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Behavioral Economics and Your 401(k)

How would you feel if your employer took charge of your 401(k) plan? Several recent articles (The New York Times, The Wall Street Journal, Contra Costa Times) explore the pros and cons of this concept, referred to as automatic enrollment, and the forces behind it. The New York Times examines one of those forces, a term that piqued my interest: behavioral economics.

How would you feel if your employer took charge of your 401(k) plan?

Several recent articles (The New York Times, The Wall Street Journal, Contra Costa Times) explore the pros and cons of this concept, referred to as automatic enrollment, and the forces behind it.

The New York Times examines one of those forces, a term that piqued my interest: behavioral economics.

According to the NYT story:

Do You Know What You're Worth?

Over the last couple of decades, a new field of economics, behavioral economics, has
emerged to explain why people so often act in ways that are contrary to their own
interests. They overeat, smoke, forget to take their medicine and don’t save enough for
retirement, saying all the while that they wish they could change. Figuring out how to
turn these wishes into action could put a dent in some big social problems.

Last year, President Bush signed a new pension law that was based in part on this idea.
It gave companies an incentive to sign up workers automatically for 401(k) plans. The
workers can still opt out; in fact, they have the same range of choices they have always
had. But if they do nothing, a small part of their salary is set aside for retirement.

The pension bill sprang directly from academic research showing that automatic plans
vastly increased the amount of money that people saved. “It’s the success of behavioral
economics, by far,” Daniel Kahneman, the Nobel Prize-winning psychologist who helped
found the field, recently told me.

The Contra Costa Times also looks at automatic enrollment and behavioral economics:

Why does the average employee find automatic enrollment to be so attractive? The answer
can be found in the book “Why Smart People Make Big Money Mistakes.” It’s the definitive
(but readable) work on behavioral economics.

In general, the human condition makes us feel much worse when a bad thing happens as a
result of a decision we have made — worse than when the same bad thing happens just out
of the blue with no effort on our part. Knowing this, we are reluctant to make a decision
at all when we know there is at least some possibility for experiencing a bad result.

This is also known as “the status quo bias.” When considering a 401(k) contribution, we
weigh it against the status quo of having that extra $100 or more per paycheck to spend.
Who wants to tamper with that condition?

The popularity of automatic enrollment has now been determined statistically.

Automatic Enrollment: Boon or Bane?

Given the abominable personal savings rate in the United States, automatic enrollment strikes me as a boon for many. Those who’ve been reluctant to take the leap of saving may see that 401(k)s–and saving in general–aren’t as difficult and painful as they’d imagined.

Getting to the root of the reluctance through behavioral economics is perhaps even more empowering. Knowing what’s triggering the troubling trend is the best way to quash it.

What do you think of automatic enrollment when it comes to your 401(k)? Do you identify with the behavioral economics-side of the story?

-kc

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Matt Schneider
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