What can be done differently to encourage people to take the steps required to improve their retirement security? Behavioural finance examines how emotional, social and cognitive factors influence our decision making. It tells us that retirement plan design and communication is too often based on assumptions about people that are wrong.
People don’t always approach retirement decisions (in fact, all sorts of decisions) in a rational way that is in their best interests. The insights of behavioural finance have the potential to help make changes that can yield a difference in the actions of how people save for retirement.
Here are the second five of ten tips based on the principles of behavioural finance for helping people achieve a secure retirement.
6. Use opt-out versus opt-in features. People who don’t enroll in their retirement plan are making a choice. They are choosing to do nothing. Failing to do something (inertia) and putting off doing it (procrastination) are also the reasons many people fail to increase the amount they are saving and do not rebalance the investments in their portfolios. Autoenrollment and auto escalation features in a defined contribution (DC) retirement plan combined with the use of a target-date fund default option have proven to be highly successful strategies for countering these behaviors.
7. Limit investment choices. People find it easier to make decisions when they have a small menu of choices. The unintended consequence of a large number of choices is choice avoidance—another way to describe participant inertia and procrastination. A consensus is growing among experts that the appropriate number of funds in the investment menu for a DC plan is between five and ten. Be aware that in a naïve effort to diversify, some participants split their contributions evenly among investment offerings. If a plan offers more aggressive funds than conservative funds, these participants will invest more heavily in the aggressive vehicles than in those that are more conservative (and vice versa).
8. Structure the menu of investment choice. When people are provided a list of choices, they tend to choose the first choice they are given. If the list is very long, another behavior kicks in—choosing the last items because these are the items that stick in their minds. Consider the implications of these behaviors when a list of investment choices is ordered from least to most risky. Participants may choose the option at the top of the list, which may be too conservative for their needs. At the other extreme, a very long list might result in the selection of inappropriately aggressive investments. Similar problems can occur when investments are listed alphabetically. An optimal investment menu might have at the top a “basket of funds” like a balanced or target-date fund that is appropriate for a majority of people.
9. Use a stretch match. People tend to follow an employer’s message, even if it isn’t in their best interest to do so. As an example, consider employers that auto enroll employees into a company retirement savings plan offering a 100% match on amounts up to 3% of an employee’s pay. Those who stick with their employer’s “endorsement” will have a total savings equal to 6% of their pay—an amount unlikely to achieve their retirement goals. Take advantage of the endorsement effect by using a stretch match. Offer 50% on amounts up to 6%, which yields total savings of 9%. Alternatively, offer a 50% match on amounts up to 10% to encourage a total savings of 15%. Both of these stretch matches are good starting points.
10. Provide access to a financial advisor. Thanks to inertia and procrastination, many people also don’t take the time to assess how much they will need to achieve a secure retirement. A lack of knowledge and the complexity of the retirement planning process are viewed as the roots of these behaviors. Providing access to and encouraging the use of financial advice helps people make smarter decisions that keep them moving in the right direction toward their retirement objectives. DC plan participants who have received advice from an independent professional save more, have more diversified portfolios and stay on course even when they feel vulnerable in market downturns.
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