«Shlomo Benartzi* The Anderson School at UCLA 110 Westwood Plaza Los Angeles, CA 90095-1481 benartzi Ehud Peleg The Anderson School at UCLA ...»
Choice Architecture and Retirement Saving Plans
The Anderson School at UCLA
110 Westwood Plaza
Los Angeles, CA 90095-1481
The Anderson School at UCLA
110 Westwood Plaza
Los Angeles, CA 90095-1481
Richard H. Thaler
University of Chicago
Graduate School of Business
1101 E. 58th St.
Chicago, IL 60637
ABSTRACTIn this paper, we apply basic principles from the domain of design and architecture to choices
made by employees saving for retirement. Three of the basic principles of design we apply are:
(1) there is no neutral design, (2) design does matter, and (3) many of the seemingly minor design elements could matter as well. Applying these principles to the domain of retirement savings, we show that the design of retirement saving vehicles has a large effect on saving rates and investment elections, and that some of the minor details involved in the architecture of retirement plans could have dramatic effects on savings behavior. We conclude our paper by discussing how lessons learned from the design of objects could be applied to help people make better decisions, which we refer to as “choice architecture.” * Benartzi is grateful for financial support from Reish Luftman McDaniel & Reicher and Vanguard. We are also grateful to Warren Cormier from the Boston Research Group, Jodi DiCenzo, Liat Hadar, Steve Utkus of Vanguard and Carol Waddell of T. Rowe Price for all the data and support they have provided us over the years. We received helpful comments from Avanidhar Subrahmanyam and Mark Grinblatt.
On March 28, 1979, the Unit 2 nuclear power plant on the Three Mile Island Nuclear Generating Station in Dauphin County, Pennsylvania, suffered a core meltdown. In the investigation that followed, it became clear that a valve that was supposed to regulate the flow of cooling water had failed. The operators sent a control signal to remotely shut the valve, and when they received an indication that the signal had been sent, they assumed that the valve was indeed shut. An actual “positive feedback” lamp indicating the true position of the valve did not exist, so the operator had no way of verifying whether the signal was received and the necessary actions taken. Such lamp was deemed expendable during the construction of the facility to save time and money. As a result of this design error, operators were unaware that the valve was not turned off, that the cooling water continued to pour out, and that the reactor’s core continued to overheat and eventually melted down. Even though initial reports blamed “human error,” subsequent investigations found the design of controls equally at fault. They determined that ringing alarms and flashing warning lights left operators overwhelmed by information, much of it irrelevant, misleading or incorrect.1 The Three Mile Island incident is one example of how a faulty design can lead even highly qualified decision makers to devastating results. Although managing a retirement portfolio is not a national mission-critical operation, a financial meltdown can be just as painful to an individual as a plant meltdown is to the masses. In this article, we propose that the design of nuclear plant control rooms, everyday objects and retirement saving vehicles share similar properties. There are two crucial factors to consider. First, everything matters. Tiny details, from the color of an alert lamp to the size of the font can influence choices. Second, since A concise description of the event can be found in the US Nuclear Regulatory Fact Sheet at http://www.nrc.gov/reading-rm/doc-collections/fact-sheets/3mile-isle.html everything matters, it is important for those who design choice environments, who Thaler and
architecture is particularly important in domains such as retirement savings where most of the decision makers are unsophisticated.
Prior research in the domain of retirement savings has illustrated the potential role of improved choice architecture. Madrian and Shea (2001), for example, showed that the choice of default has a dramatic effect on savings behavior. They have studied several plans that changed the default so that employees who take no action are automatically enrolled into the retirement savings plan. It is important to note, however, that freedom of choice is preserved as employees could always opt-out of the retirement plan and are not in any way forced to save. In one of the plans studied, the percentage of employees saving for retirement increased from 49 percent to 86 percent as the default was changed to automatically enrolling employees into the plan.
Other studies have also documented that design does matter. Benartzi and Thaler (2001), for example, showed that the menu of investment funds offered to employees affects their risktaking behavior. In particular, some employees follow a naïve diversification strategy of spreading their money equally across funds, something they have dubbed the 1/n rule. As a result of using the 1/n rule (or a variant of this rule), a plan offering a bond fund, a small cap stock fund and a large cap stock fund might result in employees leaning toward an allocation of two thirds in stocks. In comparison, a plan with a money market fund, a bond fund and a diversified stock fund might result in just one third allocated to stocks.2 Huberman and Jiang (2006) extended the analysis in Benartzi and Thaler and showed that employees are more likely to use the 1/n heuristic when the number of funds is small and when 100 percent is divisible by n. For example, only five percent of those selecting nine funds use an approximately equal allocation across the nine funds, whereas 53 percent of those using 10 funds use an equal allocation.
Iyengar and Kamenica (2006) documented that the size of the menu of funds also affects savings behavior. They studied a cross-section of retirement savings plans, some offering as few as two funds and others with as many as 59 funds. They estimate that the addition of 10 funds to the menu of choices decreases participation in the plan by two percent, as some employees might be overwhelmed by the degree of choice.
The intuitive principle that many minor design elements could end up being important also applies to retirement saving vehicles. Benartzi and Thaler (forthcoming), for example, show that the number of lines displayed on the investment election form could have the unintended consequence of influencing the number of funds people choose. In one experiment they conducted, visitors to the Morningstar.com website (an online provider of financial information) were presented with an investment election form that had either four or eight lines displayed.
