The Limits of Behavioral Finance?

  It’s long been noted that inertia is a powerful force regarding behavioral finance and automatic enrollment — but it may have limits, according to a new study.

Coverage of the report — titled “Smaller than We Thought?  The Effect of Automatic Savings Policies” — focused on how job change undermines retirement savings — both because of vesting, as well as the effectiveness of automatic enrollment, and more specifically auto-escalation, since those mechanisms tend to reset with the change in employers (and payroll).   

Don’t get me wrong. The report states quite clearly that these automatic mechanisms provide a positive result — the authors comment only that it’s perhaps not quite as positive as most think.  Their solution — give people less access to these monies before retirement, and require savings, rather than permitting an opt-out. 

From a pure mathematical stance, there’s little argument there — making people save and prohibiting pre-retirement access to those funds certainly benefits retirement savings, though it also exacts a financial toll in the here and now.

There’s little to be done about job change — which, as I’ve noted before, isn’t really all that different today than it was several decades back. And it should come as no surprise that folks that have been accustomed to automatically being defaulted[i] into saving at employer #1 will readily come to rely on that convenience at employer No. 2, if the option is available, and even if it resets their rate of savings. 

Indeed, we’ve long embraced a working assumption that automatic enrollment takes participation rates of 65%-70% and turns them into 90%.  Said another way, only about 1 in 10 take the time/energy to opt-out of automatic enrollment. 

Opt-Out Observations

That said, what caught my eye here was what turns out to be an extraordinarily high rate of opt-out when it comes to automatic escalation.  Among the plans/participants studied[ii], more than half - 57% - opted OUT of automatic escalation the very first time it came up.  And it gets worse as time progresses; while on average, the acceptance rate of the auto escalation default is 43% on the first escalation date[iii], it slips to 36% on the second date, and 29% on the third date. 

Admittedly that’s higher than previous research suggests — in fact, the researchers acknowledge that in the Vanguard “universe”, the acceptance rate of an auto-escalation default is 63%, 63%, and 60% after one, two and three years of tenure — though even that was significantly below the 85% found by in a 2013 study by Benartzi, Peleg, and Thaler. 

Those differences can be attributed to different employers, different employee populations, even different periods of time during which the assessments are made.  Just as significantly, we don’t know anything about their financial situations, the rate of deferral they were defaulted in at, or why they opted out. 

That said, the opt-out rates struck me as higher than most might be led to expect — suggesting that while inertia can be a powerful force, it’s not without its limits.

• Nevin E. Adams, JD

 

[i] The 67^th Annual Survey of Profit-Sharing and 401(k) Plans by the Plan Sponsor Council of America found that 64% of surveyed plans use an automatic enrollment feature (74.3% among larger plans).  That same survey found that more than three-quarters of the plans that use automatic enrollment also employ contribution acceleration.

[ii] The study focuses on nine firms that, sometime between 2005 and 2011, introduced either (1) automatic enrollment on its own, (2) default auto-escalation in a 401(k) plan where automatic enrollment was already present, or (3) automatic enrollment and default auto escalation simultaneously. The automatic policies applied only to employees hired from a certain date onward, so they identified their effect by comparing 62,430 employees hired in the year after the policy introductions to 55,937 employees hired in the year before the policy introductions.

[iii] Opt-out rates that, as it turns out, aren’t very different from that reported from most of the state-run IRAs.

Withdrawal Symptoms?

 There’s nothing like a global pandemic to fuel interest in, if not the need for, emergency savings. Indeed, there are a half dozen provisions[i] in the new SECURE 2.0 designed to make it easier for workers to tap into their retirement savings—two aimed specifically at emergency savings.

Though the financial impact of the pandemic (not to mention a series of natural disasters) has arguably been uneven, a report from Vanguard[ii] highlighted the longer-term impacts of the economic slowdown and inflation’s growing bite of the household budget. It's also widely acknowledged that concerns about the inability to fund an unexpected financial emergency is a source of stress for workers, undermining financial wellness.   

