At the CFDD conference, Shlomo Benartzi explains how to use behavioral finance principles in 401(k) plans.

Shlomo Benartzi, the UCLA professor and Allianz behavioral economist, opened his session at the Center for Due Diligence’s 2011 conference on Wednesday with a short survey for the audience rearding 401(k) participation.

In it he asked advisors what percentage of employees should be participating in their employer’s plan; what percentage of their salaries they should be deferring; and what percentage of participants would be better off selecting “one-stop” options like target-date funds instead of attempting to self-construct their own portfolio.

“It’s not enough to think about improving outcomes,” Benartzi said while attendees’ answers were being tallied. “There’s plenty of discussion about legal liabilities and fees in plans.”

Rather, advisors need to focus on ways to improve employee access. Half of employees do not have access to a 401(k) plan, Benartzi, said. Furthermore, a third of employees who have access don’t take advantage of it, partly due to procrastination. And, “as we all know, tomorrow is a different kind of day that never arrives,” said Benartzi, professor and co-chair of the behavioral decision-making group at UCLA and the chief behavioral economist at Allianz Global Investors Center for Behavioral Finance.

Further hindering employees’ retirement plans are low savings rates that hover around 6% and their tendency to self-construct portfolios.

In spite of all this, advisors largely believe that all Americans deserve access to a 401(k) plan; that at least 90% should be participating in their employer’s plan; that savings rates should exceed 10% at least; and that 90% of investors should let an advisor build their portfolio. Benartzi called this 90-10-90 rule the PlanSuccess system.

A successful retirement plan begins with a behavioral audit to evaluate the plan followed by implementation of suggested improvement. Finally, adivsors must measure results to gain a real understanding of the plan’s success.

Benartzi described three behavioral obstacles to a successful retirement plan:

  1. Inertia
  2. Loss aversion
  3. Myopia

Advisors and plan sponsors have already started implementing solutions to these obstacles. Inertia can be fought with automatic enrollment. The sequence in which funds appear is also important. The first fund on the investment menu tends to get the most assets. Rather than listing funds alphabetically or according to risk, beginning with the funds that are appropriate for the largest number of people can help direct assets into a more appropriate fund than they might have chosen otherwise.

Providing an employer match helps ease the pain of loss aversion. To demonstrate the power of loss aversion, Benartzi relayed an experiment where one group of monkeys was given an apple and another group was given two apples. The monkeys that received two apples had one taken away and became very angry. Even though they still had an apple, the pain of loss was greater.

One way to beat loss aversion that prevents people from increasing their contributions on their own is to implement auto-escalation at the same time that employees receive a pay raise. That way they are insulated from a perceived loss of income when a greater percentage of their earnings are saved rather than spent.

Myopia is a more difficult problem. People tend to focus on short-term goals rather than thinking about their future, according to Benartzi. They see saving for retirement as putting money away for a stranger to enjoy in the future, he said. He suggested showing participants a picture of how they might look in the future to help them identify with their future selves.

Benartzi warned against measuring a plan’s success against industry benchmarks too closely. “Benchmarking, while entertaining, is a very, very bad practice,” he said. Quite simply because “if everyone is doing the wrong thing, so are you.”

Of the approximately 100 attendees whose answers to the survey Benartzi opened the session with were counted before the end of the session, the average participation rate in an employer-sponsored plan was 97.3%. Attendees believe that employees should be saving an average of 13.2% and that 83% should use target-date funds or model portfolios rather than self-constructing their portfolios.

Benartzi had strong parting words for attendees. “I believe the industry’s not doing well and we should set the bar a lot higher.”