The Father of Auto-Enroll is a Sensible Choice for a Nobel Prize

Each year, the Nobel Prize committee recognizes individuals for their lifelong work to further the study of medicine, physics, chemistry and economics. The accomplishments that the Nobel committee recognizes are significant contributions to the laureates’ respective fields, but are often obscure and generally unappreciated by the public at large.

That’s not the case with this year’s recipient of the Nobel Prize in Economics, Richard Thaler of the University of Chicago. Thaler is something of a celebrity in academic circles; he has written best-selling books including Nudge and Misbehaving, and even appeared beside singer Selena Gomez during a brief scene in the film The Big Short about the housing bubble and securitized debt crisis.

But Thaler’s work has practical implications for any retirement plan sponsor or fiduciary. His ideas are behind the evolution of the auto-enroll and auto-escalation features that have become commonplace in the retirement plan market. Since Thaler and his peers began talking about investor behavior and predictable irrationality, the financial services and retirement plan industry have used their insights to craft products and solutions to better help individuals prepare for their financial future.

Theory Meets Practice

Behavioral economics challenged some long-held ideas in the “dismal science” of economic thought, and it remains controversial to some economists.

Traditional economic theories tend to presume that people are rational and will act and in their best economic interests. But behavioral economics flipped this idea on its head. What Thaler and others in this emerging field believe is that humans aren’t rational after all—they often make decisions based on emotion not reason. Therefore, people don’t always act in their economic best interests.

Are Thaler and his fellow behavioral economists, right? That’s a debate better left in the academic halls and university economics departments. But from a lay person perspective, the ideas behind behavioral economics have some merit—it’s not hard to see instances of people acting irrationally and letting their emotions guide their financial decisions. The dot-com stock craze of the late 90s and the real estate bubble of the mid-2000s come to mind.

Birth of the “Nudge”

The thinking behind behavior economics helped create what is probably Thaler’s biggest contribution to modern financial life—automating participation in workplace retirement plans. Because people can’t be counted on to make a seemingly rational decision—to save part of their earnings on a pre-tax basis and invest it for the future in a 401(k) account—employers and retirement plan sponsors should step in to make this decision on behalf of their workers and plan participants.

Of course, workers need to be told they are automatically enrolled in the company’s retirement plan, and also given the option to “opt out” if they don’t want to participate. But auto-enrollment provisions work like a “nudge”, pushing people in a prudent direction to make an important economic decision on their own (at least seemingly.)

By looking at recent statistics, it seems Thaler’s “nudges” are catching on in the workplace. According to a recent survey by the Society for Human Resources Management, auto-enrollment is used in 40% of defined contribution plans for new employees and in 24% of plan for current employees. Both figures are higher from the previous year.

Fiduciary Concerns

For workers and plan participants, automatic features for enrollment and increasing payroll contributions work because they reduce the likelihood of irrational decision making. These provisions are generally good for participants, but are they good for plan sponsors as well?

There is good reason to raise that question. Some plan sponsors may be concerned about their liability in making investment decisions on behalf of plan participants. A participant who experiences a drop in the value of their retirement plan account make look to take a plan sponsor to court over failure to carry out their fiduciary duty.

This is a rational concern given the number of lawsuits faced by plan sponsors, accusing them breach of fiduciary duty for failing to monitor investment fees or to provide lower-cost alternatives.

As provided for in the Pension Protection Act of 2006, plan sponsors can limit their fiduciary liability when adding auto-enroll provisions, by including qualified default investment alternatives (QDIAs) in their plan menus. Some participants who do nothing to “opt in” to their workplace retirement plan may also choose to do nothing when it comes to their investment selections. QDIAs can make suitable investment vehicles for these types of investors.

QDIAs are designed to seek returns and manage risk in a way that aligns with a specific time horizon or risk tolerance level. As the default fund in a plan lineup, participants who do nothing with their investment allocations have their savings automatically invested for them.

Ain’t “Misbehaving” Anymore

With the growing popularity of QDIAs, auto-enrollment and auto-escalation features, Richard Thaler is among the fortunate Nobel laureates to see the practical outcomes of his work. These automatic features are likely to continue to proliferate as the ideas behind behavioral economics gain further acceptance by the market and investors.

For plan sponsors and fiduciaries, the lessons of behavioral economic and predictable irrationality are important to keep in mind when designing programs to help individuals’ investors achieve financial success.