All that said, well before COVID-19, there have been concerns about Americans’ lack of emergency savings[iii] and, perhaps more broadly, that they were using their retirement savings accounts as that resource. Behavioral finance-types have counseled that a mental, if not physical, segregation of money by purpose is helpful, and at least one of the new SECURE 2.0 provisions seems designed to make that structure a reality by creating an emergency savings “sidecar” alongside regular retirement savings accounts. 

The first of these is found in Section 115 and, beginning in 2024 it says a participant may generally make a withdrawal of up to $1,000 per year from their retirement account for certain emergencies. The withdrawal may be taxable (unless drawn from Roth) and MAY be repaid within three years, but it will not be subject to the 10% penalty for early withdrawals. Only one withdrawal is permitted per the three-year repayment period—if the first withdrawal has not been repaid.

The other emergency savings provision (Section 127)—and the one that seems to be garnering most of the media attention is the (confusingly labeled) “Pension Linked Emergency Savings Accounts.” Beginning in 2024, it will ALLOW (not require) employers to create an Emergency Savings Account (ESA) as part of a defined contribution plan (401(k) or 403(b)). Only non-highly compensated employees may contribute to the account, though employers MAY auto-enroll such individuals in an EAS up to 3% of their compensation, and the EAS value cannot exceed $2,500[iv] (indexed for inflation). All employee contributions to this emergency savings account MUST be made on an after-tax basis—and each month participants may take withdrawals from the account (just to further complicate administration, the first four withdrawals for a year cannot be subject to distribution fees). 

Oh—and speaking of complications, those employee contributions must be treated as elective deferrals for purposes of any matching contributions. The matching contributions are treated by a plan no differently than matching contributions made on account of elective deferrals.   

Now this provision likely makes the behavioral science-types happy—it provides a separate mental (and notational) accounting—and one that doesn’t force the individual to choose between saving for retirement or saving for that “rainy day” emergency, at least in terms of foregoing a company match. 

But, aside from the obvious administrative complexities of this option (certainly for the plan sponsor/recordkeeper), it’s by no means clear that this kind of set up won’t create a kind of “Christmas club” account, with individuals withdrawing these contributions for just about any reason every year (just) long enough to get the match—and then the next year they could do it all over again. And again. The Treasury is authorized to issue regulations to prevent abuse, but there’s no telling if or when (or  what) those rules would be.  

It might be good mental “accounting”—but I’m not sure that it will be good for retirement. 

- Nevin E. Adams, JD 

---

[i] While I’m focusing on only two of those provisions here, the others are Section 314 (allows for up to $10,000 of withdrawals from plans and IRAs in cases of domestic abuse, effective 2024), Section 326 (exempts from the 10% excise tax withdrawals from plans and IRAs in cases of terminal illness, effective now), Section 331 (allows for withdrawals from plans and IRAs of up to $22,000 in federally declared disasters, effective retroactively to Jan. 26, 2021), and Section 334 (allows for up to $2,500 a year of withdrawals from workplace plans to pay for long-term care, effective three years after enactment (so generally not until 2026)).

[ii] In fact, that report, published last October, and amidst growing concerns about the above factors and volatile investment markets, noted that the share of workers taking cash from their employer retirement plans through new loans, non-hardship withdrawals, and hardship withdrawals were on the rise in 2022.  Called out for special note was the rise in hardship withdrawals, which Vanguard said had reached an all-time high—though that was only 0.5% of workers tracked by Vanguard (5 million participants in 1,700 employer-sponsored retirement plans administered by the firm).

[iii] The most widely repeated likely being the Federal Reserve survey asking Americans if/how they’d handle a $400 emergency (approximately 1 in 9 said they couldn’t, and while that’s a minority, the headlines have tended to highlight the impact)—but see https://www.minneapolisfed.org/article/2021/what-a-400-dollar-emergency-expense-tells-us-about-the-economy.

[iv] Though there’s been some question as to whether $2,500 is “enough” (there’s language in the bill calling for a study to see if it needs to be higher).

The Big(ger) Picture

Our industry often seems to treat participants like children who can’t make big decisions—but a recent research paper suggests they might make better choices if we expanded their perspective.

