How employers can help workers better prepare for retirement
We are often our own worst enemies — and that certainly applies to how we manage our 401(k) accounts.
To have a successful 401(k), participants need to overcome the barriers that often prevent them from taking advantage of the plans. Employers can help.
Listed below are common obstacles — some of which are from a recent white paper by Arnerich Massena, while others are from articles and papers that Shlomo Benartzi from UCLA has co-authored or written. Using my experience from working with 401(k) participants for more than 30 years, I’ve listed after each obstacle a solution that plan sponsors can employ.
Loss aversion (also referred to as risk aversion) may be described as valuing the avoidance of loss over the accrual of gains. In other words, some participants are more afraid of losing money than they are of not having enough money in retirement (as a result of investing too conservatively).
It has been well-documented that we all feel the pain of loss much more than the pleasure of gain. However, participants who allocate their 401(k) account balances too conservatively are destined to fall short of achieving retirement-ready balances.
Solution: To help overcome this obstacle, plan sponsors should make sure their investment fund menu includes target date funds (TDFs). These professionally managed, balanced options offer declining exposure to equities as participants age. They take care of the asset allocation problem for participants who are intimidated by the fund selection process. TDFs make it easy for participants to ensure they are getting an appropriate mix of fixed income and equity exposure.
Endowment effect (what I call “falling in love”)
Participants sometimes fall in love with their investments, treating them like good friends. I have heard participants say, “That fund has always been good to me, Bob.” Unfortunately, right now that fund is not an appropriate investment for you.
It is also hard for us to cut our losses early when we make bad investment decisions. Some of us put a lot of time and analysis into an investment decision and feel that the opportunity “just needs a little more time.” We neglect to reevaluate when unpredictable events occur (e.g., Trump’s election) and become enamored with the investment. As a result, many investors “endow” some of their investments with greater value simply because they own them.
Solution: All participants should be encouraged to have the investment advisor who works with their plan review their investment allocations annually.
Many of us divide up our financial worlds and create constructs that make sense to us but are really not all that logical. We may attach different meanings and rules to retirement savings, personal savings, vacation savings, etc.
For example, I have talked with participants who have decided not to contribute the amount required to receive the maximum company match because they are saving for a vacation. Giving up free money by not receiving the maximum company match is something I see participants do all the time. It is a poor investment strategy.
Solution: Many employers have decided to offer financial wellness education and have been merging it with their 401(k) education. Consider offering both at your company. Also, run a report from your recordkeeper’s website that shows which participants in your plan are not receiving the maximum company match. Send out an email to these individuals making them aware of their shortfall and give the report to your investment advisor and ask him or her to talk to them.
We like to anchor the logic we use in making a decision to facts we believe to be true. If we wonder whether we are making the right decision, we often seek reassurance that our facts and logic are valid, rather than searching for and accepting other data that might challenge our ideas and conclusions. The result is that sometimes we work hard to justify an incorrect conclusion based on consideration of the wrong facts.
In my discussions with plan participants, I have seen anchoring show up in many forms. Participants have said to me since the day I started in this business that they believe Social Security won’t be around when it is time for them to collect. That conclusion is silly and is often based on media stories that talk about Social Security running out of money. The reality is that even as dysfunctional as Congress can be, lawmakers know not to mess with anyone’s Social Security benefit.
Solution: The best way to combat anchoring problems is with a good 401(k) education program. Make your annual 401(k) education sessions mandatory. Consider offering online education that requires employees to complete modules by a specific date.
Survey data indicate that more than 80% of us believe that we are above-average investors. (Studies also show that the majority of us believe we are above-average drivers, spouses and parents!) As a result, we feel we understand the investment process much better than we actually do and don't get help at critical points in our retirement-planning journey.
Solution: I believe that every 401(k) plan participant should have access to a source of investment advice. It could be a robo-advisor, your plan's investment adviser, advice services offered by your recordkeeper or a company like Financial Engines. There are so many options available to participants that there is no reason for any participant to feel they cannot get advice when they need it. Make sure your 401(k) plan offers an investment advice option to your participants.
When your plan offers too many investment options, your participants become paralyzed, unable to make allocation decisions. They become confused and devalue your plan. Most plan participants are looking for easy solutions to their allocation questions. They would prefer not spending a lot of time trying to understand your 401(k) plan.
Solution: Offer an investment menu that recognizes that you have participants who need different investment tracks. The vast majority of your participants (studies estimate up to 85%) just want to “get it done” and spend as little time as possible with their 401(k) plan. Target date funds are perfect for them. Your executives, however, appreciate a core funds menu that offers solid options in a number of asset classes. And, of course, you have a contingent of employees who will only invest in index options. Talk with your investment advisor and make sure you have all bases covered.
