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Using Behavioral Finance to Help Employees Achieve Their Retirement Saving Goals
by Alessandro Previtero UCLA Anderson School of Management

Table of Contents y y y y y y y Executive summary 1 Introduction: saving for retirement is complicated for many employees 2 The first challenge: choosing to participate in a retirement plan 4 The second challenge:how much to save? 7 The third challenge:how to invest retirementsavings? 9 The case of Mainspring Managed 12 References 1

Executive summary
Thirty years after the birth of the 401(k) plan, why are so many employees still saving so little for retirement, despite the efforts of plan sponsors and providers? The brief answer is that while the retirement plan landscape has shifted from employer-funded defined benefit (pension) plans to defined contribution plans funded largely by employees, basic human behavior hasnt evolved to keep up. Investing for retirement is a complex, lifelong endeavor, which may be why so many people fall short of their savings goals.

Changing roles, challenges and plan design opportunities

Despite this sea change in the retirement plan landscape, a startling number of American workers have saved little to nothing for retirement, according to the Employee Benefit Research Institute. A number of challenges contribute to this retirement saving deficit, but progress has been made with new programs and tools that use insights gained from behavioral science and psychology about plan participants behaviors. Research shows that retirement plans designed to work with peoples natural behavior patterns versus trying to change behavior through education can be effective at increasing participation and contribution levels. The first challenge is to get people to enroll in their workplace retirement plans where employers offer one. This decision should be easy, but inertia, the complexities of enrolling and the preference for an immediate payout deter many. Requiring explicit decisions from employees, simplified enrollment and automatic enrollment have all shown promise in increasing participation rates. The second challenge is to teach employees how to calculate a contribution rate that will provide them with enough income for retirement. Many currently do little more than guess or use rules of thumb. Others stay with an initial default rate indefinitely. Education and programs, such as automatic contribution escalators, have helped some employees understand how much retirement costs, but others turn a deaf ear. Deciding how to invest is the third and perhaps thorniest challenge employees must overcome. An array of employee retirement education programs has been developed, yet employees must actively choose to learn from these programs to invest effectively during different lifestages on the way to retirement. Newer products, such as lifecycle funds, help ease this process.

A comprehensive, simplified approach

Despite incremental improvements in helping employees prepare financially for the future, retirement balances remain low. This paper will examine the insights gained from behavioral finance research and show how they can be applied to plan design, using The Standards recently

enhanced Mainspring Managed program as an example. From automatic or simplified enrollment and automatic escalators to age-appropriate asset allocation and rebalancing, Mainspring Managed illustrates how evolving best practices can be combined in a retirement plan.

Introduction: saving for retirement is complicated for many employees

During the past 30 years, retirement plans have dramatically shifted from defined benefit (DB) plans toward defined contribution (DC) plans. In a DB plan, salary history and length of employment determine a fixed benefit without employee input. The plan sponsor is usually responsible for providing the benefit. In a DC plan, workers are solely responsible for making decisions that determine the size of their retirement accounts. Consequently, employees have more autonomy and responsibility than ever in managing their retirement savings. These decisions include: 1. Whether to participate 2. How much to save 3. How to invest The latter two decisions, how much to save for retirement and how to invest savings, remain daunting challenges for most individuals. However, an approach based on insights from behavioral finance may be the best way to help employees help themselves and potentially reachtheir retirement savings goals.

Taking an approach based on insights from behavioral finance may be the best way to help employees help themselves and potentially reach their retirement savings goals.

The challenges are numerous

First, employees have a longer average life expectancy, but longevity will differ according to the individual. One of 10 employees who reach age 65 will live for only more four years and one will live for 34 more years (based on my own elaboration from 2007 U.S. Census Bureau raw data on life expectancy in the United States), creating uncertainty about how long retirement income must last. Second, investment risk is potentially substantial. Over long horizons, equities have traditionally outperformed fixed-income investments, such as bonds, but higher returns come at a price, namely increased risk. As some employees have painfully discovered in the past two years, investing heavily in equities in the years close to retirement can dramatically reduce retirement wealth and force them to work longer. The flip side to investment risk is that an employee who invests too conservatively for retirement can end up with significantly lower retirement wealth. Balancing longevity risk the risk of outliving ones own retirement wealth and investment risk is not an easy task. Given the inherent complexity of managing retirement savings, it should not come as a surprise that some employees are not taking the steps needed to secure a comfortable retirement.

