Procrastination and the status quo bias can delay or prevent people from signing up for retirement plans, even when tax advantageous and with added incentives such as company matching contributions. In an extreme example, a study found that in a sample of 25 defined benefit plans in the United Kingdom that were fully paid for by the employer, only about half of the eligible employees signed up. Further, the greater the number of funds offered by the plan, the lower the participation rate, presumably thanks to the added complexity of the decision problem.
Anchoring can cause retirement plan participants to stick to the generally low default contribution rates, perhaps believing them to be an implicit plan recommendation. Other naïve rules of thumb, such as contributing just enough to maximize company matching contributions or simply picking the maximum allowed rate, are also blind to an individual’s true funding needs. As for asset allocation, people sometimes use diversification strategies such as dividing their savings equally across funds, or some other arithmetically simple rule. If plan participants are offered a large enough number of funds to cause a choice overload, they may simply give up and just go with the safest fund in the menu.
Overconfidence and other types of biases that plague individual investors’ portfolios in general, which can lead to a heavy concentration in the employer’s stock and under-diversification, and poor stock market timing, have also been discovered in retirement portfolios.
The obvious risk of these poor saving and investing behaviors is insufficient income at retirement. Research shows that the average working US household has virtually no retirement savings, and even when considering not just retirement assets, but total net worth, around 65% of households fall short of conservative retirement savings targets for their age and income.
How do you mitigate the impact of biases?
While financial education by itself hasn’t been found to be very successful in tackling behavioral biases, there are three steps investors can take to improve their retirement savings behavior:
- Tackle procrastination. Address the inherent complexity in saving for retirement by breaking tasks into less intimidating components, getting financial advice in the process if needed. Set explicit rewards for completing individual tasks.
- Frame the problem differently. Focus in as much detail as possible on the happier retirement that can result from saving and investing today, rather than the immediate monetary loss from saving. The more vivid the picture of a happy retirement, the more powerful this method is likely to be in changing behaviors.
- Use software tools. Creating realistic depictions of aged versions of yourself can help bridge the gap between how much you care about yourself today vs. in the future.
This is where, as an investor, knowing yourself is especially valuable. You can read more about that here.
Nelli Oster, PhD, is a Director and Investment Strategist at BlackRock. You can read more of her posts here.