How to ‘Opt In’ to Retirement Savings

On this episode of The Long View, James Choi, professor of finance at the Yale School of Management shares his research on choice architecture, retirement plan design, and emergency savings.

Here are a few excerpts from Choi’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Choice Architecture

Christine Benz: You’ve done a lot of work on choice architecture, both within and outside of the context of retirement plans. To begin with, can you explain what you mean by choice architecture?

James Choi: I can’t take credit for the phrase myself. Choice architecture was a phrase that was coined by Cass Sunstein and Richard Thaler, and they used that phrase to refer to an emerging body of research that had come into being at the time that indicated the circumstances and contexts within which a choice is made can make a big difference to what choice is ultimately made. And so, even the small things will matter is the takeaway that they pushed from that phrase. The biggest example of choice architecture that’s used today is opt in versus opt out, particularly in the finance context in retirement savings plan. So, if you have opt-out savings, then you’re much more likely to end up saving in the retirement savings plan than if you have to opt in. This was a big discovery at the time. This was about 20 years ago where this really became known, because economists thought retirement savings, it’s such a high-stakes decision that something as minor as to have to opt in versus opt out couldn’t possibly have a material impact of what people end up doing, and what we’ve discovered is that actually that very minor change in the choice architecture has a big impact on what people end up doing.

Active Choice for Retirement Plan Design

Jeff Ptak: I wanted to build on that and ask you about the implications of what’s referred to as active choice for retirement plan design. Specifically, when is it better for the plan sponsor to choose on a participant’s behalf and when is it preferable for the participant herself to actively make the choice?

Choi: Let me back up for a second and just define what active choice is, because your listeners might not be so familiar with that phrase.

When people first started talking about defaults in retirement savings plans and default contribution rate or default asset allocation, there was this thought that maybe we don’t like defaults because they’re quite paternalistic in who is the employer or the plan administrator, or whoever, “Who do they think they are to choose as a default?” But actually, if you give people the option to do nothing, then something has to happen when they choose nothing. And that something is the default. And so, the only way that you can get away from choosing a default is if you take away the option for people to do nothing. So, that’s what an active choice regime is. It says that by a certain deadline you must actively state what your preference is. So, in the 401(k) retirement savings plan context, I do want to save in the 401(k) plan at this contribution rate and asset allocation, or no, I do not want to save in the 401(k) plan at any positive contribution rate. So, no matter what you want, you have to actively make a statement of your preference. So, that’s an active choice regime.

Honestly, it has not been a very common implementation within retirement savings plans. You see it more often in benefits elections. So, in open-enrollment periods at companies, you have to choose actively what health insurance plan you’re going to be in, for example. In what context will we think that active choice is better than setting some kind of default? I think it would be in situations where there’s a lot of heterogeneity in the right decision for people. So, you can’t just say, “Oh, 99% of the population would be better off with Choice A rather than Choice B.” Well, then, maybe we should just choose Choice A for everybody and let the small sliver of people for whom Choice B is better actively choose to opt out of that default.

It’s also probably going to be better to have a default rather than active choice if people just don’t have a lot of expertise in choosing one option versus the other, in which case you might want to step in and provide more guidance to the individuals rather than saying you’re on your own, you have to make a choice, but we’re not going to tell you what it is.

Decumulation Decisions and Defaults

Benz: I have to ask, is the point at which people leave their employer-provided plans and have to make decisions about decumulation and spending from their portfolio and whether to buy an annuity and so forth, has that piece of the life stage planning been underdiscussed with respect to defaults, do you think?

Choi: The decumulation decision has been a thorn in the side of, I think, the retirement finance industry for a long time. And I remember even 15, 20 years ago, people said, “Oh, we don’t talk about decumulation nearly enough.” But here we are. And I don’t think that the conversation has advanced all that much. And I think it’s because it’s a hard problem and to know exactly what the right rate of decumulation is for any given individual is pretty hard not only because of considerations of, say, life expectancy or family circumstance, but also we know now from some JPMorgan Chase data that when people retire, it’s not that they spend smoothly over the course of their retirement. It seems like at the beginning there’s a lot of spending that happens as people try to figure out what’s right for them at this stage of life. So, they might buy a boat, and then they discover they don’t like boating at all. And so, they’ll try a few different things, and it costs money to try these things. And then, eventually, they’ll settle down into maybe a more consistent pattern of life in retirement. It’s these very idiosyncratic features of what people want in their spending path that makes choosing on their behalf, say, through some default mechanism, I think, fairly difficult.