Many people do not save enough for retirement, a fact that is a growing concern for the US government. But low saving rates are a problem also for US employers, because – according to NDT (non-discrimination testing) rules – the low participation of low-paid workers restricts the benefits that can be given to highly paid employees.
Recently some companies have tried to deal with this problem by adopting automatic enrolment strategies: plans where as soon as the employees become eligible, they are automatically enrolled unless they explicitly opt out. These plans’ default is to join at a modest saving rate, between 2% and 3% of the salary, and the standard investment is very conservative, in bonds. According to the latest annual survey of profit sharing and 401(k) plans by PSCA, 4.2% of US plans offer automatic enrolment. In these, the average participation rate has improved.
The problem with automatic enrolment is that the inertia that stops people opting out also keeps the savings rate at the low default level, which is not enough for a healthy retirement. Besides, adding a large number of low-revenue, low-balance accounts, points out a paper by the Vanguard Center for Retirement Research, means increased costs for record-keeping, account services and education for all participants, with no positive impact for high-paid employees.
One solution is proposed by two very well-known pioneers of behavioural finance, an academic discipline that attempts to integrate the tenets of human psychology with modern finance. Richard Thaler and Shlomo Benartzi, economists respectively at the University of Chicago and University of California in Los Angeles, in their paper Save more tomorrow: using behavioural economics to increase employee savings, propose a plan where people commit in advance to allocate a portion of their future salary increases towards retirement savings. They provide evidence that the plan works, based on its first implementation in a mid-size manufacturing company. Interestingly, now the Vanguard Group, one of the leading US providers of 401(k) plan services – is strongly encouraging its clients to adopt the SMarT – ‘Save More Tomorrow’ – plan. One of its clients, Philips Electronics North America, has decided to experiment with such a SMarT plan. Vanguard will administer the test while Thaler and Benartzi will advise.
The two professors’ philosophy is pretty simple, grounded in four psychological principles. “First,” their paper reads, “many people do want to save more, but lack the self-control. Second, restrictions on future choices are easier to accept if they take effect sometime in the future. We all plan our exercise and dieting regimes to start next week or month. Third, people are very sensitive to perceived losses in their well-being. Evidence shows that it is much easier to forego a gain than it is to accept a loss. Fourth, people tend to code gains and losses in nominal rather than real dollars, so, for example, a pay increase that is less than the rate of inflation may still be considered a gain rather than a loss.”
These principles are put to use in the SMarT plan in the following way: workers agree to use a portion of their future pay raises to increase their contributions to the saving plans. “The workers are assured that their pay cheque will not fall,” observe Thaler and Benartzi. “In fact, since the contribution to the saving plan is tax- deductible, only part of the increased saving is out-of-pocket, and the actual change in pay is likely to be unnoticeable. The increases will continue until the worker reaches the maximum tax shelter contribution, or opts out of the plan. Once employees are in the plan, we expect inertia to help keep them in them in.”
Indeed, that is what happened at the company where the SMarT plan was first implemented. Some 162 out of 315 workers who were 401(k) plan participants, agreed to increase their saving rates by three percentage points a year, starting with the next pay increase, which was due in three months. Only four participants (2%) dropped out of the plan prior to the second pay rise, with 29 more (18%) dropping out between the second and the third pay rises, the two professors explain in their report. “Hence, the vast majority of the participants (80%) have remained in the plan through three pay rises” and their savings rates jumped from 3.5% to 11.6%.
In the next few weeks, Philips will ask 2,000 workers to commit to annual increases in 401(k) contributions of one, two or three percentage points. It, Vanguard, Thaler and Benartzi all hope that inertia works in this experiment too.