The primary goal of using behavioral finance principles in your practice is to “positively manipulate behavior on a subconscious level,” Darrin Farrow said on Monday at the 2011 Center for Due Diligence conference in Chicago.
Farrow, principal at Rehmann Financial, used questionnaires as an example of where advisors can improve their behavioral finance process. Most questionnaires are written above the average client’s level of understanding; investors would rather do nothing than something they don’t understand, Farrow said.
Dorann Cafaro, general partner and principal at Cafaro Greenleaf, hinted that participants’ responses may not always be reliable anyway. Their behaviors are driven by the moment, she said. Even if they say they want to save, when the time comes for action, they’ll hesitate.
For example, if you offer them a chocolate bar and an apple, she suggested, many will take the chocolate bar right away. However, if you ask them whether they’d prefer an apple or a chocolate bar, most will say they would eat the apple.
Data from Diversified Investment Advisors seems to support the conclusion that what participants say they will do and what they ultimately do are not always the same.
Patricia Advaney, senior vice president of participant strategy at Diversified, said that in a survey by Diversified, 69% of participants said they would stay in a retirement plan after auto-enrollment and increase their savings. However, just 18% followed through. Likewise, while just 25% said they would stay in the plan at the automatic 3% deferral rate, 68% did so.
Automatic enrollment, Advaney argued, may solve low participation rates, but wondered if it actually improves outcomes for participants. “It’s a plan solution, not an individual solution,” she said. Investors are still saving too little and, often, the participants with the greatest need are the ones who opt out. (Cafaro noted that divorced participants, on the advice of their attorneys, are frequently part of the 4% who do opt out of retirement plans.)
To optimize automatic enrollment, Advaney said, plans should adopt the highest deferral rate possible combined with automatic escalation to move participants to a higher rate as they get older. This strategy should be adopted for existing participants as well as new ones, she said.
Simplifying participants’ options is also beneficial. Offering just a few carefully chosen options instead of a full menu of choices is a more effective strategy to engage participants; in fact, engagement levels off at around 10 to 20 options. Advaney suggested creating a mental picture of what participants’ contributions are doing. Charitable organizations have utilized this strategy to great advantage, she said, by describing what dollar amounts provide in concrete terms. For example, a $50 dollar contribution might feed four families, Advaney suggested.
Advisors can help direct their clients’ decisions toward more positive outcomes by framing their questions differently, Cafaro said. When asked to choose between three risk allocations—conservative, moderate or aggressive—most investors chose to invest in moderate risk vehicles, Cafaro said. However, when their options were limited to simply conservative or aggressive, most investors chose to invest aggressively.
This evidence may lead some advisors to ask, “Why do we expect people to manage their own money at all?”
The best plan design is a hybrid between participant-directed investments and professionally managed plans, Farrow said.