How a Freethinking Economist Saved Your Retirement Portfolio

The first modern retirement plans were defined-benefit plans. After a certain number of years, a given employee would receive a predetermined income based on previous salary and number of years worked. Social Security is a good example of a defined-benefit plan. These plans have one huge advantage. The only decision to make is when to start collecting the benefit.

However, over the last few decades, public and private sector employees have begun offering defined-contribution plans like 401(k)s. While these plans are flexible and portable, they are not necessarily forgiving. Research shows that most people define a contribution amount and forget about it, despite variables like pay raises and years before retirement. Though many employers offer generous plans that match employee contributions, studies show that 30 percent of eligible employees fail to enroll in 401(k) plans. It’s as if people were turning down the opportunity to pocket free money.

That’s why Thaler suggests that people need a “nudge” in the form of automatic enrollment. Here’s how it works. Once an employee becomes eligible for a defined-contribution plan, he or she is automatically enrolled unless the choice is made to opt-out. In one study comparing opt-in to automatic enrollment, researchers found that participation rates in opt-in plans were just 20 percent after three months, increasing to 65 percent after 36 months. With automatic enrollment, by contrast, the rates were 90 percent and 98 percent, respectively.

Next, Thaler suggests that choice architects design plans that encourage higher savings rates. Studies find that most people save at a meager rate of 2 percent, nary enough to save for retirement expenses. By simply changing the match formula from 50 percent on the first 6 percent of pay to 30 percent on the first 10 percent of pay, employers could encourage greater savings rates.

Save More Tomorrow

Save More Tomorrow participants commit themselves to saving more by increasing their contributions when they receive a pay raise. According to Thaler, the plan (developed with UCLA’s Shlomo Benartzi) rests on three concepts of behavioral economics. “People have good intentions about the future,” he said, “but lack the self-control to implement the plans now, so [the plan] allow[s] people to commit themselves to save more later.” Furthermore, he adds, “there is massive inertia in [defined contribution] plans. We use that to help people by making future increases automatic until some cap is reached.” Lastly, “people are loss averse, so we tie savings increases to pay increases to eliminate any nominal pay cuts.”

Thaler’s research shows that participants in the program quadrupled their savings rate to 13.6 percent from 3.5 percent. Indeed, the program’s success has spurred major retirement plan administrators like Vanguard, T. Rowe Price, TIAA-CREF, Fidelity and Hewitt Associates to adopt the Save More Tomorrow concepts. As of 2007, the Profit Sharing Council of America found that 39 percent of large U.S. employers had adopted some kind of automatic escalation plan.

Decumulation and Company Stock

Thaler said the broker-dealer industry would be wise to focus on two areas that require reform and innovation: decumulation of assets after retirement and ownership of company stock.

“As it is,” he says, “most 401(k) investors are handed a pile of money when they retire and sent on their not-so-merry way. We need to give people more help on this phase, which is actually more difficult than the accumulation phase. I am working on those issues now.”

Over-accumulation of company stock would also benefit from a dose of libertarian paternalism, says Thaler. There are still employers who prevent employees from selling their match in company stock. Worse, there are employees who hold the majority of their savings in the stock of their employers. After the disasters of Enron and Bear Stearns, one might have thought that employees and employers alike would have learned their lessons. On the contrary, says Thaler.

“I have talked to the CFOs of companies with this problem and they will privately agree that it makes no sense for an employee to have so much invested in one company, especially their employer, but are afraid to do anything about it because it might seem like they had lost faith in their own stock.” Thaler explained. “[Shlomo] Benartzi and I have been pushing an idea we call Sell More Tomorrow to deal with this problem. Offer employees a plan where their company stock holdings are sold off gradually and invested in a diversified portfolio until the holdings reach some sensible proportion of savings such as 10 percent or less. So far we have not had any takers (though, as with Save More Tomorrow, we give these ideas away at no charge). Here is hoping that someone will take us up on this before the next company blows up.”