The paper, intriguingly titled “Financial Wellness Meets Behavioral Economics,” highlights a behavioral tendency known as “narrow framing”—basically a tendency to focus on one complex choice, or one element of a complex choice, at a time.  Now, at first blush this seems rational, and perhaps even prudent—but the paper suggests that this kind of linear thinking means that people are inclined to overlook real-life disruptions like financial emergencies—which are not only uncertain with regard to amount or timing, but even in terms of whether they will occur at all. Little wonder, therefore,  that studies routinely find that workers say they are ill prepared to come up with the funds to cover some kind of short-term emergency outlay of $400.

This particular e paper—authored by none other than Shlomo Benartzi, Professor Emeritus, UCLA Anderson School of Management and Senior Academic Advisor at Voya Financial, which published the paper—explains that “when it comes to household financial planning, the ‘one future’ fallacy often leads people to focus on predictable and recurring expenses, such as rent and the monthly phone bill.” It cites research by Abigail Sussman and Adam Alter that finds that people struggle to budget for any kind of “exceptional expense,” whether it’s a summer vacation or a new television. Since these expenses are not recurring, and most household budgets are narrowly framed around regular monthly charges, people fail to consider them as part of their financial plan. So far, so good.

The paper’s ultimate premise seems to be that if people could see the full range of their financial needs, they could do a better job of allocating funds—that, among other things,  they’d make more rational health care decisions if they were presented a full integrated cost impact of a plan with premiums and deductibles (the author suggests most focus on the deductible). In short, the paper suggests that we (advisors and the retirement industry generally) need to do a better, holistic job of helping individuals see the full range of options and alternatives, work with them to choose the most optimal—and, of course, make it easy for them to act, rather than defer acting on those choices.

Or, said another way (as the paper does), “the ultimate goal is to develop a data-driven financial wellness platform that helps people better allocate their scarce dollars.”

Now I don’t doubt for a minute that people “overlook” budgeting for emergency expenses because they don’t view them as a specific reality (I also figure that many don’t because they feel they have other, better uses for that money, including perhaps “eating”). In that sense, creating a “slot” for emergencies alongside the budgetary savings/spending slot for “retirement,” rent, food, and transportation is logical in both acknowledging the potential need alongside those that tend to be seen as “must-pays.”   

I’m not altogether sure, however, that an unspecified emergency (and approximated cost) will warrant the appropriate attention—and more than a little concerned that if it did, it would do so at the expense of items that feel more “discretionary” (like retirement).[i] And while this may be old-world thinking, I’ve seen (and heard of) far too many situations where giving people not only lots of decisions to make, but forcing them to come up with “answers” for all of them might well produce a misallocation of resources—or in a worst-case scenario, forestall a decision of any kind whatsoever.   

So from an academic perspective, “narrow framing” might well be a “bad behavior” that precludes “rational” decision-making, though I tend to see it more as a coping strategy for folks struggling to make complex financial decisions spread across limited means. But then I’d also argue that sometimes you need to make choices that, while perhaps deemed financially rational, aren’t necessarily the ones you need to make in order to sleep at night.

Thoughts?

- Nevin E. Adams, JD

---

[i] I am, however, convinced that the positioning of health care programs/options/expenses could do with some improvement.

Misbehavioral Finance

It’s hard to believe it’s now been 10 years since the 2008 financial crisis. Let’s face it — no matter how busy or hectic your week has been, I’m betting it’s been a walk in the park compared to those times.

Yes, it was just 10 years ago this week that Lehman Brothers filed for bankruptcy — the same day that Bank of America announced its plans to acquire Merrill Lynch, and a day on which, not surprisingly, the Dow Jones Industrial Average closed down just over 500 points. That, in turn, was just a day before the Fed authorized an $85 billion loan to AIG — and that on the same day that the net asset value of shares in the Reserve Primary Money Fund “broke the buck.” This was made all the more surreal to me because it was going on while I — and several hundred advisers — were in the middle of an adviser conference. Not that the folks on the panels were getting much attention.

The funny thing is, looking back (and armed with the prism of 20/20 hindsight), there were lots of signs of the trouble that eventually cascaded like a set of dominos, resetting not only the structures of the financial services industry, but also disrupting the businesses and lives of thousands (if not tens of thousands) of advisers, not to mention the retirement plans of millions of workers worldwide.

