Behavioral Finance and Retirement Plan Contributions: How Participants Behave, and Prescriptive Solutions

January 2007
EBRI Issue Brief #301
Paperback, 20 pp.
PDF, 519 kb
Employee Benefit Research Institute, 2007

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Executive Summary

Behavioral research: This Issue Brief discusses behavioral finance research, underlying causes for both passive and active saving and investing choices, and prescriptions offered by contemporary behaviorists to overcome the effects of less-than-ideal savings and investing choices.

Congress implicitly endorsed behavioral finance in PPA: Enactment of the Pension Protection Act of 2006 (PPA), notably its automatic enrollment, automatic default contribution, and automatic deferral increase provisions, illustrates that Congress implicitly endorsed the value of behavioral economics as applied to retirement policy.

The “path of least resistance”: Behavioral research has repeatedly demonstrated many workers’ tendency to follow whatever retirement planning path provides the least resistance. Benefit plan architects and administrators effectively direct and pave that path when they design retirement plans, especially when establishing plan default provisions, the “rules” governing what happens when workers fail to make active decisions.

Has retirement plan decision making really shifted? The decline of defined benefit (pension) plans, coupled with the growth of defined contribution (401(k)) plans is often cited as evidence of a significant shift in retirement-funding risk and decision making away from corporate plan sponsors and toward workers. However, behavioral research raises the question of whether decision making has really shifted: In fact, many participants seem to simply accept plan defaults set by corporate plan sponsors. The path of least resistance is paved by the plan sponsor.

Passive choices: Behaviorists have highlighted predictable behavioral tendencies (and their underlying causes) that help explain passive “choices.” These include procrastination, status-quo bias, hyperbolic discounting, bounded rationality and complexity, and choice overload.

Active savings decisions also succumb to behavioral pitfalls: Many of the same tendencies that affect the willingness to passively accept a default contribution rate also contribute to actively selecting a less-than-ideal savings rate—or to not selecting a savings rate at all.

Behaviorists offer prescriptive insights: Workers can benefit from a simplified enrollment process, “required” active decisions may increase participation and contribution deferral rates, and other plan features (such as automatic deferral escalation) are effective in increasing participant savings rates.