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Auto Enrollment and Auto Deferral Are Effective, But to What Degree?

Behavioral finance research has identified many of the reasons why plan participants follow the path of least resistance when planning for retirement. These human traits are highlighted in the January 2007 Employee Benefit Research Institute (EBRI) Issue Brief entitled “Behavioral Finance and Retirement Plan Contributions: How Participants Behave and Prescriptive Solutions” by Jodi DiCenzo, Behavioral Research Associates.

The common human tendencies described in the issue brief ring so true that they are almost painful to read, especially when you recognize one or more of these shortcomings in yourself. For example, many of us lack the ability to overcome inertia and procrastination, even when it is in our financial best interest. For those of us who do take action, we are prone to making poor investment decisions for a variety of reasons. Fortunately, behavioral economists offer a prescription to plan sponsors to help ease individual retirement plan investors deal with their inability to modify our natural inclinations.

Behaviorists explain that procrastination may result from a bias toward the status quo and that short-term decisions often conflict with long-term desires and goals. A related behavioral bias called hyperbolic discounting is the human tendency, when faced with uncertainty, to sharply reduce the importance of the future in the decision-making process. No matter whether the future consequences are good or bad, the further off they are in the future, the less importance we attach to current choices. This theory is certainly applicable when faced with making contribution and investment decisions today for your future retirement. In addition, the behavioral model known as the Prospect Theory suggests that individuals are more sensitive to losses than to gains of the same magnitude. This loss-aversion results in our reluctance to lose income today even if it is for a future gain.

Whereas traditional economic theories assume that humans will always act logically, behavioral economists understand our limits as humans. They realize that our ability to make rational decisions may be limited by our lack of information, time, costs, and intelligence. Behaviorists also acknowledge that calculating an optimal savings rate is complex and involves making assumptions about future employment, earnings, longevity, health care, retirement age, inflation, and capital markets, to name a few.

Complexity and “choice overload” come into play in the plan-enrollment process and is influenced by the effectiveness of the retirement plan communications provided to plan participants. As the presentation of investment information, as well as the method by which participants enroll, becomes more convoluted, the less likely participants will take any action whatsoever. Empirical findings suggest, for example, that for every 10 additional investment options added to an average plan, which currently has between 10 and 20 investment options, participation will drop by approximately 2 percent due to “choice overload” associated with the additional ten investment options.

Not only are we inert and loss adverse, but many of us also suffer from overconfidence in our investment decisions. Coupled with this is the false belief that investments with which investors are most familiar are less risky. This is most evident in the case where individuals maintain a high percentage of their retirement assets invested in employer stock. Chasing the performance of top well-known funds, particularly those that are heavily advertised, is another one of our flaws.

To top it all off, behaviorists tell us that investment education and targeted communication programs alone will unlikely be effective in changing our behavior. Our lawmakers, however, have been listening to the findings of the behavioral economists. The enactment of the Pension Protection Act of 2006 (PPA) illustrates the implicit endorsement of Congress by providing plan sponsors a fiduciary safe harbor for automatic enrollment, default contributions, and automatic deferral increase plan provisions. Armed with new safe harbor incentives, many more plan sponsors are expected to add automatic enrollment to 401(k) plans. A question is whether the default contribution rate will be sufficient for individuals to save an adequate amount for retirement, assuming there are no other employer savings programs to count on, such as a defined benefit pension.

In the Issue Brief, Jodi DiCenzo highlights a study in 2006 by behavioral economists Craig McKenzie, Michael Liersch, and Stacey Finkelstein entitled “Recommendations Implicit in Policy Defaults.” This study suggests that when automatic enrollment is included, many automatically enrolled participants remain at the default contribution rate after several years, even when the matching percentage exceeds the default percentage. In addition to being anchored to the default savings rate, automatically enrolled participants are also predisposed to remain wholly invested in the default investment fund. One reason for this may be due to a perception by these participants that the default percentage and default investment fund are considered implicit investment advice by the plan sponsor.

If plan sponsors raise the default rate to achieve higher savings, some are concerned that participation in the plan will fall. The Issue Brief notes, however, that in one study, participation remained high after the default rate was increased from 3 to 6 percent. Another study reflects that the plan with the highest default rate also had the highest participation rate.

Since plan sponsors can influence participants’ security in retirement, the Issue Brief stresses that plan sponsors should carefully consider the contribution percentage that is set as the default. The choice of default options and the manner in which the defaults are conveyed are important because they may signal a recommendation of action, or inaction, to plan participants, which will impact the level of participation and savings overall.

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