People often put off making decisions for a variety of reasons. For decisions about saving for retirement, the main reason often comes down to complexity. Many people don’t know where to start in saving or have other influences competing for their time and money. So, the easiest solution is often to just do nothing. Plan sponsors can help employees make their 401(k) savings take off and use inertia to their advantage through plan design.
It’s great to think of taking a trait like inaction that might be considered negative and make it work to an employee’s benefit. Once inertia sets in, it can be hard to reverse. That’s why the idea of “nudges” has gained popularity among behavioral economists, with wider acceptance among retirement plan sponsors.
Rather than relying on persuasion or coercion and hoping that people make wholesale changes in their behavior, “nudges” favor automatic or “opt-out” decisions to encourage the helpful behavior.
For example, if people prefer doing nothing, plan design could put inertia to work by asking participants to choose the behavior with the negative outcome. If a participant does nothing, which is more likely the case, the outcome they “choose” would be the more beneficial outcome for their future.
How can plan sponsors integrate these “nudges” into plan design?
Auto-Enrollment
When employees are given the choice to enroll in a workplace retirement plan, many choose not to act. The retirement outcomes for these workers are often obvious—many don’t save and end up facing an uncertain financial future. They aren’t able to have the retirement they envisioned.
But when employees are “nudged” to participate by making 401(k) enrollments automatic and giving participants the choice to opt out, retirement plan enrollment tends to increase.
Inertia is still at work—participants who do nothing are enrolled in the retirement plan—but this plan design “nudge” pushes employees in a more beneficial direction.
There are rules around auto-enrollment that a plan sponsor should know before considering this feature for plan design. Employees must be notified that they will be automatically signed up for the retirement plan unless they choose to “opt out.” Plan sponsors also need to advise auto-enrolling participants that contributions will be deducted directly from the paychecks and what percentage of their gross pay will go toward their retirement plan contributions every pay period.
Auto-Escalation
Getting participants auto-enrolled in the retirement plan is an important first step. But inertia continues to hold sway even while participants are active in the plan.
On average, participants contribute around 6% of pay to their workplace retirement plan, per a 2015 Vanguard survey. But more than half of participants are contributing less than 6%. And with inertia in play, it’s unlikely participants will ever make the choice to increase how much they contribute on a regular basis.
That’s why auto-escalation features can be useful in helping participants close the gap between how much they are saving for retirement and how much they should be saving. Incremental contribution increases every year make it easier for participants to save more, while they feel just a small pinch in their take-home pay.
Plan sponsors can also time auto-escalation to coincide with employee annual reviews and salary increases, to encourage participants to put more of their higher paychecks toward their financial future.
Just like auto-enrollment, plan participants have the choice to opt out of automatic contribution increases. But because many participants will choose not to take action, auto-escalation helps nudge them toward saving more for retirement.
Auto-Allocation
Once participants are auto-enrolled in their retirement plans and are auto-escalating their contributions every year, they still face one more difficult choice—how to invest the money they are saving for retirement.
Naturally, inertia is still at work when it comes to asset allocation. Plan sponsors who have insight into participant allocation data can see the consequences of inertia at this stage—many participants often “choose” the default investment option or put their savings in a cash account, even when they have many years until retirement.
Another “nudge” that plan sponsors can include in plan design is the use of target date or target risk funds that automatically allocate participant investments in an asset mix suitable for their time horizon or risk tolerance. And because the allocation mix in these funds adjusts as they approach retirement, participants really don’t have to do anything to stay on track toward their retirement goals.
Plus, many target date funds meet the requirements as qualified default investment alternatives (QDIA). So, plan sponsors can make these funds the default options for auto-enrolling participants and let inertia “nudge” them into an appropriate portfolio for their retirement plan.
Making No Choice the Helpful Choice
Plan sponsors offer 401(k) plans to help their employees save and they measure the success of the plan in how their employees actively participate in their workplace retirement plans. The reality is, inertia is often too strong a force among many people and keeps participants from making choices that can help their financial future.
Instead of trying to move an immovable object, plan sponsors can take advantage of human nature in plan design by putting inertia to work through these automatic features.
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