Behavioral Finance: How 401(k) Plan Design Impacts Participation

Dec 04, 2014
Behavioral Finance, Research, Personal Finance, Investing

Reading through lengthy Vanguard report on 401(k) plans (if you are a data geek you will love the detailed charts).  Vanguard is one of the largest 401(k) plan providers and annually analyzes their 3.5 million plan participants to call out key trends.

What caught my eye was the section that showed how 401(k) plan design impacted employee behavior.   My takeaway:  More companies should adopt automatic enrollment designs to increase participation with one caveat: companies with automatic enrollment designs often set low default levels which employees don’t change (stat: “Fifty-one percent of these plans automatically enroll participants at a 3% contribution rate.  Seven in 10 plans (69%) automatically increase the contribution rate annually).”

From the report:

Automatic enrollment designs

In a typical 401(k) or 403(b) plan, employees must make an active choice to join the plan. The
enrollment decision is framed as a positive election:  “Decide if you’d like to join the plan.” Why do employees fail to take advantage of their employers’ plans? Research in the field of behavioral finance provides a number of explanations:

Lack of planning skills. Some employees are not active, motivated decision-makers when it comes to retirement planning. They have weak planning skills and find it difficult to defer gratification.

Default decisions. Faced with a complex choice and unsure what to do, many individuals often take the default or “no decision” choice. In the case of a voluntary savings plan, which requires that a participant take action in order to sign up, the “no decision” choice is a decision not to contribute to the plan.

Inertia and procrastination. Many individuals deal with a difficult choice by deferring it to another day. Eligible nonparticipants, unsure of what to do, decide to postpone their decision. While many employees know they are not saving enough and express an interest in saving more, they simply never get around to joining the plan or, if they do join, to increasing their contribution rates over time.

Automatic enrollment or autopilot plan designs reframe the savings decision. With an autopilot
design, individuals are automatically enrolled into the plan, their deferral rates are automatically
increased each year, and their contributions are automatically invested in a balanced investment strategy. Under an autopilot plan, the decision to save is framed negatively: “Quit the plan if you like.” In such a design, “doing nothing” leads to participation in the plan and investment of assets in a long-term retirement portfolio.


Why is this information important for your students?

  • Encouraging your students to sign up for a 401(k) plan at their first job is necessary but not sufficient advice.  They need to understand what they are signing up for and to proactively manage their account by setting their contribution rate (which is usually quite low) at a level that works for them and at a minimum to a level that maximizes their company match (that is “free money”!).

About the Author

Tim Ranzetta

Tim's saving habits started at seven when a neighbor with a broken hip gave him a dog walking job. Her recovery, which took almost a year, resulted in Tim getting to know the bank tellers quite well (and accumulating a savings account balance of over $300!). His recent entrepreneurial adventures have included driving a shredding truck, analyzing executive compensation packages for Fortune 500 companies and helping families make better college financing decisions. After volunteering in 2010 to create and teach a personal finance program at Eastside College Prep in East Palo Alto, Tim saw firsthand the impact of an engaging and activity-based curriculum, which inspired him to start a new non-profit, Next Gen Personal Finance.

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