Will Baby-Boomers’ Retirement Years Go Bust from a Lack of Savings?

In recent years, the format of Americans’ pension plans has changed as an increasing number of companies move to a defined contribution model that places more responsibility on the shoulders of the employees. But even as it becomes more important for workers to prepare for retirement, surveys and other data indicate that many plan participants confess to having little or no understanding of these vital tools. Worse, because of the complex nature of 401(k)s and other plans, employee contributions tend to be far lower than they should, increasing the likelihood that employees will outlive and outspend their retirement funds.

These issues were explored by a variety of experts from government, industry and academia at a recent Pension Research Council conference titled “Decision-Making under Uncertainty: Implications for Pensions.” While the conference speakers painted a bleak retirement picture for an aging population, they also suggested some innovative solutions.

“In most aspects of life, people do best at tasks with known deadlines, especially those that offer immediate and certain gratification,” observes Olivia S. Mitchell, executive director of the Pension Research Council and Wharton professor of insurance and risk management. “Sadly, saving for retirement doesn’t offer quick and positive reinforcement, and the rewards are far from certain. Indeed, it’s a wonder that some people manage to save at all, given the obstacles.”

The very concept of retirement savings may be difficult to assimilate, according to some conference participants.

“Investing for retirement is different from just about anything else people are asked to do,” says Gary W. Selnow, a professor at San Francisco State University whose presentation, titled Decision-Making Under Uncertainty: Lessons from Recent Research, focused on approaches that may promote retirement investment. “The savings ethic is resistant to nearly all the motivators we commonly use to encourage desired behaviors, and that robs you of the most useful and effective tools to stimulate wise investment decisions.”

He notes that a variety of factors and cultural influences work against a long-term investment approach. Workers, for example, don’t easily buy the idea of payoffs in the distant future, and the payoff of retirement investing is seen as uncertain (particularly in a defined contribution environment).

In fact, he adds, “saving for pleasure tomorrow means pain today, since setting aside even a few dollars each month is most painful when the need for cash is greatest – in the years of raising children, buying a home, preparing for the kids’ education.”

Educating employees about retirement issues may help, suggests Selnow. But although many companies have instituted some form of financial education, he quotes from a study that found 70% of American workers “have not even calculated their financial needs for retirement, half have made negligible contributions to their retirement funds, and fully 15% have saved nothing for their later years.”

He notes, though, that some studies, including one from the Pension Research Council, may suggest an alternative – automatic enrollment. Under this approach, an employee would by default enter a 401(k) or other plan without being required to fill out volumes of forms or choose among many alternative investment options.

A paper by James J. Choi, a doctoral student in economics at Harvard University, David Laibson, professor of economics at Harvard, Brigitte Madrian, professor at the University of Chicago’s Graduate School of Business, and Andrew Metrick, professor of finance at Wharton, titled For Better or For Worse: Default Effects and 401(k) Savings Behavior, notes that “automatic enrollment has a dramatic impact on retirement savings behavior,” says Selnow. “For example, 401(k) participation rates in all three firms (they studied) exceed 85%.”

Selnow brings a psychological dimension to the question of retirement involvement (or lack of it), noting that people often “follow the path of least resistance.” Thus, if signing up for a pension plan requires effort, many people will simply avoid it. In contrast, an automatic pension enrollment plan takes advantage of this tendency towards inaction. He notes too, that the very act of enrolling an employee in a retirement savings plan by default may bring about a positive change in attitude about investing for the future.

But one condition must be in place. “We must see ourselves as having an escape, and having at least some choices in the behavior,” he explains. “Because if we believe we are coerced, the force of the coercion becomes the obvious explanation for our behaviors, rather than our supporting beliefs.”

Regardless of the psychology behind it, Selnow notes that “nine-in-ten employees stay with an automatic retirement savings program after six months. And after 36 months the enrollment numbers remain about a third higher than for employees not under automatic enrollment plans.”

