Humans believe that if one of something is good, two must be better. And if two is better, then many will make us even happier. That is why there are now 25 kinds of Ritz Crackers. And it doesn’t stop with crackers. Consumers of all kinds of products, from snacks to denim to medical care, are faced with too many options. And they react one of three ways: choose not to choose, grab the first thing they see or agonize over making the exact right choice. All three very human reactions have negative consequences for successful retirement planning. Behavioral economists call this choice overload, and their solution is simple: reduce the number of choices. The good news is that limiting the number of funds in a 401k plan does help employees improve their own retirement outcomes. But in my experience as a plan advisor, giving employees one choice – be in a professionally managed solution, or not – delivers the best results.
Too Many Choices
The 2004 book “The Paradox of Choice” explained why the golden age of consumerism we live in makes us unhappy, anxious and unable to make decisions. Everywhere we go, from the supermarket, to the mall, to shopping for doctors, we are confronted by a bewildering array of choices. The consequences of a poor choice can be minor, such as an unflattering style of jeans. They can also be potentially life-altering, such as choosing the wrong doctor. Either way, the human brain can’t cope with too many options. Humans react in predictable ways to this excess. They embark on an endless search for the perfect choice, they go with the ‘usual’, or they choose not to choose at all. They are more afraid of a wrong choice than any choice at all. Choice overload can have serious consequences for employees investing in their company 401k plan.
Research shows that humans can evaluate a handful of options with composure and confidence. Reducing the number of investment options in a typical 401k plan can ease some of the choice overload. After all, plan sponsors and advisors have been adjusting 401k plans to accommodate the way human beings actually make economic decisions for years. It’s true that the behavioral economics theories of auto-enrollment, auto-escalation and auto-investment were initially controversial. But years of data show that metrics for plan participation and savings rate have increased significantly, thanks to inertia. Employees have so many decisions to make around retirement: when to start saving, how much to save, which investments to choose and when to stop saving. Ninety-five percent of the employees I work with gravitate toward the ‘just do it for me’ option because they don’t want to make any choices at all.
An Opt-Out Option is Best for Employees
A plan that offers employees the best chance of achieving their desired retirement outcome accepts human nature and prevents poor decisions before they can happen. In my experience as a plan advisor, most employees don’t want to make any decisions on their own about something so important yet confusing. They just want to be enrolled in the best choice without any analysis on their part. Using an actuarially-based, fully-managed solution that I help design creates a one-choice option: Take advantage of the solution or not. Then institutional professional management does the rest. Employers who use all three of the ‘automatic’ practices, and who offer a fully managed solution as the plan’s QDIA have the most employees in solid investment positions with the best chance of achieving their retirement goals. In the plans I manage, 90 to 95 percent of participants are automatically enrolled into a fully managed solution and stay there.
Choice overload is a natural reaction to the ‘more is better’ world we live in. Humans can get away with grabbing the first thing off the shelf when shopping for food or clothes. But they can unfortunately sabotage their future if they do the same thing when confronted with their employer’s 401k plan. Plan sponsors use the automatic, opt-out techniques of auto-enrollment, auto-investment and auto-escalation to benefit both employee and employer. The best solution is to have the fully managed option as the default that employees are opted into – then all they have to do is not opt out. Everyone wins when more employees participate in the 401k plan, when the default investment option is a sound choice and savings rates gradually and subtly increase.