The question that many of us have been asking ourselves (or perhaps been asked by our clients) since is — why didn’t we do something about it — before it happened?

Now, doubtless, some of you did. And those of you who didn’t can hardly be faulted for not fully appreciating the breadth, and severity, of the financial crisis we with which we were “suddenly” confronted. Still, having lived through a number of other “bubbles” during the course of my career, “afterwards” I’m always wondering why so many wait so long — generally too long — to get out of the way.

Greed explains some of it: As human beings, we may later disparage the motives of those who, with leverage and avarice, press markets to unsustainable heights (from which they inevitably fall) — though we are frequently willing to go along for the ride. Some of that can surely be explained by our human proclivity to stay with the pack, even when it seems destined for trouble, and some surely by nothing more than an inability to recognize the portents that precede the coming fall. When it comes to retirement plan participants, mere inertia surely accounts for most, though some are doubtless waylaid by bad, or inattentive, counsel.

There is, of course, a behavioral finance theory called “prospect theory,” which claims that human beings value gains and losses differently; that we are more afraid of loss than optimistic about gain. An extension of that theory, the “disposition effect,” claims to explain our tendency to hold on to losing investments too long: to avoid acknowledging our investing mistakes by actually selling them. It is, of course, an attribute rationalized every time someone says that the losses in our portfolios are “unrealized.” Unfortunately for investors planning for their retirement, unrealized and unreal are not the same thing.

We all know that markets move up and down, of course, and we must do the things we do without the benefit of a crystal-clear view of what lies just over the horizon. We also know that “staying the course” is the inevitable (and generally wise) counsel provided in the midst of the markets’ occasional storms. And, unlike 2008, other than the markets’ dizzying heights, and a fair amount of economic uncertainty regarding trade policies and the like, to this admittedly untrained eye there doesn’t seem to be the same sort of “bubble” that led to the 2008 crisis.

That said, with the markets at all-time highs, and as we stand at the 10-year anniversary of the 2008 tumult, it seems a good time to ask: Are you looking out for trouble — as well as opportunity?

- Nevin E. Adams, JD

Behavioral Finance – the Next Frontier

All too often the innovations honored with a Nobel Prize fly under the radar of “regular” Americans. But that wasn’t the case last week when the work of University of Chicago’s Richard Thaler was acknowledged.

Thaler was, of course, recognized by the Royal Swedish Academy of Sciences, who said that his focus on limited rationality, social preferences and lack of self-control has “built a bridge between the economic and psychological analyses of individual decision-making.” More plainly, to my reading, Thaler (finally) managed to prove to economists that human beings don’t (always) act rationally and/or in their own self-interest.

Now, anybody who has ever actually interacted with human beings knows this. Indeed, in some ways the most amazing thing about Thaler’s insights of this reality is that it is seen as being innovative by economists.¹ I still remember reading the report that Thaler and Schlomo Benartzi authored way back in 2004, “Save for Tomorrow: Using Behavioral Economics to Increase Employee Saving.” That’s where (among other things) I first learned about the concept of what we today call contribution acceleration, based on the premise that people are more likely to act (and act more aggressively) on their good (but painful) intentions in the future than if they had to do so today.

There’s no denying that Thaler’s work has had a big impact on retirement savings (about $29.6 billion worth, according to one estimate). And if Thaler and Benartzi did not exactly create the notion of automatic enrollment, they at least freed it from the “dark” connotations of “negative election,” as it was called at the time.

Today we may wonder at – but no longer question – the notions that human beings rely on heuristics (mental shortcuts) when making complex decisions, that they fear loss more than they value gain, that they tend to diversify across the number of options provided, without regard to what lies within those choices, and that they tend to treat “old” money differently than “new” money. For this, Prof. Thaler and his collaborators over the years deserve our thanks.

