Commentary: Behavioral insights are key to retirement success

When University of Chicago Economist Richard H. Thaler was awarded the 2017 Nobel Prize for his seminal role in behavioral economics, it came as no surprise to those of us working in the retirement savings industry. For more than 30 years, we have been applying the ideas of academics like Mr. Thaler and others to create workplace savings plan designs that help working Americans achieve much greater retirement readiness.

Insights from behavioral finance now underlie such best practices as automatic enrollment, allocation and escalation that help tens of millions of workers turn wages into wealth through 401(k) plans and individual retirement accounts that today hold more than $16 trillion.

The insights gleaned from behavioral finance continue to transform our industry — for the better. Workers that are "nudged" to defer 10% of their wages to well-managed retirement savings accounts are on track to match and even surpass their working incomes in retirement. Of course, this success only benefits the 60% of American workers who are actually in plans. The challenge today — for industry and public policy — is to deepen worker engagement in plans and to expand plan coverage to millions of more workers.

To understand the role of behavioral finance in retirement savings today, it helps to remember just how far we have come.

In the early years of 401(k) plans during the 1980s and 1990s, the three most critical decisions of retirement savings — when to begin saving, how much to save and how to allocate assets — were left to workers with little or no financial expertise. Their improvised strategies often resulted in excessive risk concentration (too many equities or sponsoring company stock), or excessive risk aversion (overexposure to low-return money market or stable value funds). Worse still was the temptation to chase returns and indulge in market timing — i.e., buying at the top and selling at the bottom.

Many plan sponsors understood these behavioral hazards and spent a fortune on communications and investor education programs that, sadly, did little to change this self-defeating behavior. Knowing they had to do more, many undertook to "nudge" employees toward savings best practices that would help them replace their working incomes once they retire.

Fortunately, academics were pioneering the new discipline of behavioral finance at precisely the time American workers began accumulating hundreds of billions of dollars' worth of retirement savings. The key findings told far-sighted plan sponsors that savings for retirement was a complex, emotionally driven process far different from the coldly "rational" decision-making traditional economics has always assumed most people engage in. The theoretical "Homo Economicus" might be a cool, rational decision-maker. But in the real world:

• Individual workplace savers often showed systematic over-confidence.


• They exhibited "framing bias" — a tendency to make long-term investment decisions in response to the way options were presented to them.


• They were extremely loss-averse, which led to panic selling amid financial dislocations like the dot-com bubble of the early 2000s.


• Workplace savers, faced with too many investment choices, were ill-equipped to handle the complex risk optimization of long-term lifecycle investing.


• Many fell victim to inertia, failing to adjust their investment allocations over time and experiencing "portfolio drift" — overexposure to either risk (equities) or safety (money market funds).

In response to this challenge, financial services firms and plan sponsors collaborated with academics like Brigitte C. Madrian and Dennis F. Shea, who documented the impact of automatic enrollment on plan participation. We drew on ideas from Mr. Thaler and Cass R. Sunstein, who advocated automatic enrollment, allocation and escalation; from Shlomo Benartzi and Roger Lewin, who noted the prevalence of short-term, narrowly informed decision-making; and from Nobel laureate Daniel Kahneman, who documented the emotional predominance of optimism, overconfidence and snap judgment.

These early years of experimentation and collaboration centered on the then-radical concept of "automaticity." By the early 1990s, some forward-thinking plan sponsors began automatically enrolling workers into workplace savings plans. More active sponsors also began defaulting workers to balanced funds or to the then-new target-date funds). The most far-sighted employers even implemented automatic escalation — starting investment deferrals at an initial level of say, 3%, automatically elevating toward 6% to 10%.

These were bold ideas and an ambitious agenda, particularly since the science behind these initiatives was still emerging. Many questions arose. Would workers object to being "told what to do"? Would being asked to "save too much" dissuade enrollment? Would investors cut-and-run in the face of routine volatility and market corrections? And could they tolerate the blending of diverse factors like savings volumes, investment allocation, and the need to evolve savings levels and allocations over time?

It turns out that automaticity — by simplifying this complex array of decisions, actions and timing — worked like a charm. For workplace plans that embraced automatic processes, enrollment, deferrals and allocation to professionally designed glidepaths spiked like the proverbial hockey stick. It was an "aha" moment for all of us — proof that well-designed defined contribution plans really could empower workers, make success easier and failure hard.

Complexity and too-much choice is a drag on performance at all stages of the investment process.

This is why automaticity is so valuable; it eliminates a blizzard of small decisions, paperwork and opportunities for error.

For example, we now know that prior to the era of automatic enrollment, millions of workers left money on the table, forgoing savings, tax deferrals and employer matches because they couldn't deal with the cumbersome and emotionally charged process of enrolling, re-enrolling and making specific investment choices.

Even today, complexity still plagues far too many workplace savings plans and many workers lose momentum in building assets due to frequent job changes.

According to the U.S. Bureau of Labor Statistics, over the course of their careers American workers average just 2.5 years on any given job and have 12 different employers. Workplace tenures in America have been falling for decades; some analysts project a majority of Americans may one day be contingent workers in a vastly expanded "gig" economy.

Each of these job transitions presents a threat of "leakage" from workplace savings as workers avoid the complex paperwork of rolling over savings, enrolling in new plans and recalibrating investment strategies. Some workers even lose track of their investments, giving rise to a subset of our industry dedicated to reconnecting workers with "lost" workplace savings accounts. Indeed, the next frontier in automating workplace plans might be the "automatic rollover" of retirement accounts between jobs.

Despite these continuing challenges, America's workplace retirement savings machine is a remarkable economic engine. A majority of workers have access to plans. Those with access to automatic enrollment welcome it — and take part at levels north of 90%. Average investment deferrals are rising, particularly among millennials. Well-designed target-date funds and managed accounts have become the norm among most large firms, covering tens of millions of workers. Plan costs keep falling, transparency keeps rising and investor satisfaction is at record highs.

We still have much work to do to achieve a fully automatic, universal and seamless retirement savings system that enables nearly all workers to supplement Social Security and fully replace their work-life incomes. But behavioral finance has given us the insights we need to get there. Just as intelligent algorithms are transforming medicine, technology and transportation, workplace savings plans, too, are getting smarter and delivering ever-greater success.

To accelerate this, we need three public policy reforms. First, we must extend workplace savings access to the 40% of workers who still have no access to on-the-job savings. Second, we should spread automaticity across all existing plans. Finally, we must lift systemwide savings rates to 10% or more so workers accumulate enough savings to finance dignified retirements.

These changes will require strong and visionary political leadership. But the insights of behavioral finance tell us that if we enact these reforms, we really can solve this country's retirement challenge.

Robert L. Reynolds is president and CEO of Putnam Investments and Great West Financial, owner of Empower Retirement. He is the author of the new book "From Here to Security: How Workplace Savings Can Keep America's Promise." This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.