While the path of least resistance may help employees stay the course, “the fact that they were enrolled and could un-enroll at any time of their choosing – but did not – may actually lead to altered beliefs about savings,” he says. “The automatic enrollment approach has a real chance of success because it skirts the natural impediments to employee-initiated pension plans. The delay and uncertainty of payoffs, the deferral of rewards, the imposition of sacrifices and other pains and suffering of initiating a retirement savings plan become less relevant.”

More Choice, Less Participation

Another study presented at the conference did not directly address the issue of the effect of automatic enrollment on employee pension plan participation, but nonetheless appeared to reinforce the principles behind Selnow’s observations.

Sheena Sethi-Iyengar, a professor of management at Columbia Business School, focused on the desirability of choices in 401(k) plans. Along with colleagues Wei Jiang and Gur Huberman, she notes that while choice has been considered both desirable and powerful, recent studies demonstrate potential limitations to this assumption. They have written a paper entitled How Much Choice Is Too Much?

Referring to field and laboratory experiments, including one in a supermarket in which the intrinsic motivation of participants who encountered limited, as opposed to extensive, choices were compared, she says that “although extensive choice initially proved to be more enticing than limited choice, the limited choice was clearly more motivating.”

Iyengar explains that people may not be unhappy in the face of abundant choices (or choice overload), but are instead unsure of themselves.

To consider decision-making influences as they relate to pension choices, Iyengar and a group of colleagues examined employees’ participation and contribution levels in retirement benefit plans offered by employers. Given the advantages of 401(k) plans and the many options available within them, the researchers expected participation rates to be at an all-time high.

Despite the fact that average 401(k) plan offerings increased available options by 20.5% from 1998 to 2001, according to Vanguard Pension Research Council, only about 75%-80% of eligible workers participate in them, according to the Profit-Sharing/401(k) Council of America.

Data indicate that the participation rate is even lower among younger and low-income workers. Further, although financial advisors suggest a contribution rate of 10% or more of pre-tax salary, the average 401(k) participant contributes less than seven percent, according to the Employee Benefit Research Institute.

Iyengar explains this by hypothesizing that the importance of the investment decision, combined with the fact that employees were intimidated by the complex details of the various plan offerings, contribute to a “choice overload” effect that results in a greater likelihood of “investors choosing not to choose.”

Iyengar and her colleagues tested the theory by examining 401(k) participation rates among nearly 793,000 employees of 647 Vanguard plans in 69 industries, and found that more funds offered by the plans led to fewer employee participation rates. “At two extreme ends, when there are two funds offered, participation rates are at a peak of 75%,” says Iyengar. “When there are 60 funds, participation rates are at a low of approximately 60%.”

She concludes that “there is a distinctive trend suggesting that the decline in participation rates is exacerbated as offerings increase further.”

Battling the Urge to Procrastinate

If psychology acts to constrain employees from signing up for pension plans, and if too many plan choices overwhelm them, then perhaps Shlomo Benartzi, who co-authored a paper on the use of behavioral economics to increase employee saving, has a solution. The paper is entitled Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving.

Benartzi, a professor at UCLA’s Anderson Graduate School of Management, and Richard Thaler, a professor of behavioral science and economics at the University of Chicago’s Graduate School of Business, utilized principles from psychology and behavioral economics to craft a program called Save More Tomorrow (SMT).

It is designed to increase employee retirement savings by giving workers the option of committing themselves now, to increase their savings rate later, each time they get a raise. At the heart of the plan is the realization that saving for retirement requires financial education, self control and a willingness to battle the urge to procrastinate.

“The importance of procrastination and status quo bias in the design of prescriptive savings plans is illustrated by the experience some firms have had with so-called automatic savings enrollment plans,” they write. “Consistent with behavioral predictions, automatic enrollment plans have proven to be remarkably successful in increasing enrollments. But there is a downside. The very inertia that explains why automatic enrollment increases participation can also lower the savings rate of those who do participate.”

A goal of SMT is to obtain some of the advantages of automatic enrollment while avoiding some of the disadvantages.” As a first step, employees are asked – a considerable period of time ahead of their scheduled pay increase – to increase their contribution rates.