That said, it may be worth remembering that while we tend to assume that plan fiduciaries are rational in all their decisions, they too are human beings making complex decisions. Consider that:

• Many remain hesitant to “impose” automatic enrollment for concerns about negative response from workers, though multiple surveys suggest workers would appreciate the move.
• Many continue to auto-enroll new hires, but not current workers.
• Many extend auto-enrollment to eligible workers – once.
• Many choose to implement auto-enrollment – and then wait 3 to 4 years to start contribution acceleration.
• Long-standing (and probably ill-considered) fund choices are routinely mapped during a recordkeeping conversion. Perhaps through multiple conversions.
• Plan committees often seem more worried about the negative reaction to removing a poor-performing fund than the possibility of being sued later on for keeping it on the menu.

That doesn’t mean that there aren’t any number of positive, rational reasons for those decisions (see “Why the ‘Ideal’ Plan Isn’t”). Indeed, most of us are rightly hesitant to superimpose our imperfect judgments on “other people’s” money – even on those on whose behalf fiduciaries are admonished to act.

But as we commemorate – and celebrate – those behavioral finance “nudges” that have done so much to buoy individual retirement security, perhaps some of those fiduciary decisions are worth (re) considering as well.

- Nevin E. Adams, JD

5 Ways Industry Surveys Can Be Misleading

As human beings, we’re drawn to perspectives, including surveys and studies that validate our sense of the world. This “confirmation bias,” as it’s called, is the tendency to search for, interpret, favor, and recall information in a way that confirms our preexisting beliefs or hypotheses. It also tends to make us discount findings that run afoul of our existing beliefs.

In its simplest terms then, when you see a headline that confirms your sense of the world, you’ll be naturally inclined to embrace and remember it as a validation of what you already perceive reality to be. Even if the grounds supporting that premise are shaky, sketchy, or (shudder) downright scurrilous.

Here are some things to look for – likely in the fine print – as you evaluate those findings.

There can be a difference between what people say they will (or might) do and what they actually will.

No matter how well targeted they are, surveys (and studies that incorporate the outcome of surveys) must rely on what individuals tell us they will do in specific circumstances, particularly in circumstances where the decision is hypothetical. When you’re dealing with something that hasn’t actually occurred, there’s not much help for that, but there’s plenty of evidence to suggest that, once given an opportunity to act on the actual choice(s), people act differently than their response to a survey might suggest.

For example, people tend to be less prone to action in reality than they indicate they will be – inertia being one of the most powerful forces in human nature, apparently. Also, sometimes survey respondents indicate a preference for what they think is the “right” answer, or what they think the individual conducting the survey expects, rather than what they actually think. That, of course, is why the positioning and framing of the question can be so important (as a side note, whenever possible, it helps to see the actual questions asked, and the responses available).

The bottom line is that when what people tell you they will do, or even what kind of product they would like to buy, if you later find that they don’t, just remember that there may be more powerful forces at work.

There can be a difference between what people think they have and reality.

Since, particularly with retirement plans, there are so few good sources of data at the participant level, much of what gets picked up in academic research is based on information that is “self-reported,” which is to say, it’s what people tell the people taking the survey. The most prevalent is, perhaps, the Survey of Consumer Finance (SCF), conducted by the Federal Reserve every three years.

The source is certainly credible, but the basis is phone interviews with individuals about a variety of aspects of their financial status, including a few questions on their retirement savings, expectations about pensions, etc. In that sense, it tells you what the individuals surveyed have (or perhaps wish they had), but not necessarily what they actually have.

Perhaps more significantly, the SCF surveys different people every three years, so be wary of the trendlines that are drawn from its findings – such as increases or decreases in retirement savings. Those who do are comparing apples and oranges – more precisely the savings of one group of individuals to a completely different group of people… three years later.

The survey sample size and composition matter.

Especially when people position their findings as representative of a particular group, you want to make sure that that group is, in fact, adequately represented. Perhaps needless to say, the smaller the sampling size – or the larger the statistical error – the less reliable the results.

Case in point: Several months ago, I stumbled across a survey that purported to capture a big shift in advisors’ response to the Labor Department’s fiduciary regulation. Except that between the two points in time when they assessed the shift in sentiment, they wound up talking to two completely different types of advisors. So, while the surveying firm – and the instrument – were ostensibly the same, the conclusions drawn as a shift in sentiment could have been nothing more than a difference in perspective between two completely different groups of people.

Consider the source.