According to the 2010 Employee Benefit Research Institutes (EBRI) annual Retirement Confidence Survey, 43 percent of workers ages 25 and older have less than $10,000 in retirement savings, excluding the value of their primary home and DB pension plans. The same survey reveals that 31 percent of workers and/or their spouses had not saved anything for retirement, and less than half of workers and/or their spouses have tried to calculate how much they will need for a comfortable retirement.

Workers age 25+ who have less than $10,000 in retirement savings

Workers and their spouses whohad not saved anything for retirement

43

The picture that comes from older workers (ages 50 and older) is not any better. For the period 2001-2007, the Survey of Consumer Finances documents that the median U.S. households net financial wealth is lower than $10,000. Judging by these numbers, it would seem that individuals without a DB plan or significant home equity have little more to depend on in retirement than Social Security retirement benefits.

The altered retirement plan landscape

Using data from the National Compensation Survey, the EBRI Databook on Employee Benefits (2010) documents how the percentage of employees participating in DB plans dramatically declined since DC plans were introduced. In the 1980s, the percentage of employees participating in DB plans was almost double the percentage of DC plan participants. In the second half of the 1990s, the trend reversed and in 2008 and 2009 only 33 percent of employeesparticipated in DB plans compared to 55 percent enrolled in DC plans. Given these trends, the choices employees make in DC plans will increasingly determine their ability to live comfortably in retirement. This paper examines those choices, noted earlier, and the steps employers and retirement plan providers can take to help employees improve their choices and achieve their financial goals for retirement. Ultimately, improving employeesdecision-making abilities will depend on gaining insights, and developing tools and programs culled from psychology and behavioral finance.

The first challenge: choosing to participate in a retirement plan

DC plans offer an attractive way to save and invest money for retirement. These types of plansreceive favorable tax treatment, tax-deductible contributions and tax-deferred accumulations, and employers often match at least part of employees contributions. A simplecost-benefit analysis would suggest that the decision to join a retirement savings plan when one is offered should be easy. Nonetheless enrollment in DC plans is far from commonplace.

Given the substantial incentives offered and the observed participation rates, traditional economics cannot adequately account for this evidence. However, insights frompsychology and behavioral finance can help interpret the drivers of this behavior, including the: Natural tendency toward the status quo Complexity of the decision and choice avoidance Preferences for immediate payoffs

Contrary to what we might think, increasing the number of options in a retirement plan can be detrimental and discourage any action. Too many options can increase complexity, lead to choice avoidance and can prevent employees from enrolling in the plan

Natural tendency toward the status quo Individuals tend to favor the status quo versus change. This natural tendency fosters
inertia and can cause delays in DC plan participation. Many companies still do not automatically enroll new employees in their retirement plans, so employees must actively change their status quo from not saving to joining and contributing to their DC plans. Complexity of the decision and choice avoidance Contrary to what we might think, increasing the number of options in a retirement plan can be detrimental and discourage any action. Too many options can increase complexity, lead to choice avoidance and prevent employees from enrolling in the plan. A field experiment conducted in a gourmet store illustrates this tendency (Iyengar and Lepper, 2000): shoppers who passed by a larger display of jams stopped to look more often, but more people bought from a display that offered only one-quarter of the larger displays choices. Consistent with these results, Iyengar, Huberman, and Jiang (2004) found a negative correlation between the number of funds offered in DC plans and participation rates. Using a sample of

about 900,000 employees from 647 plans in 2001, they estimated that adding 10 more fund options reduced the likelihood of employee participation by two percentage points. Preferences for immediate payoffs Another obstacle that prevents employees from achieving adequate retirement income is thatsaving for retirement involves a trade-off between actual and future consumption. Evidence suggests that some individuals exhibit strong preferences for immediate payoffs (Frederick et al., 2002). For example, they might overindulge in activities with immediate rewards, such as eating unhealthy foods or smoking, and pay less attention to related future health care costs. Conversely, they might delay activities with immediate cost, such as exercise, which offer delayed rewards, such as better health. Contrary to what we might think, increasing the number of options in a retirement plan can be detrimental and discourage any action. Too many options can increase complexity, lead to choice avoidance and can prevent employees from enrolling in the plan.Using Behavioral Finance to Help Employees Achieve Their Retirement Saving Goals: The Case of Mainspring Managed Standard Retirement Services, Inc. 5 \