The pair explains that this approach addresses the issue of “hyperbolic discounting,” which suggests that opportunities to save more in the future will be considered more attractive then those in the present.

If they opt in, the employee’s contribution is increased beginning with the first paycheck following a raise. “This feature mitigates the perceived loss aversion of a cut in take-home pay,” writes Benartzi. “Then the rate continues to increase at each scheduled raise until the contribution rate reaches a preset maximum. In this way, inertia and status quo work to keep people in the plan.”

Finally, employees may opt out at any time, since the ability to do so will make them more comfortable about joining the plan in the first place.

Benartzi notes that SMT was originally launched in 1998 at a midsize manufacturing company that did not have a defined benefits plan.

“Prior to its adoption, the company had a low participation rate and a low savings rate, which concerned management for two reasons: First, some workers might be unable to support themselves upon retirement, and second, the low participation rates meant the company was being constrained by U.S. Department of Labor anti-discrimination rules that restrict the proportion of benefits that could be paid to higher-paid employees,” he writes. “After an outside investment consultant convinced the company to implement an SMT plan, only two percent of the participants dropped out prior to the third pay raise, with another 18% dropping out between the second and third raises. Even those who withdrew from the plan did not reduce their contribution rates – they merely put a halt to future increases. Meanwhile, those who joined the plan tripled their savings rate in 28 months.”

Benartzi goes on to cite data from Hewitt Associates that he says indicate significant positive savings increases could be achieved if SMT were rolled out on a national level. “The plan would boost the savings rate in the (Hewitt Associates) sample from 5% to 9.7% within five years. If employees are automatically enrolled in the plan, the projected average savings rate would increase to 10.9% within that period,” he notes. “In terms of dollars, a 5% increase would boost personal savings by $125 billion a year, or 1.5% of disposable income, compared to a current personal savings rate that hovers near zero. The results suggest that behavioral economics can be used to design effective prescriptive programs for important economic decisions.”

Momentum Vs. Contrarian Investors

At a time when high-profile cases have highlighted the dangers of over-concentrating employee investments in company stock, the issue of employee investment decisions was studied in another paper by Choi, Laibson, Madrian and Metrick, this one titled Employees’ Investment Decisions about Company Stock.

Based on data provided by Hewitt Associates, the researchers identified three large companies, referred to as Alpha, Delta and Gamma, that offered stock as an investment option. They also obtained detailed data on individual participants in each plan. The paper studied the decisions of almost 100,000 401(k) participants to gain a better understanding of the determinants of employees’ discretionary investment in company stock.

“The pattern of results suggests that when company stock returns are high, newly enrolled participants contribute a higher fraction of their flows to company stock and a lower fraction to other equity,” says Choi. “The relationship between salary and total equity is positive and significant, while the relationship between salary and company stock is negative and significant.”

But he adds that past returns appear to be a deciding factor. “We find that high returns on company stock for the year prior to enrollment induce participants to make higher initial contributions to company stock. Further, high returns over a one-year period induce participants to increase these contribution fractions.”

Interestingly though, high returns on company stock also appear to have the opposite effect on trading decisions.

“High past returns induce participants to substitute away from company stock and into other equities,” he comments. “Thus participants are momentum investors when making decisions about investments, but contrarian investors when making trading decisions.”

This may actually help to protect plan participants from being too concentrated in their company’s stock. “Since high past returns induce participants to substitute out of company stock, the strong relationship between past returns and contributions is less dangerous than it might appear from previous studies,” observes Choi.

Summing up the conference, Mitchell notes that “financial education can help spur thoughtful people to plan more sensibly, save more money, and invest it better, thereby protecting themselves from the risk of old-age ruin. Of course saving more requires that people join a pension plan and stay in it over time. At this conference, academics, plan sponsors, benefits professionals and regulators discussed new theories and evidence about how people make financial choices, and what they imply for how pension plans can be structured. I believe that the analysis has global implications for the ways in which pension sponsors, money managers, and plan participants should respond in light of current market volatility and uncertainty.”