Rise of DC-plan defaults has increased participation, but savings rates need a push.
An important story of the past decade in the defined-contribution space is the rise of the use of defaults. In an effort to increase participation in retirement plans and the amount participants save, many plan sponsors and companies are automatically enrolling employees into plans instead of forcing them to opt in.
In theory, defaults should have little impact on decisions, because the element of choice remains. In reality, however, defaults have a significant impact on individual decisions. But do these individual decisions lead to better retirement outcomes for participants? In this article, we’ll explore whether, and how, defaults are nudging employees to a better or worse retirement.
The Rise of the Nudge
A nudge is a form of choice architecture designed to improve decision-making. The term comes from a 2008 book by Richard Thaler and Cass Sunstein titled Nudge: Improving Decisions About Health, Wealth, and Happiness.
Neoclassical economic theory suggests that nudges should have no impact on rational consumer choices, especially if a decision is important and transaction costs are small. In theory, people would make the right choice regardless of the default. In reality, defaults make a big difference. A growing body of empirical evidence shows that nudges can considerably affect decisions, from the relatively insignificant, such as email marketing, to those with much greater societal importance, such as organ donation.
Nudges may affect decisions for a variety of reasons. For example, individuals may perceive the default decision as being endorsed by whoever is making it. Defaults can also influence outcomes because people often lack the necessary skills to make optimal choices. People are also prone to procrastinate.
Nudges in DC Plans
Defaults in defined-contribution retirement plans, or DC plans, are especially good at overcoming bad behavior, because plan participants often make choices that are not in their best interest. The key, we find, is making sure the default is set up optimally. While default decisions generally have resulted in better outcomes for DC participants, that isn’t always the case.
I’ll explore outcomes for four key defaults in this section: default investing, automatic enrollment, automatic escalation, and default savings rates.
Before the introduction of default investing, employees who enrolled in DC plans had to build their own portfolios. This was not good from an outcomes perspective. A large body of evidence suggests that the average investor is not a very good one. After the Pension Protection Act of 2006, use of default investments—especially target-date funds—has grown significantly. Approximately 85% of participants in DC plans accept the default investment if offered.1