Retirement Plans & Behavioral Finance 101 (Part 1)

How Behavioral Finance Impacts Retirement Plans

Before getting into specific strategies for making plans demonstrably better, it is important to establish a theoretical foundation for the power of “opting-out” as a more effective plan design. In the traditional 401(k) model, individuals are responsible for ‘opting-in.” That is, they must take an affirmative action, deciding whether to participate and how much to save. Yet how a plan is structured—how participants are enrolled in the plan (opt-in versus opt-out), and how much they contribute (automated or not)—greatly affects the key drivers of participant retirement readiness.

The benefits of “opt-out” plan design have been defined, examined, and quantified by a new branch of economics: behavioral finance. And these ideas dramatically reshaped our understanding of typical participant behavior within the plan.

What Is Behavioral Finance?

Classical economics routinely assumes that human beings are “rational actors” without ever looking into this claim. The foundational hypothesis that “humans are rational animals” and they possess perfect economic knowledge may be useful in traditional economic analysis and in advancing a model, but it completely ignores the predictably irrational behavior of most people. It took behavioral finance to demonstrate that the claim of rational economic decision-making is highly dubious.

Like 401(k) plans, which were born out of the Revenue Act of 1978, behavioral finance is also a relatively new academic field, having been established roughly forty years ago. Unlike traditional microeconomics, which is the study of the basic issues of supply and demand as they affect consumers, households, and businesses, behavioral finance focuses almost exclusively on the individual and how people make economic decisions in the real world.

The insights derived from behavioral finance experiments are wide-ranging in their implications. As an empirically-driven branch of economics, behavioral finance studies the psychology, patterns, and mental shortcuts (a.k.a heuristics) of individual financial decision-making. It is greatly indebted to evolutionary psychology, neurology, and game theory, both in terms of theory and of data collection. behavioral finance has demonstrated conclusively and repeatedly that people routinely make irrational financial decisions, using simple rules of thumb based on numerous false beliefs and biases.

What Does This Mean for Retirement Plans?

Our task is to understand these well-documented behavioral patterns considering the structural limitations of 401(k) plans, and then to implement counter strategies to address these deficiencies. These behaviors can then be reframed not as a function of poor individual decision making, but rather as a reflection of hard decisions made with imperfect information.

With an understanding of some basic behavioral finance concepts, the plan sponsor’s, and consultant’s focus naturally turns away from subtly blaming the participant (i.e., “You can lead a horse to water . . .”) toward proactively addressing these structural problems. We can then design plans to specifically counter the structural limitations of 401(k) plans to build effective solutions for most plan participants. Ultimately, we want to craft a series of coherent plan designs and best practice recommendations that leverage these foundational behavioral finance insights into effective plan design solutions that deliver positive results.