401(k) auto-enrollment and target-date funds help to combat investors' inclinations to procrastinate and vulnerability to choice overload, says Andy Eschtruth of the Center for Retirement Research.
Christine Benz: Hi, I am Christine Benz from Morningstar.com.
The Retirement Income Industry Association has been holding its Spring Conference at Morningstar all this week. We're here today with Andy Eschtruth, he is with the Center for Retirement Research at Boston College.
Andy, thanks so much for being here.
Andy Eschtruth: Thank you, Christine. It's a pleasure.
Benz: So the center has conducted a lot of fascinating research into the area of behavioral finance, and specifically how it affects retirement-related decision making.
I'd like start with the area of retirement accumulation, so people who are saving for retirement. What are some of the key behavioral traps that you see this group falling into?
Eschtruth: Well, there is a great one, and there is a lot of good research on this that shows how it plays out. People have a reluctance to save. They have a reluctance to do things, even if they have an intention to do them. So there is a tremendous amount of inertia and procrastination. Those are behavioral barriers that prevent people from doing things that they probably would do if someone really prompted them to do it.
The most important of these is simply saving for retirement. And we found that people outside of a company-sponsored pension plan, they normally won't save for retirement on their own. So when they're inside a company plan, and most people have access to a 401(k), it's really important for them to take advantage of that. And another thing they get out of participating in a 401(k) is generally there's an employer match for their own contributions. So if they're failing to join the 401(k), they're not only failing to lock away some of their own money, they are actually forgoing a raise--they are leaving money on the table that the employer would throw into the pot.
So, one of the ways around this, which has worked very successfully, is a movement towards something called "automatic enrollment." And within 401(k) plans, five or six years ago this was just barely being introduced, and it's had great success, and a number of plans have adopted it. There's still a long ways to go; there are still many particularly smaller plans that haven't gotten into this yet. But if you take automatic enrollment--and that's just the first step to a fully automated plan--if you take automatic enrollment, you boost your participation rate substantially, and what automatic enrollment does is it simply, when someone signs up, joins the company, it automatically puts you in a 401(k) plan.
The old-fashioned way is people would come in, and they'd have to go to HR and fill out a form. I know that sounds really simple going to HR and filling out a form, but a fairly significant percentage of people would fail to do that one simple act.
So just getting people to fill out the form, automatically putting them in the plan allows that savings to start immediately coming out of their paycheck. When you couple that with something called auto-escalation, that lets them increase their savings over time. So maybe you start them at 3% of their salary, and then the next year--maybe on the anniversary of their hire date--they go up to 4%. And the next year, they go up to 5%. And there's some reasonable ceiling in there, but at some point in their savings behavior, they get more used to saving and saving a little more. If it coincides with a salary increase, they're more likely to stick with it because they're not seeing their overall income go down in their paycheck. So those two mechanisms are really very powerful.
And there is one beautiful thing that I love about automatic approaches is that they still leave people the freedom to do whatever they want.
Read Full Transcript
Benz: So they can get out if they want to.
Eschtruth: They can get out. It's not pure coercion. There is usually a default investment fund that they are sent into. They can change that default investment fund very easily, so if they feel like that's not an appropriate solution for them, they can get out of that.
Benz: Yeah. So they can override some of these pre-programmed choices.
Eschtruth: Absolutely.
Benz: Another issue I wanted to talk about is this issue of choice overload, where people are confronted with this overwhelming array of choices in a 401(k) plan. Sometimes that's another impetus to do nothing or to make bad choices. Is that something that you see at the center in the work that your team has done?
Eschtruth: Yes, it is something that I've experienced. I mean, when I started work there, one of the investment providers we had hit something like a 100-plus mutual funds for me to pick from. And I said, how am I going to wade through a 100-plus mutual funds. I'm not going to read a prospectus for each and every one of these funds.
So I felt that myself, and then what we've seen in the research conducted by many of the behavioral finance people that we've been associated with is, this is a real problem for people. Too much choice is clearly paralyzing, and there are some classic examples of this. People have done experiments with chocolates and with jellies, and they find that when they give people many choices to pick from, people love the idea of getting to pick from among all these different choices, but then when it comes to actually deciding what to buy, it's a more effective strategy to offer them a limited number of choices. So, if you're in a grocery store, and you have your little tasting station, don't give them 30 different kinds of jelly. Give them three or four or five, if you really want to boost your sales.
That same psychology carries over to the idea of investment behavior, and for example, one mistake that people commonly make is they'll say, oh, there are 20 funds. I don't know which of those 20 funds is the best. I'm going to put one-twentieth of my money in each of those 20 funds.
Benz: Right, 5% in each fund.
Eschtruth: If half those funds are bond funds, and you are a young person, you probably want to be with a higher equity allocation at that point.
Benz: Right, so you I know are a big enthusiast about target-date. You feel like it helps people tackle one of these challenges, or this challenge.
Eschtruth: Absolutely. We found that very encouraging trend. These target date funds, which are basically a one-investment-choice solution to diversification, what they really do is they invest in a number of other different funds, and they are packaged around an individual's expected retirement date. So the portfolios are automatically rebalanced over time, and they gradually shift from a more aggressive investment allocation to a more conservative allocation. And I think those are really good solutions, and they are often adopted within the context of automatic enrollment. So if someone is automatically enrolled in a plan, it might be automatically put into one of these target-date funds. Now that's not going to be the best solution for everybody. But again, for most people, it's a reasonable place to put them, and it really probably avoids a lot more mistakes than it causes.
Benz: So one thing your research shows, though, is that sometimes people misunderstand the target date funds. They think it's not a stand-alone option. They are meant to supplement it with other offerings. That's something that you have found in your research.
Eschtruth: Absolutely. That's one danger is that people have been very good at learning this maxim that investment advisors have been repeating, a mantra, for many years, which is "don't put all of your eggs in one basket; don't put all of your eggs in one basket." And they've got this running around inside their head, and then someone gives them a target date fund and they think, "Oh my gosh--this is only one investment." I know that I'm not supposed to have only one investment." And what they often fail to understand is that the target day fund itself was designed to be that solution. It's actually many investments packaged into one wrapper--so that is a danger that people will actually misuse the target date funds. They'll invest in multiple target-date funds, or they'll pick target date funds and mix it with other allocations in a portfolio.
Again, there might be sometimes where that's perfectly appropriate as part of a sophisticated strategy, but if you don't understand the target date fund, you're more likely to make a mistake.
