Automatic features in 401(k) plans have made it easier for more Americans to start saving for retirement. But many participants are still saving only minimal amounts. How can plan sponsors help them to save more? II recently sat down with Naomi Fink, MA, MSc, FRM®, and Troy Block, CFA®, retirement research specialists at Capital Group®, who shared some lessons from the latest academic research and the experiences of other countries.
Auto-enrollment features were seen as the solution to some of investors’ behavioral biases, such as inertia. Have they worked?
Naomi Fink: Auto-enrollment has addressed procrastination, while target date funds to some extent have addressed paralyzing “choice overload.” Target date funds also have resolved some rebalancing concerns and given participants a more appropriate, dynamic investment mix. But auto-enrollment hasn’t addressed other behavioral biases that can prevent participants from saving enough. In fact, auto-enrollment can actually reinforce what’s known as “anchoring bias”: many employees assume that the employer’s default is the “correct” savings rate. In reality, the most common default rate — 3% — is far too low. An academic study with a mid-sized U.S. chemical company clearly showed the negative effect of anchoring bias. The company doubled its dollar-for-dollar match from 3% of employee contributions to 6%. Yet, most of the participants who were auto-enrolled at 3% kept their contribution around that level. Not only were those employees not saving enough, they weren’t taking full advantage of the employer match. Another key behavioral bias is “compounding bias,” which is a failure to visualize how returns accrue over time.
So how can we address these biases?
Troy Block: A combination of good advice and helpful structural features may nudge investors in the right direction. For example, online calculators can help participants understand the real financial advantages of a tax-exempt account and the advantages of compounding. Also, on the expense side of the equation, providing tangible examples of the impact of inflation can help illustrate how much money retirees will need in the future. For example, according to federal data, a basket of groceries that cost $50 in 1984 costs $120 today. In another 35 years at the same rate of inflation, imagine what that same basket of groceries will cost!
Isn’t auto-escalation the solution to the inadequate savings problem, as it forces participants to save more each year?
NF: This is an example of good policy and comes directly from Richard Thaler’s idea of “save more tomorrow,” which encourages savers to commit a portion of future salary increases to retirement savings. While auto-escalation helps, the benefit depends on individual circumstances and is an example of where an advisor could provide guidance. Currently, safe-harbor rules limit the maximum auto-escalated contribution rate to 10%. Unfortunately, the pace of auto-escalation is often too slow. In many cases, it can take an employee seven years to reach 10%. That’s way too long for older employees who have gotten a late start on saving. At Capital Group, we suggest setting the default high — based on the demographic composition of employees — as it’s very difficult to change participants’ behavior mid-stream. Congress is considering upping the top rate to 15%, which would be helpful.
How well do people account for lumpy, or unexpected, expenses in retirement?
TB: Not very well. Most people in their 40s aren’t thinking about whether they will have enough set aside 25 years from now for a hip replacement. But this isn’t just a participant problem. The financial industry often models income sustainability by calculating how many years a participant can withdraw 4% of her ending savings balance (adjusted for inflation) before running out of money. In reality, expenditures aren’t smooth. Either unpredictable events or our own behavior can get in the way of ensuring a smooth lifetime income and consumption path. At Capital Group, we try to incorporate periodic spending “shocks” — such as health care — into our quantitative models to get a more realistic view.
What’s more important to improving participant outcomes — getting them to save more or getting them to make the right investment choices?
NF: Both are obviously important, but their relevance varies by life stage. Research has found that the greatest contributing factor to retirement inadequacy is not saving enough in the first place. Although there are a number of decumulation strategies once in retirement — such as to delay claiming Social Security benefits or make “catch-up” contributions — none top starting saving early. But in retirement itself, your investment choices matter a lot more. Investment losses early in retirement may hurt a lot more than those later in retirement. That’s one big advantage of target date funds — they grow more conservative over time.
You’ve spent quite a bit of time studying defined contribution-like systems in other countries. Any lessons for the U.S.?
TB: There are many good things to say about the 401(k) structure in the U.S. But the 401(k) system is voluntary for employers, and even when employees have access to plans, many don’t participate. In the U.K. and Australia, employers are required to offer savings plans. And although the tax structure and incentives are different, Australia’s superannuation system has been overly successful by many measures — in fact, the government is concerned that participants aren’t spending enough in retirement and treating their savings as bequests.
What parts of the Australian system should we consider adopting in the U.S.?
TB: Some have questioned the effectiveness of financial education. But Australia shows that the nature and quality of financial education can matter. There are service providers there that specialize in financial education, and do a very good job of it. Australia also offers lessons on improving plan portability. Australia’s system is very good at helping participants keep track of their savings even when they change jobs. In the U.S., it is much more difficult to move assets from one employer to the next. As a result, many employees end up cashing out when they change jobs, rather than transferring funds to the new employer’s plan. Even small amounts of such “leakage” can have a big impact. Take a 30-year-old worker who decides to transfer $10,000 to her new employer rather than cashing it out. Assuming a 7% annual return, that sum would grow to $106,766 by age 65. That is the power of compounding.
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