Human beings have certain biases – and so do the organizations that conduct and pay to surveys and studies conducted. Not that sponsored research can’t provide valuable insights. But approach with caution the conclusions drawn by those that tell you that everybody wants to buy the type of product offered by the firm(s) that have underwritten the survey.

When you ask may matter as much as what you ask.

Objective surveys can be complicated instruments to create, and identifying and garnering responses from the “right” audiences can be an even more challenging undertaking. That said, people’s perspectives on certain issues are often influenced by events around them – and a question asked in January can generate an entirely different response even a month later, much less a year after the fact.

For example, a 2015 survey of plan sponsor sentiment on a topic like 401(k) fee litigation is unlikely to produce identical results to one conducted in the past 30 days, nor would an advisor survey about the fiduciary regulation prior to the publication of the final rule as to its impact. Down in those footnotes about sample size/composition, you’ll likely find an indication as to when the survey was conducted. There’s nothing wrong with recycling survey results, properly disclosed. But things do change, and you need to be careful about any conclusions drawn from old data.

Not to mention the conclusions you might be otherwise inclined to draw from conclusions about old data.

- Nevin E. Adams, JD

See also:

• EBRI Report Calls Out Pew, CRR on Retirement Conclusions
• 4 Things That Make Me Go ‘Huh?’
• Could Fees Cost Millennials $590,000 in Retirement Savings?
• A Preference on ‘Preferences’?
• 3 (More) Pervasive Retirement Myths — an Academic Perspective

The "Hassle" Factor

Much is made these days of the application of behavioral finance and the implications for plan design, as well as the role of choice architecture in helping workers make “better” (if not more informed) benefit decisions.  Valuable as these insights have been, I think much of human behavior (or lack thereof) in these matters can be more simply explained.

What’s at work is a concept a friend of mine described to me more than 20 years ago – something he called “the hassle factor.”  It was a philosophy he routinely applied in many aspects of his personal and professional life.  Simply stated, presented with a choice between doing something that is hard, time-consuming, complicated, or even inconvenient, and doing something else, my friend – and, in fairness, human beings generally seem to be – inclined to opt for the latter.

Of course, the “hassle factor” CAN be trumped by exterior needs or forces, as anyone who has endured the long lines at the DMV or sat through the background music on an interminably long customer service line can attest.  That said, things like an unduly complicated 401(k) enrollment form/process can certainly serve as a barrier to plan entry, and there’s every reason to expect that the same might apply when it comes time to exit the plan.

Job change is a point in time at which a lot of important decisions are made—some voluntary and some forced upon us—and the disposition of one’s retirement savings account certainly looms large among them.  A recent EBRI Notes article examined what workers age 50 and above did with their defined contribution account balances at the point of job change, looking at data from the Health and Retirement Study (HRS), a study of a nationally representative sample of U.S. households with individuals age 50 and over.  EBRI analyzed responses from 2008 and 2010 for this study.

In terms of demographic characteristics, no significant difference was found between men and women in terms of their DC account balances and what they chose to do with them at job change.  And while married or partnered individuals were less likely to withdraw their assets and more likely to roll them over into an IRA than singles, the differences were small.

The EBRI analysis did find that a decision to take a withdrawal in cash declined with higher account balances, higher incomes, existing ownership of an IRA, and higher financial wealth. Not surprisingly, the decision to cash out rose with individual debt levels.

However, among those who left their employer but remained in the workforce, the most common outcome was to leave their retirement account balance with their prior employer’s plan.  The EBRI report notes that, unlike the outcomes detailed above, there was no clear trend between the financial variables, and the decision to leave those DC balances in the prior employer plans.

As for what might explain that outcome, the report noted that it might simply be a decision to postpone taking the money until it was needed, or that there “may be behavioral factors, such as inertia, driving what might be seen as a ‘non-decision.’”

Or, as my friend might have been inclined to say, a non-decision based on the “hassle factor.”

• Nevin E. Adams, JD

“Take it or Leave it? The Disposition of DC Accounts: Who Rolls Over into an IRA? Who Leaves Money in the Plan and Who Withdraws Cash?” is published in the EBRI May Notes, available here.