Adopt Behavioral Best Practices for Your 401k Account
Smart investment management and discipline are often cited as keys to a great 401k savings strategy. But your employer’s 401k plan may be based on a set of industry best practices that are rooted in behavioral-finance principles, in which investment smarts and disciple aren’t requirements. Once you understand these principles, you can use these behavioral-finance principles to help you manage your 401k better.
Behavioral finance is the study of why we make the financial decisions we do—often, that translates to why we make poor decisions. For example, when a big reward is at hand, our excitement causes us to lose perspective on the odds of landing that reward. That’s one reason Americans spend more than $60 billion a year on lottery tickets. It also explains why so many people buy investments, such as stocks and mutual funds, at high prices and sell at low prices, and why the average investor falls a few percentage points short of earning the market rate of return.
Smart practitioners of behavioral finance have figured out ways to use the foibles that trip us up to our advantage. Consider the most powerful behavioral challenge: inertia. We tend to follow the status quo and not take action. In a typical 401k plan that means about one-third of people don’t even join the plan. Inertia keeps them from signing up, though most of these people think that they should be saving.
Traditional 401k plans are opt-in, meaning employees have to make the choice to enroll. But more and more plans are using automatic enrollment, which puts employees in the plan automatically but allows them to easily opt-out. Automatic enrollment has boosted employee participation in 401k plans from less than 70 percent, on average, to more than 90 percent.
But even with automatic enrollment, inertia works against us. That’s because most 401k plans that automatically enroll workers do so with contributions equaling just 3 percent of pay. If you don’t take the initiative to raise your contributions past 3 percent, you won’t be on track to save a comfortable nest egg for retirement.
To give your 401k a boost, follow these behavioral-finance tips:
Start saving at 6 percent of your pay or more. Think of that 3 percent for what it is—an arbitrary guideline once put forth by the IRS that has been adopted as gospel by many companies. In fact, behavioral-finance research shows that workers are indifferent to being enrolled at 3 percent of pay versus 6 percent of pay. So start saving at 6 percent, or if you’re already saving at 3 percent, increase your savings to 6 percent or more. If your company automatically enrolls its employees at 6 percent of pay, it’s following a behavioral-finance best practice.
Now you’re off to a good start, but it’s only a start. You need to raise your savings to 10 percent or more to build a nest egg big enough to help maintain your standard of living in retirement. The behavioral-finance answer to this is automatic escalation, which means that every year your savings are automatically bumped up a bit until they reach a certain amount (often 10 percent). Those who are automatically enrolled in such a plan tend to stay in it, thanks to inertia.
Add to your savings by 2 percent of your pay per year. If you’re uncomfortable with immediately raising your savings rate to 10 percent or more, increase your savings by 2 percent per year. This is another best practice. Research shows that employees are indifferent to automatic escalation of 2 percent a year versus 1 percent a year. So, if your plan offers auto escalation, sign up and contribute an additional 2 percent per year to your 401(k). You won’t miss that extra 1 percent, but it will make a big difference in your savings.
If you don’t have auto escalation, make a New Year’s resolution to bump up your savings by 2 percent each year. Why New Year’s? Again, it’s behavioral. We’re used to making resolutions on the first of the year. Case in point: The New Year’s Effect takes hold at gyms everywhere in January and February, as people enroll after months of inertia. Fortunately, inertia is on our side when it comes to automatic 401k contributions. If only inertia could help us go to the gym more often.
Increase savings with pay raises, and agree to save more in the future. If you hesitate to increase your savings because you don’t want a smaller paycheck, that’s only natural. Another of our behavioral challenges is loss aversion, which means we feel the pain of a loss twice as much as we feel a gain of the same size. But if you invest, say, half of your raise in your 401k account, your paycheck will still increase and you won’t feel the pain of loss.
Matching increases in savings to pay raises, when done automatically, is one focus of the Save More Tomorrow (SMT) program. Save More Tomorrow was pioneered by professors Shlomo Benartzi, of UCLA, and Richard Thaler, of the University of Chicago.
Another part of the program has to do with agreeing to savings increases in the future. This really boosts savings rates because of something called present bias. Present bias is our tendency to want to do what’s fun and gratifying for ourselves in the present, while agreeing to do prudent and healthy things for ourselves in the future. So, if you’re having a hard time saving more today, you’ll find agreeing to save more at some point in the future much easier.
Let the professionals help with investing decisions. We have many biases that can cause us to make the wrong choices from the investment menu presented by an employer. We may tend to choose the first thing on the list because of something called the primacy effect. If there are too many investment choices, we may become overloaded with information and lock up, unable to sort through the options. And since investing isn’t easy for most people, they tend to make poor choices—for example, they might put all of their money in a stable value fund, which barely grows the investment at all.
If you’re having a tough time making such decisions, let the professionals do it. Most plans offer professionally managed portfolios, such as target-date funds, which are a good choice for those who are not comfortable picking funds and managing a portfolio.
So, to recap best practices based on behavioral finance:
– Start saving at 6 percent, at least, and don’t stick to the 3 percent default savings offered in many 401kplans.
– Increase your savings by 2 percent of your paycheck per year.
– To make increasing your savings easier, agree to do it at some point in the future (when you get a raise, or in January for a great New Year’s resolution).
– If you’re not into managing your own investments, a professionally managed portfolio, such as a target-date fund, is an easy, effective choice.
Follow these best practices and you’ll be well on your way to becoming a 401kMillionaire.