Overcoming psychological biases in the age of the 401k: financial literacy, better plan design, higher allocations help employees prepare for retirement.

• Author: Nofsinger, John
• Position: EMPLOYER BENEFITS

Our society's change from defined benefit plans to the modern 401k plans moves the burden of acquiring retirement assets from employers to citizens. Many citizens are not up to the task. But after decades of researching employee 401k choices, it turns out that the employers still have a large role in their employees' retirement standard of living. Sure, employees have the ultimate say in how much they contribute and how retirement assets are invested. But as managers and business owners, know that the structure of your plan may still have the biggest impact--more than employee decisions. Why? Employees' lack of financial knowledge and their own psychological biases are barriers to success. Interestingly, you can design a retirement plan that nudges employees toward success or nudges them toward failure.

There have been two main ways of helping employees make good 401k plan choices. The first is improving financial literacy, which has had important, but surprisingly small impacts. The greater impact has been through redesigning the enrollment process to nudge people in the right direction. People's psychological biases can be used to help them make better decisions, instead of letting those biases hold them back.

The Historically Poor Design

Traditionally, a new employee would receive a complicated form and a large packet with investment information on the dozens, even hundreds, of choices. Instructions were to take it home, make decisions, and return the form to human resources. This is known as an "opt-in" process. But people tend to get overwhelmed and procrastinate so long that they never enroll. Just a decade ago, less than half of the people who were eligible actually contributed to their 401k plans.

In addition, people's asset allocation choices are odd. Examining the assets in 401k plans nationwide finds about half are invested in stocks and half in bonds. Although this sounds good, the details paint a different picture. Nearly half of the people own no equities and one fifth are 100 percent invested in stocks. These people are not well diversified. This problem mostly comes from a common extrapolation bias. When a new employee enrolls, he or she chooses all stock investments if the stock market has recently been strong. If the market has been weak, he or she selects no stocks. Unfortunately, most people never change their asset allocation once it is initially determined.

The Better Design

Through automatic registration, new...