1/n rule, also called naive diversification
I have talked with many participants who employ this way of diversifying their 401(k) accounts. If there are 10 investment options in their plan, they will allocate 1/10 of their contributions to each. This sort of diversification does not take into account a participant's ability to bear risk, age, life expectancy or goals in retirement. Rarely is this an appropriate investment strategy for participants.
Solution: Participants should be encouraged to have an investment professional review their 401(k) allocations and contribution elections at least once each year. That professional can be the investment advisor who works with your plan. Or participants can use the investment advisory services offered by most recordkeepers. Both sets of services can generally be obtained at no charge.
This is the classic buy-high, sell-low behavior that most plan participants follow. In fact, most investors are guilty of practicing this approach. We tend to be drawn to purchasing investments that have soared in value recently, feeling that we might be missing a once in a lifetime opportunity. On the other hand, when equities decline, many of us feel we need to get out of them before they go any lower and we lose everything. We get greedy, then we get scared.
Solution: Your annual 401(k) education/financial wellness education sessions need to hit this obstacle hard. Dalbar calculates that for 2016 the average equity investor earned a little more than 7% while the S&P returned nearly 12%. That difference is attributable to participants buying high and selling low. Getting more participants to invest in target date funds also addresses this issue, since these participants should “set it and forget it.”
Your plan participants are busy. Therefore, it is easier for them to do nothing when faced with a decision related to their 401(k) plan. Inertia affects plan participants when they fail to enroll in your plan, when they don’t take the time to allocate their account balances and contribution elections correctly, and when they don’t increase their contribution percentages to capture your full match.
Solution: Add automatic enrollment and auto contribution escalation features to your 401(k) plan. The data is there showing that auto features work. Recordkeepers Vanguard and The Newport Group report that approximately one-third of the 401(k) plans they administer have auto features. Experts believe that within three to five years, the majority of 401(k) plans will adopt these plan design elements.
Make sure you offer target date funds as well. Model portfolios and risk-based portfolios aren’t a good solution because both require participants to change funds as they age or their ability to bear risk changes. If participants don't adjust their elections as they age or their ability to bear risk changes, they end up invested in funds that are much more risky than they thought. Unfortunately, participants learn that they are invested inappropriately only after suffering large losses when markets fall.
Target date funds do not require any employee interaction as participants age since the investment manager reduces the portfolio's risk level as time goes by. I also advise avoiding custom target date funds, for the many reasons outlined in this blog post.
Myopia is the hardest obstacle to overcome. Participants have a tendency to focus on immediate, short-term goals rather than their future. Many participants view the process of saving as difficult and not worthwhile. They may feel that they will be too old to ever enjoy their savings, or they may believe they will pass away before they are able to retire. Regardless of the reason, participants are not eager to fund a future they have a difficult time envisioning.
Solution: Nearly every recordkeeper produces quarterly statements that highlight participants’ “gaps” — the difference between what they will need to retire and what they are on track to save. Be sure you are electing to have this gap analysis displayed on your quarterly statements. If you aren’t working with a recordkeeper that provides this analysis, think about changing to one that does.
Some of your plan participants enjoy trading their 401(k) accounts. They believe they can market-time their buys and sells to take advantage of market fluctuations. Unfortunately, these participants normally trade their 401(k) accounts down to nothing.
Solution: Require these individuals to meet with the investment advisor who works with your plan. You can identify who they are by looking at the website reports that your recordkeeper produces. They will be the individuals who are not close to retirement who check their balances every day and make frequent trades.
We tend to take comfort in doing what everyone else is doing, especially during emotionally charged times. We rationalize that everyone can’t be wrong and if things turn out badly, oh well, we will have plenty of company to be miserable with. As a result, we sell out of equities when markets fall and over-allocate our account balances to equities when the stock market soars.
Solution: Plan participants should stick to their savings and investment plans and manage their emotions effectively regardless of whether the markets rise or fall. To help them do that, make sure that your investment adviser’s contact information is widely distributed and available. Encourage participants in your 401(k) education sessions to call your adviser before making any significant changes to their savings and investment plans.
The next time you are putting together ideas for a 401(k) education session, make sure you address these behavioral finance concepts. Plan sponsors who help participants over these obstacles have a much better chance of seeing their participants achieve retirement readiness.
Robert C. Lawton, AIF, CRPS is the founder and president of Lawton Retirement Plan Consultants, LLC.