Ever made a poor financial decision? If you’re like the rest of us, you occasionally make a decision that baffles even you. You may sometimes wonder why your employees don’t do things, like participating in the 401(k) plan, that are obvious ways to improve their financial well-being. Sheri Fitts, director of Communications and Large Plan Sales at The Standard, addressed the problem in a recent webinar about behavioral finance.
Most of the time, she explained, we believe that our decisions are based on rational, logical reasoning. And most of the time, that isn’t the case. Human beings are very susceptible to subtle suggestions and emotion in our decision making. “We like to think that we’re like Spock,” she says, “but we just aren’t.”
Examining some common misconceptions about how we make financial decisions allows us to react with our heads instead of our hearts. If we extend the information to our employees, we can often encourage better financial decisions, especially in regard to the 401(k) plan.
Behavioral finance is thoroughly explained in some excellent books—Fitts particularly likes Nudge: Improving Decisions About Health, Wealth and Happiness, by Richard H. Thaler and Cass R. Sunstein (Penguin Books, 2008). In the interest of space, we’ll include a few highlights and key concepts of behavioral finance here; you can view The Standard’s webinar at (http://tinyurl.com/35r2eqr) to learn more.
Some of the basic principles of behavioral finance are risk aversion, status quo bias, lack of self-control, and unrealistic optimism.
Risk Aversion
We like to win, but we really hate to lose. Research repeatedly shows that people feel a loss about 2½ times more keenly than they feel a similar win.
Application: Employees presented with a choice of “losing” $125 per paycheck to the 401(k) plan may not sign up. But, if they are shown that they can accumulate $2,400 in a year toward their retirement, they may decide to enroll.
Status Quo Bias
OK, admit it: It’s easier to do nothing than it is to do … well, anything. This means we are more inclined to stay where we are than to make any move, even when we know it’s the best or the right thing to do.
Application: “Automatically enrolling employees in the 401(k) plan, or automatically increasing their contributions (with the ability to opt out, of course) results in a demonstrated increase in plan participation. It’s just easier to go ahead and contribute 3% of pay than it is to take the steps to opt out,” Fitts says.
The federal government, recognizing the principles of behavioral finance, paved the way for automatic enrollment with the Pension Protection Act of 2006. When certain conditions are met, plan sponsors may automatically enroll employees and automatically increase their contributions on a regular schedule.
The effect can be dramatic. In one company studied by researchers, the rate of participation among employees under the age of 65 went from 37.4% before automatic enrollment to 85.6% after.
But Fitts adds a word of caution. “Just because people participate in the plan doesn’t mean they will take an active role in their participation,” Fitts says. The same bias can also mean that participants continue at the minimal contribution rate and never take another look. “They can also assume that the automatic enrollment rate is your suggestion about how much they should be saving. More often than not, it is just a starting point, and you’ll need to encourage them to save more.”
The same study mentioned above demonstrated the effects of this bias. More than 70% of the automatically enrolled participants stayed at the 3% default contribution rate and in the money market default investment fund. A year later, half of them were still contributing just 3%, and 2 years later, 40%. “This is where communication can really help,” Fitts says, “and so can automatic contribution increases.”
Lack of Self-Control
You want to lose weight before summer really gets going, but you really want that chocolate cake. We don’t need to tell you which one wins. The same thing applies to wanting to increase your clothing budget every month compared with saving more toward a distant retirement.
Application: Automatic enrollment can help here, too, by moving people past the decision point. The status quo bias kicks in, and they often think, “Oh well, I might as well stay in the plan.”
Unrealistic Optimism
When we don’t know what the future holds, we often discount its importance. Researchers call this idea hyperbolic discounting, and it leads us to be irrationally optimistic. For example, a participant who is not in the 401(k) plan, or who is saving at a minimal rate, talks himself or herself into believing the retirement will take care of itself.
Application: Projection tools help employees see how their savings will accumulate. Realistic stories from actual plan participants and retirees illustrate the effects of saving enough—or not. In other words, communicate in an accurate and interesting way to help employees peer into the future.
Rules of Thumb
Behavioral finance defines several rules of thumb, or heuristics, commonly used in decision making. Fitts says some of them are anchoring, availability, and representativeness.
Anchoring. In essence, this is the idea that your starting point determines where you’re comfortable. If you’re working full-time, for example, you might be more comfortable moving to part-time employment than leaving the workforce entirely. The same can be said about contributing to a retirement plan. If you automatically enroll employees at 3% of pay and increase it 1% each year, they will be much more comfortable than if you asked them to enroll at 6% immediately.
Availability. If something has happened close to us and/or recently, we are much more likely to be able to call it to mind. “This becomes clear following an earthquake—especially a local one,” says Fitts.
“Requests for earthquake insurance become much more common following the event and drop dramatically a few months later. You can use this in your retirement plan communications. Use real-life examples from your employee population to tell the story of how the retirement plan helps employees. Recent retirees can be examples of how saving (or not saving) makes a real difference in life-after-employment.”
Representativeness. People tend to categorize, seeing patterns where none exist. If your favorite athlete is having a good season, you’re likely to believe it will continue, and you may even put your money where your mouth is. When the stock market is on the rise, people invest at a higher rate than they do when it drops, even though the best bargains are available when the market is down.
Think about representativeness when educating employees about joining the plan; make sure they know the market is cyclical, and money invested when it is down can realize a much greater return.
Fitts recommends identifying thought leaders from among your employee population: those employees who seem to join everything and always know what’s happening. “Other employees often look to these folks when making decisions,” she says. “If you can encourage them to join the plan, you’ll probably get higher participation rates and better contribution rates. Tell their stories in company newsletter articles, and encourage them to talk with their peers about it.”
She also believes that framing is important. “It’s all about context. How you say something may be even more important than what you say.”
As mentioned, the idea of accumulating a decent sum at the end of 1 year is much more energizing than the idea of losing a smaller sum every payday. Always phrase the benefits of joining and contributing to the plan in positive terms.
While behavioral finance principles apply to all of us, there are things you can do to help employees overcome these natural tendencies. And if you do, you might help them realize a better retirement.