Basic Behavioral Finance Concepts Applied to Participant-Directed DC Plans
Choice Architecture and Framing:
How choices are presented to people has a significant influence on what actions they decide to take. If a sponsor designs a 401(k) plan requiring participants to opt-in, or actively sign up to join the plan, typically 20 to 40 percent of the population will not participate. On the other hand, with an opt-out architecture, 10 percent of the same eligible population will actively choose not to participate. This is a significant difference.
Inertia, or a tendency to remain unchanged, manifests itself in ways. First, in an opt-in plan design, employees who do not join the plan as soon as they are eligible often wait years to join (or never join at all), creating a huge opportunity cost. Remember, retirement plans work because of regular contributions and the compound growth of invested assets over multiple market cycles. Second, few employees actively increase their savings rate on their own, and few regularly review their investment allocations and make changes to their overall risk allocation.
Information or Choice Overload:
The typical 401(k) plan today offers between ten and twenty discrete fund choices, not including target-date funds. Most plan sponsors and advisers focus on discrete fund choices as opposed to building investment menus for different types of investors, creating asset-class duplication in a lineup. Most participants are overwhelmed with this much choice, and without guidance from the plan sponsor, they often invest an equal percentage into each fund, chase hot funds, or invest 100 percent of their contributions into one fund, often choosing the most conservative or the most aggressive funds. This lack of asset allocation increases risk exposures and leads to an investment strategy that isn’t aligned with the participants’ risk tolerance or financial goals.
This cognitive bias convinces us newer information is more valuable than older information. In investments, the most common application of the bias is to overweight recent performance or long-term performance. Participants rebalancing their portfolios and overallocating to the best performers of the recent quarter may subject themselves to a pattern of “buying high and selling low.” A much better strategy is to focus on performance over longer periods of time, up to and including a full business cycle, and allocated assets to a diversified portfolio. This ever changing optimal allocation challenge is another reason why target date portfolios may be an appealing option for many retirement plan participants.
Round Number Bias and Anchoring:
Absent a matching contribution from an employer, most employees will save to a round number. And when a match is introduced, participants tend to save to the level of the match cap. For example, if your plan matches 50 cents on the dollar to 5% of pay, most participants will anchor on the 5% match cap as their savings percentage. The unintended consequence is that most participants will set their savings level to this number, and this may not be the right savings amount for them to reach their income replacement goal.
The Pain of Loss Far Exceeds the Joy of Gain:
During events such as significant market declines, some participants will change their asset allocation by moving to less volatile asset classes, never returning to reallocate and therefore missing market advances.
This is because the fear of loss is a far greater motivator to most people than the opportunity of gain. Financial loss is more palpable, visceral, and real than the more ephemeral satisfaction associated with economic gain. As a result, people go out of their way to avoid losses, but that aversion to loss may cost them tens of thousands of dollars in potential growth over the long run.
Structuring 401(k) Plan Investments Based on Common Participant Behaviors
Having a basic understanding of these six behavioral finance concepts means you can take the next step to building a 401(k) investment lineup that reduces or eliminates many of these biases. Between auto-enrollment and auto-escalation, age-based target date QDIA funds, and focused fund menus, it is possible to short-circuit the cognitive biases that plague many of your current plan participants. Taken together, these actions can help plan sponsors redesign their retirement plans to put their employees on track for a secure retirement.
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