With a little Psychology 101, DC plan sponsors can learn what makes employees tick
Dale Carnegie’s 1936 classic, How to Win Friends and Influence People, might have been written directly for DC plan sponsors. While plan sponsors can’t force members to join a DC plan, they can influence them. But they have to know how their members think. Understanding the psychology behind their decisions can only help plan sponsors to influence employee behaviour.
Fighting Inertia
DC plans are an attractive way for employees to save money for retirement because of favourable tax treatment and employer contributions. In fact, a simple cost-benefit analysis would suggest that deciding to join such a plan is a no-brainer. Unfortunately, the uptake of DC plans among employees is far from unanimous. Three insights from psychology can help plan sponsors to interpret the drivers of this behaviour.
1| Favouring the status quo – Individuals tend to favour the status quo versus any change—a natural tendency that fosters inertia and can cause members to delay joining the DC plan. Many companies do not automatically enrol new employees in DC plans: employees have to actively change their status quo from not joining to joining the plan.
2| Avoiding choice – Having choice can be a good thing, but increasing the number of options in the DC plan can be detrimental to employees and discourage action. Too many options can increase complexity and lead to choice avoidance (and favour the status quo of non-enrollment even more). An experiment conducted in a gourmet store in the U.S. by S.S. Iyengar and M.R. Lepper (with results published in 2000 in the Journal of Personality and Social Psychology) illustrates this. On two different occasions, shoppers were presented with jams for tasting, either 24 different flavours or six flavours. While more people who passed by the large display stopped (60%, versus 40% for the limited display), a higher number of consumers who saw the limited display purchased a jar of jam (30%, versus only 3% for the extensive display).
Consistent with these results, a 2004 U.S. study by Iyengar, G. Huberman and W. Jiang found a negative correlation between the number of funds offered in DC plans and participation rates. Using a sample of roughly 900,000 employees from 647 plans, they estimated that adding 10 more fund options (the median number of funds chosen was between three and four) reduces the likelihood of employee participation by two percentage points.
3| Preferring immediate payoffs – Saving for retirement involves a trade-off between consumption today and future consumption. In a 2002 review article in the Journal of Economic Literature, S. Frederick, G. Loewenstein and T. O’Donoghue noted that some individuals exhibit strong preferences for immediate payoffs. These individuals might overindulge in activities with immediate rewards and delayed costs (e.g., eating unhealthy foods or smoking) while, at the same time, delaying activities with immediate costs and delayed rewards (e.g., exercising). Joining a retirement savings plan belongs to the latter category. The costs are immediate: having less money to spend today, deciding whether to join, determining how much to save and figuring out how to invest, as well as completing the paperwork to actually join the plan. The benefits are in the future—namely, greater income in retirement. Individuals with a preference for immediacy might procrastinate in preparing for retirement and in joining the plan.
Creating Joiners
Using insights from behavioural economics, plan sponsors can help to solve member inertia and decision avoidance due to complexity and procrastination.
Employee choice – Many DC plans are currently structured as opt-in. Not surprisingly, an opt-in enrollment tends to favour inertia—in other words, members tend to take no action, since no immediate action is required, and they never follow up later. A practical alternative comes from requiring individuals to make an explicit choice (or active decision). A 2009 U.S. study by G.D. Carroll, J.J. Choi, D. Laibson, B.C. Madrian and A. Metrick (published in the Quarterly Journal of Economics) found that requiring new hires to check a yes or a no box for participation in a retirement plan raises enrollment by 28 percentage points relative to a standard opt-in procedure.
Pre-selected contribution rate – A 2006 U.S. study by J. Beshears, Choi, Laibson and Madrian tested another intervention designed to simplify the retirement saving decision and overcome procrastination. Employees had the opportunity to enrol at a pre-selected contribution rate and asset allocation, reducing a complex set of options to a binary choice between the status quo and the pre-selected alternative. The result was an increase in participation rate of between 10 and 20 percentage points.
Automatic enrollment – The most effective method to encourage participation in retirement plans is to change the default option from an opt-in to an opt-out mechanism. Under automatic enrollment, employees are enrolled in the plan (with a specified contribution rate and asset allocation), unless they actively choose not to participate. A 2001 U.S. study by Madrian and D.F. Shea (published in the Quarterly Journal of Economics) found that, after the adoption of auto-enrollment in one company, participation rates jumped to 86%, compared with rates under the previous opt-in approach of 37%. Changing the opt-in or opt-out option increases the number of employees joining immediately.
