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Savings in America: Helping Individuals Provide for Their Own Retirement

Fewer employers are providing traditional pensions and many employees feel that they can't count on Social Security. Are individuals up to the task of assuring their own financial security during retirement? How can employers help?

Research by Brigitte C. Madrian

Procrastination often prevents employees from using employer-sponsored 401(k) plans to save for their retirement, according to recent research by Brigitte C. Madrian, an associate professor of economics at the University of Chicago Graduate School of Business, and Dennis F. Shea, vice president of total compensation for UnitedHealth Group in Minneapolis.

While automatic enrollment helps to counter that inertia, more than doubling 401(k) participation among newly hired employees, procrastination soon sets in again. Many employees don't bother to choose a contribution rate or fund allocation. Instead, they stick with the contribution rate and fund allocation chosen by the employer as the automatic enrollment default. In many cases, that means they miss out on receiving the full match benefit from their employers and on investment options that could provide better long-term returns.

Madrian's research, "The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior," examines the impact of automatic enrollment on 401(k) savings behavior. Her research highlights the important effects that defaults have on individual behavior and sheds light on the ongoing discussion of how companies can create the best savings incentives for employees.

For example, employers can dramatically increase the fraction of employees saving for retirement simply by making 401(k) participation the default, rather than nonparticipation. They can also help counter the underlying causes of procrastination in retirement decisions-such as the complexity of making the best decision-by finding ways to make these decisions simpler or by offering financial education.

Old Habits are Hard to Break

Paradoxically, predefined contribution rates and fund allocation can work to the detriment of employees who are automatically enrolled. Among all 401(k) participants at the company studied, the average contribution rate was 6.4 percent of compensation. For employees hired under automatic enrollment, however, the average contribution rate was much lower, at 4.4 percent of compensation. Madrian attributes this to the fact that 76 percent of these participants contributed at a rate of 3 percent, the default at which they had been automatically enrolled. Overall, Madrian concludes that automatic enrollment resulted in a 2.9 percent decline in the average contribution rate of plan participants, cutting across all demographic groups.

Automatic enrollment also leads to a very different allocation of funds among 401(k) participants. Fifteen months after the plan change, three-quarters of the participants hired under utomatic enrollment had their entire 401(k) balances invested in the money market fund, the default option, although they were given eight other possible fund choices. By contrast, other company employees spread out their investments; less than 25 percent had their 401(k) balances invested in only one fund. They also allocated more than 70 percent of their contributions to stocks, with less than 10 percent going into the money market.

These results highlight an important consequence of automatic enrollment-many participants remained at the automatic enrollment default contribution rate and fund allocation. "Automatic enrollment increases 401(k) participation, but many of these new participants are what I would call passive savers-they are reluctant to make savings decisions on their own," says Madrian. These passive savers are the same types of people who are less likely to participate in the absence of automatic enrollment: younger employees, lower paid employees, and black and Hispanic employees.

Madrian suggests several reasons why many 401(k) participants accepted the default contribution rate and fund allocation. Because the employer chose the default, employees may interpret it as retirement savings advice. They may also give preference to the default when weighing their savings options because it is the only option with which they have experience. Finally, employees may procrastinate in their decision to move away from the default in much the same way as they put off their participation in the plan in the absence of automatic enrollment.

"Given some time, many individuals do appear to recognize that the automatic enrollment default is not their optimal savings strategy and they opt to change," notes Madrian. Nonetheless, subsequent research has shown that more than two years after automatic enrollment, fully one-third of participants are still at the automatic enrollment default.

Madrian believes that her research suggests several ways that employers can help encourage their employees to save. She suggests a higher default contribution rate, or one that increases over time, and a less conservative default fund. Simplifying investment choices and offering investment education may also help.

"Some employees feel very comfortable making retirement savings and investment decisions, but many are overwhelmed when they face too many options-these are the folks who end up procrastinating," she says.

Madrian's ongoing research includes corroborating her current findings in two other companies, studying the effects of automatic enrollment on 401(k) savings behavior over a longer time period, and looking at whether employees' financial choices are affected by their peers. Other projects explore the effectiveness of financial education in changing savings behavior and other 401(k) plan features that employers can use to promote savings.

Brigitte C. Madrian is associate professor of economics at the University of Chicago Graduate School of Business.