think our forecasts were better than they actually were. This is hindsight bias, or Monday-morning quarterbacking. It can hurt in sports when managers are second-guessed for decisions that were well founded but turned out badly. Good decisions should be rewarded, even if they come with an unlucky, bad outcome. Advisors and their clients can avoid disputes down the road by documenting the assumptions that went into the portfolio formation so neither side can say “I told you so” unless they really did.

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