Financial Nudging Works!
Having a hard time saving for retirement? You aren’t alone. The problem is that unless we automate the process, saving often becomes an afterthought. And who can blame you? It’s way more fun to go out to dinner, take trips and buy tech toys then to stash that money into a long term saving or investing vehicle. But what if you never got a chance to get your hands on the dough – would you miss it? Many retirement plan sponsors are testing this theory in practice. The trend started with the passage of the Pension Protection Act of 2006 (PPA). In addition to addressing issues around defined benefit or pension plans, the law also contained big changes for employer-sponsored retirement plans.
After years of low enrollment levels (according to the Employee Benefit Research Institute, roughly 30 percent of workers who had been offered a 401(k) plan at work failed to participate in it, and many workers made no change to their contribution rate or investment choices once they did sign up), retirement experts along with academics who study behavioral finance (the intersection of psychology, sociology, business and economics), petitioned the government to help nudge employees into better financial behavior.
In the PPA, the Department of Labor blessed the automatic enrollment of workers into defined contribution retirement plans at a default savings contribution rate (usually 3 percent); default investment elections into age-appropriate “life-cycle” or “target date” funds; and automatic escalation of workers' contributions to their 401(k) accounts on a periodic basis.
Of course employees could always opt out of a retirement plan, elect a different contribution rate, or choose different investments, but to do so would require taking action. And given human nature, you can guess what happened: more employees have participated in retirement plans and the shift also helped workers form the retirement savings habit early in their careers, a critical step to staying on course to hit financial goals, according to behavioral economists.
According to the Bureau of Labor Statistics, one study found a whopping 48-percentage point increase in participation among newly hired employees and the BLS itself found that plans with automatic enrollment have participation rate that is 8.4 percent higher than do plans without the feature. “Automatic enrollment has been particularly successful at increasing 401(k) participation among employees least likely to participate in retirement savings plans—namely, employees who are young, lower paid, black, or Hispanic.”
In fact, as much as we hate it in the moment, most of us respond pretty well to gentle nudging. Last year, American Century Investments conducted a survey of soon-to-be retirees and found that they would have liked their employers to play a more active role in helping to save for retirement. Maybe this kind of thinking only comes with hindsight, but when asked exactly what they wanted their companies to do, two in five said “a slight nudge,” while an additional two in five preferred either “a strong nudge” or a “kick in the pants.”
Some employers have responded with something in between a gentle nudge and a kick in the pants. A small group of companies are carrying behavioral finance to the next level by auto enrolling participants at an 8 or even 10 percent level. They report that the employee response has been pretty much what you might expect: they accept it.
The beauty of any automatic saving or investing plan is that it takes the onus off of you to do something and maybe even alleviates that low level of guilt that might be kicking around your head that you should be doing more. In fact, whenever possible, consumers seem to reap the benefit of financial nudging, whether in retirement contributions, automatic rebalancing of investment accounts or automatic bill paying. Whenever we can extract the emotional pull of inertia from the process, we are likely to be better off.