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The "Save More Tomorrow" Plan: Using Psychology to Encourage Saving for Retirement

Employers who sponsor defined-contribution retirement plans face two big challenges with regard to participant behavior. One is convincing workers to save enough money, and the other is convincing them to invest what they do save appropriately. Employers can do both, suggests professor Richard Thaler, by understanding the psychological tendencies of the typical investor.

Thaler is the Robert P. Gwinn Professor of Behavioral Science and Economics at the University of Chicago Graduate School of Business. In an address to the SVIA Forum, Thaler described two profound psychological tendencies among retirement investors. One is that they typically invest more in a particular asset class when given increasing numbers of investment options within that class. The other is that while they are reluctant to authorize immediate increases in the amount of money they save for retirement, they are quite willing to authorize increases that are phased in over time. The obvious implications for employers are that they should carefully tailor the number and type of investment options they make available to participants in defined contribution plans, and offer ways for employees to commit now to increasing their savings levels later.

Thaler's findings stem in part from an examination of asset allocation behavior by workers at a California university and by pilots for a U.S. airline. The university employees, who had one stock fund and four fixed income funds to choose from in their defined contribution retirement plan, invested just 34% of their assets in stocks. By contrast, the airline pilots had five stock funds and one fixed-income fund to choose from and invested 75% of their assets in stocks.

To see how they might respond to alternative investment options, Thaler asked the participants in the university plan how they would allocate their retirement savings if given three different scenarios with only two investment options each. In the first scenario, their plan would offer one stock fund and one bond fund. In the second, the plan would offer a stock fund and a balanced fund (a portfolio of both stocks and bonds). In the third, the plan would offer a bond fund and a balanced fund.

Under each scenario, Thaler discovered a strong tendency for plan participants to split their retirement savings 50-50 between the two investment options, regardless of the makeup of the funds. Other studies examining the asset allocation question in slightly different ways produced similar results.

In still more studies, Thaler found that workers are reluctant to commit more to their retirement savings plans when those increases would take effect immediately, but more willing to do so if the increases would be phased-in over time. His response was to develop what he calls the Save More Tomorrow Plan, or SMarT Plan, which he has already helped to implement at two companies.

In the first implementation, a manufacturing company was seeking to increase the amount of money its employees were saving for retirement. Using the SMarT Plan, they would agree to increase their savings rate by a fixed percentage (i.e., 3%) per year, with each increase linked to a future salary hike. The increases would continue for three years unless participants chose to drop out of the plan.

In the first implementation of the SMarT Plan, all 315 of the plan's participants first had an opportunity to meet with an investment advisor who reviewed their savings plan and recommended increased savings where appropriate. While the advisor's professional training told him to recommend that workers save the maximum 15% of salary, he typically recommended only 5% increases when he sensed resistance to the larger number.

Of the 286 participants who met with the financial advisor, only 79 accepted his advice to increase their rate of savings—a 28% acceptance rate. The 207 who declined to accept that advice were then offered the SMarT Plan as an alternative. Of that number, 162—or 78%—agreed to participate in the SMarT Plan. Four opted out before receiving their second raise, and 33 more did so before receiving their third raise. That still left 125 out of 207 workers participating, and the results were impressive for the SmarT Plan. After three years, the participants who had taken no advice of any kind were still contributing the same amount to their retirement plan as they were at the start of the implementation—less than 7%. Participants who took the financial advisor's advice were saving 8.7% versus 4.4% at the start of the effort. Participants who stayed in the SMarT plan were saving 11.6% of their salary versus 3.5% at the beginning.

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