Note that those who were presented with four lines could still select more than four funds by simply clicking on a link to the form with eight lines. Benartzi and Thaler found that only 10 percent of those presented with four lines ended up picking more than four funds versus 40 percent for those who saw eight lines on their form to begin with. In other words, the graphic designer who creates the investment election form could accidentally influence the number of funds people pick.
Another example of how seemingly inconsequential design features could have dramatic effects is offered by Duflo and Saez (2002) who studied saving and investing choices among university librarians. They find that saving and investing choices vary significantly across libraries within the same university, even when employees are randomly assigned to libraries.
They conclude the peer effects, that is, consulting with a co-worker, drive the results. The findings suggest that the organizational structure of libraries could affect saving and investing behavior. In particular, a university with one central library is likely to exhibit more homogenous saving patterns than a university with multiple libraries. In another study, Duflo et al (2006) investigated the effect of matching contributions, and they propose that the specific example used to illustrate the effect of matching contributions could by itself influence saving behavior.3 In this paper, we provide new evidence on choice architecture in the domain of retirement savings plans. We focus on two timely design issues related to the Pension Protection Act of 2006 (hereafter, PPA). The first design issue has to do with escalator programs, where employees pre-commit to periodic saving increases (see Thaler and Benartzi, 2004). Whereas PPA encourages the use of escalator programs, there are many design elements that are left to the discretion of the employer, such as the timing of the saving increases. Since every design element could end up being important, we explore the effect of a variety of design issues in this context. Our goal is to identify the choice architecture that helps employees save more.
Interestingly, most employees (68 percent) feel they are saving too little, so we are just trying to identify the choice architecture that helps people reach their own stated goal (Choi et al, 2002).
Consistent with the work of Madrian and Shea (2001), we find that inertia plays a crucial role in choice architecture. In particular, when the escalator program is set as an opt-in program, about 15 percent of new hires sign up for the program. In contrast, when employees are automatically enrolled in the escalator program, only 16.5 percent opt out and the remaining 83.5 percent end up in the escalator program.4 We also find that seemingly minor design elements do matter in the context of escalator programs. For example, we document that employees prefer to In another domain, Bertrand et al (2005) found that the inclusion of a photograph of a credit loan officer could affect the take up rates of personal loans.
One legitimate concern is whether we have tricked people into the program, an issue we will address later.
pre-commit to save more next January as opposed to say next February or next March. In the spirit of New Year’s resolutions, people seem to think that January is a good time to start exerting willpower.
The second design issue we explore has to do with portfolio solutions. In recent years, fund providers have come up with one-stop portfolio solutions to assist employees with the complicated task of fund selection. One solution offered by fund providers is risk-based funds.
These funds are often labeled conservative, moderate or aggressive, and employees are expected to pick the one fund that matches their risk preferences. A distinctive feature of risk-based funds is that they keep a constant asset allocation and do not reduce their equity exposure as people get older. A competing solution offered by fund providers is retirement date funds. These funds are often labeled 2010, 2020, 2030 and 2040, where the labels correspond to the expected retirement date. Unlike risk-based funds, retirement date funds decrease their equity exposure as people approach retirement. In the case of retirement date funds, employees who are looking for a simple portfolio solution should pick the fund that matches their expected retirement date.
One might view the packaging of bond funds and stock funds into one-stop portfolio solutions as inconsequential, since individuals still have access to the underlying bond funds and stock funds to select the mix of funds they truly prefer. However, we find that one-stop portfolio solutions increase equity market participation by about three percentage points. This effect is larger for lower-income employees, hence it reduces the well-documented gap in equity market participation between lower-income and higher-income individuals. We also find that retirement date funds strengthen the negative correlation between age and risk-taking behavior. It is important to note that the stronger negative correlation between age and risk taking is observed not only for investors in retirement date funds, but also for the entire population of participants in plans offering retirement date funds. Understanding how the architecture of one-stop portfolio solutions affects investor behavior is essential in light of PPA and the related guidelines by the Department of Labor blessing a spectrum of one-stop portfolio solutions.
The rest of the paper is organized as follows. In sections two and three, we discuss savings behavior and portfolio choices, respectively. We document that design matters and that seemingly minor design elements could end up being important. We provide concluding remarks in section four.
2. Choice architecture and escalator programs
2.1. Background information The worldwide trend toward defined contribution retirement plans has shifted the responsibility for retirement planning from the employer to employees. In most defined contribution plans, employees have to figure out how much to save for retirement and how to invest their funds. Given the difficultly of calculating the “optimal” saving rate as well as selfcontrol problems, it should not come as a surprise that most people are not saving enough to maintain comfortable lifestyle at retirement (Skinner, forthcoming). And as we noted earlier, 68 percent of plan participants agree that their saving rate is “too low” (Choi et al, 2002).
Being interested in helping people reach their stated goal of saving more, we have used the basic psychological principles of hyperbolic discounting, inertia and nominal loss aversion to design a program that helps employees increase their saving rates. The program offers individuals the opportunity to pre-commit to automatic saving increases, which could take place every time someone receives a pay raise, or alternatively, on a set date like every January 1. Of course, participants in the program can always change their mind and either stop the automatic saving increases or quit saving altogether. We have dubbed the program “Save More Tomorrow™” (hereafter, “SMarT”).5 Features of SMarT have been incorporated in PPA, which encourages employers to automatically enroll new and existing employees into their retirement savings plans. The Act prescribes an initial saving rate of at least three percent of pay, an annual increase increment of at least one percent, and a target rate of at least six percent, but no more than 10 percent.