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What You Didn't Learn in School: Applying Behavioral Economics to Your 401(k)

The reality facing today's workforce is that “social security will not, nor was it intended to, constitute the entirety of U.S. workers' retirement income.1”  This underscores the importance of personal financial responsibility and the role the individual plays in planning for their future financial well-being. Workers face a multitude of problems when asked to make all kinds of decisions, both simple and complex regarding saving for their retirement – and that’s where Behavioral Economics come in.

Even though Americans are asked to take charge of their financial well-being, studies show that we don’t always act in our own best interests. Behavioral Economics focuses on how and why people make irrational decisions. Applying it can help people make rational choices to help increase their savings for retirement.

Many individuals, whether they realize it or not, apply the concept of heuristics – a fancy name for “rules of thumb” into their decision making process. They use mental shortcuts such as, “save 10% of your paycheck for retirement,” or take the number 100 and subtract your age to give the percentage of your portfolio that should be invested in stocks.  Heuristics are simplistic, but not rational conclusions and can lead to errors called “cognitive biases.”

Here are four cognitive biases you and your employees should avoid in your 401(k):

  • The Follow the Herd mentality. The average person thinks “I don’t want to be left behind.” People tend to hear what their successful neighbor or brother is doing for retirement savings and then try to mimic it. Don’t risk jumping off the bridge with everyone else.
  • The Over-confident Investor.  People think they are better at picking investments than they really are. Maybe they have had some previous wins, or maybe it was just beginner’s luck, either way they are not the next Jim Cramer. When in doubt – seek investment advice. 
  • The Over-reactor.  For some, the stress and volatility of the stock market can get in the way of decisions.  If they hear on the news that markets are trending down, or there’s mayhem on Wall Street, they quickly sell, sell, SELL! Before doing anything rash call an investment advisor for a second opinion.
  • Short-sightedness. People put more thought into how decisions today will impact tomorrow. When investing think about the long run. Saving for retirement is a marathon not a sprint. 

Behavioral economists tell us to eliminate “rules of thumb” and replace it with solid, well thought out advice that considers age, goals, risk tolerance and prudent decision making.  They also tell us that by offering a plan in the workplace and selectively changing the architecture of a retirement plan – like offering auto-enrollment options, more employees will invest, stay invested longer and increase their contribution rates.

A flexible 401(k) plan like PAi’s CoPilot offers many of the tools that behavioral economists recommend to help participants with a retirement savings, automated investment options, and access to financial advisors. This means you can remain focused on running your business, not managing a retirement plan. It’s about you and your workers owning their own retirement readiness. Contact us online or give us a call to get your plan started: 800.236.7400.

Watch for Applying Behavioral Economics Part Two:  The Five A’s of a 401(k) plan.

1 Knoll, M. (2010). The role of behavioral Economics and Behavioral Decision Making in Americans’ Retirement Savings Decisions.  Social Security Bulletin, Vol. 70, No. 4. Retrieved from: https://www.ssa.gov/policy/docs/ssb/v70n4/v70n4p1.html