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Key Takeaways & Insights

The best retirement plans understand the economic concept of behavioral finance. Plan sponsors can make simple adjustments that account for irrational human behavior, and those adjustments can have profound, positive effects on improving employee retirement outcomes.

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  • Behavioral finance is an area of economics that studies “irrational” decision-making and helps us understand why people do not participate in retirement plans, save too little, or are poorly allocated across asset classes.
  • By understanding how to limit these structural issues, plan sponsors can build effective retirement plans to improve participant savings habits.
  • An “Opt-Out” plan design structure improves the likelihood of successful participant retirement outcomes.

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.


Cerity Partners LLC (“Cerity Partners”) is a registered investment adviser with offices in California, Colorado, Illinois, Ohio, Michigan, New York, Massachusetts, and Texas. Registration of an Investment Advisor does not imply any level of skill or training. This commentary is limited to general information, and should not be construed as personal investment advice. There is no guarantee that the views and opinions expressed in this piece will come to pass. The information is deemed reliable as of the date of this commentary, but is not guaranteed, and subject to change without notice. It should not be considered as an offer to sell or a solicitation of an offer to buy any security. For information pertaining to the registration status of Cerity Partners, please contact us or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov). For additional information about Cerity Partners, including fees, conflicts of interest, and services, send for our disclosure statement as set forth on Form CRS and ADV Part 2 using the contact information herein. Please read the disclosure statement carefully before you invest or send money.


Meet the Author

Neal Smith

Principal

Neal is a Principal in the Chicago office and a member of the Retirement Plan Services Group. He has more than 17 years of experience working with executives and investment management committees to develop efficient and effective retirement plan strategies. Neal specializes in creating healthy retirement plans for all types of institutional clients.

Prior to joining Cerity Partners, Neal was an ERISA Consultant for Blue Prairie Group, helping thousands of employees at all stages of their careers and across many industries implement more effective retirement savings practices. Earlier in his career, he worked in both relationship management and sales for Voya Financial and Nuveen Securities, giving him unique insights into developing retirement plans that produce healthy outcomes for employees.

Neal earned his Master of Business Administration from Loyola University Chicago and his Bachelor of Arts degree from the University of Iowa.

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401(k) Best Practices Cover

Partner Matthew Gnabasik draws on his 30 years of experience to provide you with a strategic framework for transforming your 401(k) plan into a powerful engine for retirement readiness. Inside you’ll find actionable tips for reconfiguring plan design, employing financial wellness, finding a good advisor, and much more.

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