Want to boost your retirement savings? A little nudge can help
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What’s the best way to get people to save more for retirement, in particular within defined contribution (DC) plans, like 401(k)s? This is an important question that many politicians, academics, plan sponsors, and their consultants have been asking for a long time.

Morningstar Investment Management’s recent paper, Save More Today: Improving Retirement Savings Rates With Carrots, Sticks, and Nudges, explored this concept in some depth, looking at actual participant decisions in DC plans through an online survey. The results were surprising.

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One of the somewhat recent innovations to improve DC savings has been making better use of nudges. A nudge is a form of choice architecture designed to improve decision-making. The term comes from a 2008 book by Richard Thaler and Cass Sunstein called Nudge: Improving Decisions About Health, Wealth, and Happiness.

 

Neoclassical economic theory suggests that nudges should have no impact on rational consumer choices, especially if a decision is important and transaction costs are small. In theory, people would make the right choice regardless of the default option. In reality though, default options can make a big difference.

A growing body of empirical evidence shows that nudges can considerably affect decisions, from the relatively insignificant, such as email marketing, to those with significantly greater societal importance, such as organ donation.

Nudges may affect decisions for a variety of reasons. For example, individuals may perceive the default option as being endorsed by the organization that stands behind it. Default options can also influence outcomes because people often lack the necessary skills to make optimal choices.

There are four primary default options used in DC plans today: automatic enrollment, where the default is participating in the plan; the default saving rate; the default investment option, which is oftentimes a target-date fund; and automatic escalation, where the default is to increase the saving rate by a set amount every year.

Defaults in DC plans can be good at overcoming bad behavior — that is, choices that are not in the participant’s best interest. The key is making sure the default is set up optimally. DC plan sponsors have room for improvement in setting the default savings rate for participants automatically enrolled in the plan.

Today, the most common default savings rate for DC plans is 3 percent. This is well below what most financial planners suggest people should be saving for retirement. DC plan sponsors have selected 3 percent because they’ve been worried participants would choose to not join the plan if the default were higher.

But there’s been research around for more than a decade that demonstrates plan participation doesn’t change much if the default savings rate is 3 percent versus 6 percent. Yet, with a 6 percent default, savings add up much faster. While many plan sponsors hope people will “save more tomorrow” through plan features such as automatic escalation, there are a variety of obstacles that limit the viability of these features, such as high employment turnover.

The survey results showed that it didn’t matter how high the default saving rate was, whether between 3 percent and 12 percent, about half the people accepted the default rate. We could turn DC plans into more effective retirement saving vehicles. We just need to help participants contribute more.

People with a higher default savings rate tended to save more. When people see a default rate, they become psychologically anchored to that number. When we set the saving rate higher for participants who don’t want to set their own rate, it also raises saving rates for those who do.

Defaults matter. Defaults resulted in higher savings amounts than higher employer matching contributions or recommendations from a financial planner.

This means if you want to save more for retirement, make it easy by making it automatic. This applies to individuals as well as plan sponsors. While more DC plans are automatically enrolling employees, the default savings rates are still too low. For the majority of plans, the default should be no lower than 6 percent, and probably closer to 8 percent or 10 percent.

Nudges, or defaults, can be incredibly important tools to help drive better retirement outcomes. The key is understanding how they work, because small changes can make a big difference.

David Blanchett is head of retirement research at Morningstar Investment Management.


The views expressed by contributors are their own and are not the views of The Hill.