Making Investment Decisions
Once employees decide to join the plan, they have to choose from an array of investment options. They must also decide what percentage to allocate to equity and how to change their equity exposure over time. This is fairly complicated, so it’s not surprising that members use rules of thumb (e.g., investing an equal amount in every option), which can lead to suboptimal asset allocations such as too little equity exposure. Members can face obstacles relating to the menu of offerings, the number of options offered and their presentation (i.e., which options are presented first), as well as chasing returns (investing more heavily in equities after strong equity returns).
In a 2001 study (published in the American Economic Review), S. Benartzi and R.H. Thaler used experiments and actual data from retirement plans to document how the menu of funds has a strong impact on portfolio choices. UCLA employees who were offered one equity fund and four fixed income funds allocated 34% to equities. Pilots at Trans World Airlines offered the opposite menu—five equity funds and one fixed income—had an equity exposure of 75%. In a 2006 U.S. study (published in the Journal of Finance), Huberman and Jiang analyzed records from more than half a million participants in more than 600 retirement plans. The majority of participants chose a small number of funds (three or four) and then divided assets equally among the funds selected.
When investment choice becomes overwhelming, increased complexity can create unintended consequences. In a 2010 U.S. study (published in the Journal of Public Economics), Iyengar and E. Kamenica reported that people reduce their exposure to equities as the menu of funds expands: adding 10 funds increases the percentage allocated by participants to the safest options (money market and bond funds) by more than three percentage points. In addition, the way the options are presented can have an effect. In a 2007 U.S. study (published in the Journal of Economic Perspectives), Benartzi and Thaler indicated how small details might change asset allocation (e.g., the more lines on the enrollment form, the higher the number of funds selected).
Given the nature of retirement savings, most DC plan members should have a long-term investment horizon. Nonetheless, recent stock market returns appear to affect members’ allocations—even though stock returns are largely unpredictable. In a 2001 study (published in the Journal of Finance), Benartzi showed that employees are more likely to invest their retirement funds in company stock after the company shares have experienced abnormally high returns. In a 2007 study (published in the Journal of Economic Perspectives), Benartzi and Thaler documented that, during the Internet bubble, new retirement plan members’ stock allocations were highest at the market’s peak.
These behaviours are consistent with members extrapolating past returns into the future: after positive returns, employees believe this trend will continue and increase their equity exposure. Chasing trends in the market is risky—even more so for members approaching retirement who don’t have time to recoup the losses. Choosing Wisely The use of defaults has proven to be successful in nudging employees toward better choices, such as joining the plan and saving more. Lifecycle funds simplify allocation decisions: members select a portfolio based only on an expected year of retirement, while the fund managers are responsible for initial portfolio allocations, rebalancing and portfolio changes over the fund’s lifecycle.
A 2009 U.S. study by O.S. Mitchell, G.R. Mottola, S.P. Utkus and T. Yamaguchi analyzed 250,000 plan participants covered by more than 250 plans in which lifecycle funds are introduced. Participants who elect lifecycle funds on a voluntary basis enhance their portfolio efficiency, increasing equity holdings while reducing extreme asset allocations. These funds provide a simple solution for less-sophisticated investors and can improve the overall portfolio performance of a more sophisticated investor.
One additional advantage of lifecycle funds is that participants might be able to avoid the temptation of chasing stock returns. At enrollment, equity exposure is determined by the member’s age, not by past returns. After enrollment, inertia is very powerful, and few members will change their allocations. Moreover, the long-term focus of lifecycle funds is likely to discourage trendchasing for even the most active members. In the same vein, DC plan member statements can be designed to promote long-term views. Instead of emphasizing quarterly results, these statements can present the impact of the latest results on the long-term performance of the investments (five or 10 years). The advantage is twofold. First, participants will be less prone to overreact to recent extreme events, since they would appear less dramatic once aggregated with historical events. Second, participants will be less anxious about their investments.
If sponsors can get their employees to join the plan and choose investments wisely, then they will have done their job. Maybe then both sponsors and employees will have time to read another Carnegie book: How to Stop Worrying and Start Living.
Stephen Foerster is a professor of finance, and Alessandro Previtero is an assistant professor of finance at the Ivey Business School, Western University. sfoerster@ivey.ca; aprevitero@ivey.ca
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