Tuesday, May 3, 2016

Retirement plans and choices

Behavioural Economics help me to understand why people do some of the things that they do. One seemingly irrational decision is about why people do not opt in to retirement plans when given the opportunity to do so. Behavioral Economics helps us to understand why, and this is important as governments look to changing retirement plans by examining standard economic theory. 

Many individuals deviate from standard economic theory in another important way: they can be easily influenced by decision framing. Rational economic agents would not be expected to vary their responses to a question based on how it is asked. 

But in practice, many people do exactly that, both in the savings area and, as we show note later, in investment decision-making as well. A by-now classic example of decision framing arises with automatic enrollment in retirement saving plans. Under the traditional (non-automatic) approach, the employee would have to make a “positive election” to join the 401(k) plan. 

By contrast, with automatic enrollment, the employee would be signed up by the employer for the plan at a given percentage contribution  rate, and the employee retains the right to opt out of this decision.

This simple rephrasing of the saving question elicits a dramatically different response in plan participation rates. Madrian and Shea (2001) have powerfully shown that when workers are required to opt-in, the default decision (or the non-decision) is to save nothing; by dramatic contrast, with automatic enrollment, the default decision proves to be that people save at the rate specified by the employer. 

For one large US firm, plan participation rates jumped from 37 percent to 86 percent for new hires after automatic enrollment was introduced. What this suggests, in the end, is that many workers do not have particularly firm convictions about their desired savings behavior. Merely by rephrasing the  question, their preferences can be changed—from not saving to saving.

The impact of automatic enrollment is not just an illustration of framing questions but also part of a broader behavioral phenomenon, namely the power of the “default option” and its influence on decision-making. When confronted with difficult decisions, individuals tend to adopt heuristics
(shortcuts) that simplify the complex problems they face. One simple heuristic is to accept the available default option—i.e., rather than making an active choice, accept the choice made by others. 

And, as noted in 401(k) enrollment, the simplest default is the non-decision: do nothing. An emerging literature indicates that individual behavior is easily swayed by default choices.

Again, automatic enrollment provides another illustration of the unexpected effects of default behavior. It turns out that while automatic enrollment boosts the number of individuals saving in a retirement plan, it might not actually increase total plan savings (Choi et al. 2001b). 

The reason is that, when automatically enrolled, people who would have voluntarily enrolled in the plan at higher contribution rates or chosen more aggressive investments decide to stick with the low saving rate and conservative investment option set by their employer. Thus the positive effect is that saving rises for people who formerly did not participate, but an unexpectedly negative result is that saving falls for those who would have enrolled at higher rates and in more aggressive options, but instead elected to adopt the employer’s defaults. 

On net, it appears that these two effects can largely offset one another.

More broadly. develop a model of a procrastination- and default-driven saver and the choice of optimal savings rates. That study argues that optimal defaults for such savers are, in effect, the corner points or defaults of the plan savings problem—a saving rate of 0 percent, a saving rate equal to the employer matching contribution, and a saving rate at the maximum allowed by the plan. 

Both their theoretical models and the practical evidence on automatic enrollment underscore how profound the impact can be of the selection of a default option.

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