Don’t Trust Your 401k’s Default Contribution Rate

by | May 21, 2015 | Asset Management, Investor Behavior

For many investors, their workplace retirement account is the largest nest egg they’ll accumulate. Whether your option is a 401k, 403b, or 457, recently the message has become loud and clear: tax-deferred savings are something to take advantage of. If you’re contributing to your retirement account at work, good stuff.  Now onto the next hurdle: how much should you be contributing? Obviously, that answer is going to be different for everybody. The dangerous assumption that many investors make is believing their plan’s default contribution rate is right for them. 

Many individuals assume that their retirement plan’s default rate must be in their best interests. However, that may not always be the case:

“If your plan enrolled you at 3 percent, there is a reason. It’s just not a very good reason. Three percent may be the norm simply because it was used in an example the government gave to employers early on, said Rob Austin, Aon Hewitt’s director of retirement research. The other reason it’s common, he said: Plans mimic their peers.”

Some employer sponsored plans may set their default rate with the best interests of their participants in mind, however several other factors come into this decision as well including legal liability and costs. I also think Austin’s assertion that many plans mimic their peers is probably more true than we’d like to believe. We see this phenomenon in life all the time, it’s called social proof. Social proof:

“…relies on people’s sense of “safety in numbers”. For example, we’re more likely to work late if others in our team are doing the same, put a tip in a jar if it already contains money, or eat in a restaurant if it’s busy. Here, we’re assuming that if lots of other people are doing something, then it must be OK.”

Our brain uses shortcuts, like social proof, to help us make decisions faster and more effectively. Following the crowd might work sometimes, but it’s hardly foolproof.

Another one of our brain’s shortcuts likely leads a lot of employees to leave their contributions at the default level: authority. We are predisposed to adhere to authority. This may cause individuals to stick with the default contribution rate and believe there’s a good reason for it. If their employer set the contribution rate at 3%, that must be sufficient, right? What employers don’t always make clear is that their default contribution rate is far from a recommendation. We’ve seen this referred to as the endorsement effect. In fact, a study done by the National Bureau of Economic Research shows that:

“Automatic enrollment tends to anchor employee contributions rates on the automatic enrollment default contribution rate”

I’d rather see people contributing at their plans default rate than not at all, but to remain anchored to the default rate forever is probably not wise. Some plans have instituted contribution escalators in their plans to help this issue, while others believe we need a mandatory retirement savings program (Australia’s Superannuation program comes to mind). I think the biggest issue is that so many people are enrolled into their company or organization’s retirement plan without any education. Bloomberg Business shared some alarmining data recently:

“Less than 22 percent of large companies surveyed by Towers Watson even provided 401(k) participants with a suggestion about how much to save.”

I understand that making specific recommendations to workers may be a little messy for employers, but some basic education on contribution rates and their effects would be helpful. For so many Americans, the only stake they have in the investing arena is through their workplace retirement plan. Despite this, they’re expected to know how much is right for them to contribute. (I’m not even getting into selecting investments here.) Investing is pretty complex, even if you have experience in finance. To the average person saving money in their workplace retirement plan, that complexity is multiplied tenfold. Tversky and Shafir documented that:

“The tendency to defer decision, search for new alternatives, or choose the default option can be increased when the offered set is enlarged of improved.”

We don’t like to make tough decisions so we either put them off or choose what seems like the simplest or most popular decision at the time. When it comes to retirement savings, the issue with this is that retirement plan default rates are usually not an endorsement from your employer.  So trust your 401k’s default contribution rate at your own risk. We’re all unique individuals, meaning one size (in this case, contribution rate) does not fit all.

Sources:

http://www.bloomberg.com/news/articles/2015-05-04/your-401-k-plan-may-be-selling-you-short

http://www.mindtools.com/pages/article/six-principles-influence.htm

http://kie.vse.cz/wp-content/uploads/Tversky-Shafir-1992.pdf

http://www.nber.org/papers/w12009

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