How using age-based defaults can nudge 99% of employees to select the optimal retirement plan

Default: a pre-selected option that is applied if a person does not actively make a choice.

Risk aversion: the tendency to prefer smaller, low-risk gains over larger, high-risk gains. 

Defined benefit plan: a retirement plan where the amount an employee receives during retirement is determined by the employee’s earnings and tenure. The employer bears the investment risk and administration costs, and the employee can depend on receiving a predetermined amount of retirement income. 

Defined contribution plan: a retirement plan in which the employee and/or the employer contribute to the employee’s retirement. The employee decides how to invest the contributions, thus taking on the risks and rewards of the investment. The total retirement savings depend on the employee's contributions, the employer's contributions, how long the funds have been invested, and how well the investments perform.

Personal characteristics can lead to different retirement incomes

In recent years, legislative changes and rising administrative costs of offering DB plans have resulted in employers shifting towards DC plans. As the DB and DC plans differ in their accrual patterns and risk levels, they may only benefit individuals with specific personal characteristics. For example, less risk-averse young workers would benefit more from a DC plan, as they can accrue more wealth through risky investments with higher returns. Unfortunately, the shift towards DC plans leaves some older employees with non-optimal plans, as the decision about what plan to choose cannot be revoked, leaving some employees with significantly less retirement income. Thus, default options should be personalized and implemented carefully. 

Data from a firm switching retirement plans

The intervention used data from a non-profit firm that offered 925 existing employees a one-time, irrevocable choice to switch from a DB plan to a DC plan. If employees did not make a decision, they defaulted into a plan that was optimal for their age group: employees 45 years or below defaulted into the DC plan, individuals 45 and over defaulted  into the DB plan. Employees under 45 were considered the treatment group, as they were defaulted into the DC plan. On the other hand, employees over 45 were considered the control group. The researchers compared the number of employees who enrolled into the DC plan when it was the default option and when it had to be explicitly chosen.

Solving for the optimal age cutoff 

Since the two contribution plans entail different levels of risk, the intervention also tested whether employees’ risk aversion preferences effected which plan was more optimal for them. Accounting for risk aversion, they reestimated the potential gains of an optimal, age-based default would be relative to a uniform default policy. 

MINDSPACE Framework

The MINDSPACE Framework outlines nine forces that can shape human behavior: Messenger, Incentives, Norms, Defaults, Salience, Priming, Affect, Commitments and Ego. The framework recommends that these forces be considered when creating policies in order ensure optimal results. This intervention utilized the behavioral effects associated with defaults in order to improve employee’s’ long- term welfare by setting a default policy that would result in the largest retirement wealth.

Effects of the default on plan enrollment

The default option had a strong effect on the choices made by employees, as 70% of employees who made an active choice selected the default. Young employees (under the age of 45) were 60% more likely to choose the DC plan than older employees (over 45). Conditioning the default for pension plans based on age was found to significantly improve outcomes compared to a uniform default policy, as an age-based default nudged over 99% of employees towards the plan that was most optimal for them. 

Risk-aversion and benefits from default policies

The overall level of risk aversion was found to affect the optimal age cut-off. For younger employees who are not very risk-averse, retirement income is higher in the DC plan. For employees of all ages who are highly risk-averse, the DB plan is superior. They also found that employees who are highly risk-averse are more likely to opt for the DB plan. Overall they found that, for varying levels of risk aversion, age-based defaults significantly increased aggregate wealth relative to the standard method of defaulting all employees to remain in the DB plan.

• It highlights the importance of appropriately setting defaults. 
• The study provides novel insights by quantifying the effect of a default on plan choice. Specifically, it provides novel insights about how defaults effect the choice between DB and DC plans. 
• The intervention does not explain how levels of risk aversion could be measured and accounted for when setting defaults.

How automatic saving plans save users twice as much over five years

Figuring out the best way to save for retirement can be challenging. This is precisely why programs like the Save More Tomorrow (SMarT) program were created. Each year, SMarT automatically increases employees’ contribution rate, until a maximum rate has been reached. As the saving process doesn’t require much effort, it could ultimately lead to higher savings over time. This article summarizes a study which describes the best way to implement the SMarT program.

Shlomo Benartzi: How behavioral nudges today can lead you to Save More Tomorrow

Shlomo Benartzi is the behavioral economist who created the SMarT program. While it is his most famous work, the SMart program only makes up a small portion of Benartzi’s research catalog, which aims to combine psychology and economics to help people save for retirement. This article explores the behavioral science behind the SMarT program and highlights some of Benartzi’s other notable work.