A Retirement 'Nudge'

by: Ploutos

On the continuum of modern finance, Eugene Fama, the father of efficient markets, and Richard Thaler, the influential behaviorist who believes that understanding the cognitive biases of investors can allow active managers to capitalize, sit at distinct and opposite poles. On occasion, they also lecture at the opposite end of the hall as professors at the University of Chicago. The fact that such disparate investment approaches could both be championed under the same roof was one of my favorite aspects of attending the university.

Recently, I read Richard Thaler's award-winning book, "Nudge", co-authored with Chicago law professor Cass Sunstein. The book's title refers to improving "choice architecture" to influence people to make beneficial decisions where biases occasionally cloud judgment. Thaler and Sunstein offer interesting solutions to help Americans increase their retirement savings, which I believed would be interesting to share with Seeking Alpha readers.

Increasing Savings Rates

Despite a slight tick-up post crisis, the savings rate in the United States remains at generational lows, and roughly half its trailing fifty year average.

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Source: Bureau of Economic Analysis, Bloomberg

With corporate pensions evaporating and the eventuality of cuts to the level of benefits provided through the Social Security system, increasing household savings is more important than ever. The authors make some simple observations that can bridge this gap:

  • Make 401k enrollment automatic. In a 2001 paper by Brigitte Madrian and Dennis Shea, participation rates under the common opt-in approach were twenty percent after the first three months of employment and eventually hit a steady-state of sixty-five percent. When automatic enrollment was adopted ninety percent were enrolled in the first quarter, and a steady-state of ninety-eight percent was eventually reached. The "Nudge" authors wrote frequently about default rules affecting outcomes. If enrolling and exiting a 401k were frictionless, then one would expect the steady-state enrollment percentage to be the same regardless of whether the default rule was to opt-in or opt-out. Since enrollment is not always so simplistic, making the default automatic enrollment would increase household savings and appear to align with what individuals prefer without limiting freedom of choice.
  • Automatic enrollment can get more workers into their respective plan, but the same inertia that makes the enrollment default rule have such a powerful influence also causes participants to stick with the low default contribution rate. "Nudge" author Richard Thaler and Shlomo Benartzi devised "Save More Tomorrow," which invites plan participants to pledge to increase contributions coincident with future pay raises. This choice architecture was devised to align with the fact that 68% of respondents thought they should be saving more while only 1% though that they should be saving less, behavior changes are easier to adopt if they take place in the future, people prefer avoiding losses (and lower take home pay) than gains, and again the power of inertia. The "Save More Tomorrow" plan has been catching on with private and public retirement plans around the world.

Improving Asset Allocation

  • Once participants are enrolled and have agreed to escalating contribution rates, how should they allocate their dollars? Unfortunately, data from fund giant Vanguard showed that investors unsuccessfully chase returns. New participants allocated 58% of their assets to equities in 1992, but after one of the longest economic expansions in United States history, new participants were allocating 74% of dollars to equities in 2000. After the tech bubble collapsed over the next several years, stock allocations fell again to 54%. Participants effectively bough stocks high and chose to allocate elsewhere when they were lower priced and more attractive.
  • Even Harry Markowitz, the Nobel Prize winning economist and father of Modern Portfolio Theory, allocated his retirement fund in naïve fashion, splitting his contributions equally between bonds and equities. Research, again by Benartzi and Thaler, demonstrates that asset allocation of plan participants is often shaped by the choice set since individuals frequently use a 1/n diversification methodology. Lifecycle, or lifestyle funds, where allocations are tilted away from equities and towards fixed income as the participant moves closer to retirement age, have become more common amongst fund offerings, and may help simplify asset allocation decisions. However, research has also found that few participants put all of their dollars in these singular funds as devised, and also allocate to other funds, which may skew the intended allocation weightings. Perhaps a rules-based allocation approach like my articles on momentum portfolios can help investors allocate their funds more judiciously.
  • Even naïve 1/n diversification is following the simple assumption that investors want return streams that are not perfectly correlated to lessen portfolio risk; however, eleven million Americans have over 20% of their retirement funds in their own company stock. Since this type of allocation strongly links the performance of your retirement account's financial capital with your own human capital, the diversification benefit is greatly reduced. A paper by Lisa Meulbroek suggests that the value a plan participant sacrifices holding company stock relative to holding a well-diversified stock portfolio of equivalent risk can be outsized, averaging 42% of the market value of the firm's stock. Investors severely underestimate the volatility of their own company's stock.

"Nudge" is one of the most thought-provoking books I have read recently, and provides proposals for improving education, healthcare, and the environment in addition to personal finance. If you are using naïve diversification, chasing the latest investment fads to your own longer-term detriment, or own outsized positions of your company's stock in your own retirement plan, perhaps I can nudge you towards "Nudge".

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.