Plan Sponsor Alert: Behavioral Finance Reframing Future of 401k
Everyone knows you’re supposed to buy low and sell high. This is what a rational investor would do. We know that because Modern Portfolio Theory demands it. Yet, dollars to donuts, when given the opportunity, most investors end up selling low and buying high. It turns out the typical investor, in spite of the assumptions of Modern Portfolio Theory, acts irrationally. Behavioral Finance explains why this is so. It’s one thing to treat decision-making as a quantitative exercise in the classroom. It’s quite another thing to look at decision-making in the real world. Quite simply, you can’t divorce non-numeric psychology from decision-making. This is the ultimate failure of Modern Portfolio Theory. It also explains the ascendency of Behavioral Finance and Economics.
For more than a generation, 401k plan sponsors and every other ERISA fiduciary have framed their due diligence duties in terms expressed by Modern Portfolio Theory. It appears, however, behavioral financial is, even now, reframing the future of the 401k. Fiduciaries best start paying attention lest they risk taking on more liability than they might care to.
Many would cite the 1970’s as the beginning of the behavioral economics field. The seminal paper (the one that led to a Nobel Prize) on Prospect Theory by Daniel Kahneman and Amos Tversky was published in 1979 (see, “Prospect Theory: An Analysis of Decision Under Risk” Econometrica XLVII (1979): 263-291). Others might point to the early work of Richard Thaler during his time at Cornell. As we all know, this was well before the advent of the 401k. Indeed, before this novel area of study could turn to the 401k, it had to become accepted within the general academic community. Despite a few traditional hold-outs, that acceptance could not be denied when, in 2002, Prospect Theory won the Nobel Prize in economics. At that time, researchers had only recently turned to studying 401k applications.
“There was very little scholarly research on employee behavior in 401k plans before 1999,” says John R. Nofsinger, Ph.D., Professor of Finance at Washington State University and author of The Psychology of Investing, (5th Edition, Pearson, 2014). “Then,” continues Nofsinger, “there was an explosion of work hitting economics and finance journals in 2001 and 2002. There has been a steady stream of interesting and quality work being done ever since.”
Nofsinger recently led a “Brainstorming What’s Next” session at The Annual Meeting of the Academy of Behavioral Finance and Economics at DePaul University in Chicago. He focused on framing decisions and many of his illustrations used 401k applications. He believes, as do many others judging by the volume of research, the 401k arena is ripe for discovering new and interesting aspects to behavioral finance. Why is this so?
“Defined contribution plans force people to make important financial decisions that will have enormous ramifications for the quality of their future lives,” says Nofsinger. “Employees are forced to make these decisions without much information, no formal training, and without an advisor. How do we make decisions without wisdom? We must fall back on our heuristic simplification processes (mental shortcuts) to help. Often, those processes predictably lead us astray.”
Since existing frameworks can lead investors “astray,” the objective of much of the relevant research in behavioral finance and economics is to find a systematic solution that would offer plan investors an easy course correction. In his presentation, Nofsinger said, “The way in which questions are framed have a strong impact on our decision.” He then reviewed some of the research that has had a direct bearing on how 401k plan sponsors set up their plans.
For example, in the past, plan sponsors would ask employees “How much do you want to contribute?” and “What asset allocation do you want?” This “opt-in” model led to unsatisfactory results. Less than 50% of the eligible employees participated and those that did participate did so at the relatively low contribution rate of only 5-7%. Worse, the overbearing number of choices led too many investors to pick the poorest long-term investment options (i.e., fixed-income funds). Today, based in part on the knowledge gained from behavioral finance studies and the passage of the 2006 Pension Protection Act, more plans offer “automatic enrollment” (i.e., “opt-out” programs) with a single (“no-choice”) default option. Academic studies have shown the automatic enrollment programs increase participation from a little over 50% to just about 90%.
We’re finding, unfortunately, automatic enrollment by itself is not enough. “Over time, they [investors] are still anchored to the low contribution rate and the conservative investment,” said Nofsinger to the mostly academic attendees of the Academy of Behavioral Finance and Economics conference. To address the short-comings of automatic enrollment, he mentioned how plans are utilizing other aspects of behavioral finance to help employees. For example, to help increase contribution rates, some plans are adopting policies where the contribution rate increases automatically with every raise. Studies show doing this can increase the average contribution rate from 3.5% to 13.6%. To address the issue of picking investments that are too conservative, plans are either reducing the number of fixed income choices or, more often, restructuring the entire menu option.
“We started with employees needing to make open-ended contribution choices and open-ended asset allocation decisions involving potentially dozens of investment options,” says Nofsinger. “The direction of plan design seems to be toward a menu of short ‘check the box’ choices. The menu has only a few contribution levels and a few pre-packaged portfolios. Most employees do not really understand the ramifications of individual investment choices. So the investments may not matter to their choices. Therefore, these portfolios can be characterized by their relative levels of risk instead of formal asset allocations and investment characteristics. These risk levels may be communicated as lifestyle projections.”
The most fascinating aspect of Nofsinger’s presentation, though, was the hint of things to come. He asked the entire audience to participate in a brainstorming session for future research surrounding the framing issue. Although not all the ideas dealt with the retirement application, several thoughts did cover matters relevant to 401k plans. These include the presentation of investment performance, the effort to focus on retirement readiness and savings rather than investments and the overall impact of framing decisions in terms of specific goal targets. Whatever the research, though, it is clear behavioral finance and economics studies will continue to define the leading edge of 401k design and implementation. As such, 401k plan sponsors and fiduciaries have an obligation to stay informed and up-to-date on this research.
For 401k plan sponsors and fiduciaries, behavioral finance and economics will reframe the definition of “due diligence.”
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