Left to their own devices, many people wouldn’t save enough (or at all) for retirement, no matter how attractive the 401(k) plan.
Statistically speaking, most Americans in their forties have saved an average of $63,000. But according to Fidelity, this may present a dangerous retirement savings gap if held to the conservative benchmark that a nest egg be three times a person’s annual salary.
Look closely, however, and you might notice participation and savings rates slowly creeping upward.
This may be due to the work of Richard Thaler, an economist and professor at the University of Chicago. He’s also the 2017 Nobel Prize winner for Economic Sciences.
Thaler is a pioneer in a field of study called behavioral economics. His research looks at the ways we, as human beings, are our own worst enemies when it comes to acting rationally and in our personal best interests. This is particularly true when it comes to saving and investing for the future.
For instance, a company may offer an employee the chance to participate in a tax-deferred retirement benefit, such as a 401(k) program. As an extra incentive to sign up and begin building financial security, the company may even offer to match the employee’s plan contributions up to a certain amount.
While you’d think that most employees would be jumping for joy and running to sign up, plan sponsors would likely tell you that this is not the case, and that getting people to participate in retirement savings programs is quite difficult, akin to pulling teeth.
Regardless of the reasons why people wouldn’t participate (Laziness? Lack of awareness or education? Misinformation?), the good news is that people can be influenced to act more rationally through mechanisms that Thaler calls “nudges.”
Opt Out, Not In
An example of a nudge is when an employer automatically enrolls its employees into 401(k) plans from the start, and puts the onus on people to opt out rather than opt in. The results are uncanny, with a much higher number of employees saving for retirement.
This insight kicked off an industry-wide trend toward auto-enrollment. The Plan Sponsor Council of America (PSCA) found that in 2016, 58% of plans were automatically signing up workers, up from just 8.1% in 2000.
Just getting people to participate was a big step forward, but Thaler also looked for ways to influence participants to save more.
Auto-escalation locks in higher contributions
In his paper, “Save More Tomorrow,” Thaler proposed another “nudge” to increase contributions, called auto-escalation.
Participants would start at first by allocating 3% of income to retirement. Then, with every salary raise, their investment contributions would automatically increase.
Auto-escalation has taken hold among larger plan sponsors. Callan’s 2017 Defined Contribution Trends survey found that 63% of large and mega plans offer an auto-escalation feature, up from 46% in 2015.
Thaler’s insight into why people don’t save and how to get them to do better laid the foundation for a more stable, secure retirement system—and all it took was a little nudge.