How to Nudge 401k Participation Higher

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Last week’s Fiduciary News article caused a lot of disbelieving grief among some readers. Primarily concerned with how an employer can increase employees’ enrollment in 401k plans, it explored the soon-to-be published study “$100 Bills on the Sidewalk: Suboptimal Investment in 401k Plans” (Fiduciary News, November 16, 2010) which asked why, despite the existence of a clear opportunity for financial gains, employees failed to participate in 401k matching contribution plans. Often hinted at by Fiduciary News, most decision making blunders are the direct result of psychological phenomenon that prevent humans from truly rational thinking.

Richard Thaler and Cass Sunstein tackle several fiduciary concerns regarding 401k plan enrollment in their 2008 book, Nudge. Through the frame of behavioral economics, the pair reveals the dominant role of choice architecture in economic, health, and social policy (they also continually apply this analysis to current events and media at their blog).

Waving the flag they dub, “libertarian paternalism,” they sketch out ways in which altering policy structures can have a predictable effect on individuals’ choices. The libertarian paternalist viewpoint simply states one must not just maximize choice, but must set a default or no-action-required option that will cause people to make optimal choices (i.e., those widely agreed upon to make one better off, e.g., saving more money for retirement). The ugly truth is people often get distracted from responsible, future-minded decisions; as humans we tend to avoid doing things in our own best interest if they involve excessive paperwork, long division, dealing with customer service, etc. This is the reason retailers will give rebates on products instead of simply charging less; a significant number of people will just never get around to mailing in the rebate. The case study contained in last weeks article is one of the main examples Thaler and Sunstein touched upon in their chapter on saving for retirement.

In Nudge, Thaler begins by noting, according to professionals and policy makers in the retirement industry, “people are assumed to calculate how much they are going to earn over the rest of their lifetime, figure out how much they will need when they retire, and then save up just enough to enjoy a comfortable retirement…” He correctly points out where these assumptions fail. “First, it assumes that people are capable of solving a complicated mathematical problem…to figure out how much to save….The second problem…is that it assumes people have enough willpower to implement the relevant plan…flashy sports cars, or nice vacations never distract people…” He goes on to say that, “it is a reasonable assumption that most of these workers are just spacing out or procrastinating rather than making a reasoned decision that they have a better use for their money.”

The “$100 on a Sidewalk” study also considered the efficacy of education on 401k options in upping participation. Nudge confirms the irrelevance of educational initiatives by citing two studies. Bernartzi and Thaler (2007) showed that after a financial education program with a before and after quiz in a true/false format (meaning merely answering randomly would yield a 50% score), the post-program mean score was 55%, compared to a pre-program mean score of 54%. Thaler also cites Choi et al (2002) on educational seminars. The study found, “at the seminar everyone expressed an interest in saving more, but only 14% actually joined the savings plan…an improvement, but not a large one, over the 7% of comparable employees who did not attend a seminar and joined the savings plan.”

Thaler and Sunstein demonstrate the power of a well structured default or no-action-required option to nudge people towards making the wiser choice. They suggest setting up automatic enrollment in a 401k plan or what would be considered an opt-out policy. The book cites Madrian and Shea (2001), who show that under the opt-in approach, participation rates were 20% after 3 months of employment, and gradually increased to 65% after 36 months. “But when automatic enrollment was adopted, enrollment of new employees jumped to 90 % immediately and increased to more than 98% within 36 months.” Additionally, they point out Choi et al (2006)’s finding that, “the fraction of 401k participants who dropped out of the plan in the first year as only 0.3-0.6 percentage points higher that it had been before automatic enrollment was introduced.”

In addition to avoiding initially joining a plan, it turns out people give little to no thought to choosing a savings rate. “One survey found that 58 percent spent less than one hour determining both their contribution rate and investment decisions (Bernartzi and Thaler 1999).” To address this issue and to further nudge employees towards saving more, Thaler and Sunstein advocate automatic enrollment in a program they call “Save More Tomorrow” of “SMT.” The program would start at a somewhat low savings rate (say 6% of pay to take advantage of employer matching), and would raise the savings rate every time the employee received a raise, so that a decrease in take home pay would never occur.

In the first offerings of this type of plan they saw, among the 90% of subjects who met with a retirement consultant, 25% accepted advice of an immediate 5% increase in their savings rate and, of the remaining employees, 78 percent joined the SMT program (in this case every mean pay raise was 3.5% and the coinciding savings rate increase was 3%).Several years later, those who enrolled in the SMT plan, had reached the maximum contribution level and were saving 4 percent more than those who had just increased once upon suggestion. “The few employees who did leave the program did not ask that their savings rates be dropped back to their earlier low levels. Instead, they just stopped increasing their contribution rates.” According to Nudge, since this pilot program many retirement plan administrators have adopted the SMT idea. Vanguard, T. Rowe Price, TIAA-CREF, Fidelity, and Hewitt Associates have all made SMT available. Essentially, the 2006 Pension Protection Act codified the SMT concept with its automatic enrollment program.

While to some these findings may seem like common sense or old news, to many they are a revelatory insight into bridging the gap between the ‘should’ and ‘is’ of 401k participation. Nudge promotes a unique and extremely salient approach to policy making and choice architecture. It’s a timely reframing of behavioral economic research that stretches back more than a decade. As you can see, this research has had significant implication on improving the already successful 401k program. Though the book may appeal mainly to armchair economists, it has the potential to serve 401k investors best if regulators, service providers and plan sponsors take a moment to anticipate the repercussions of the not-so-random walk investors take a statistically significant amount of time.