WHAT IS BEHAVIORAL FINANCE 2.0? Behavioral Finance 2.0 goes beyond understanding the psychology of money mistakes people make: it is about designing behavioral solutions to avoid those mistakes. It does this by transforming behavioral challenges into behavioral opportunities. Its goal is to improve outcomes.
We have seen that inertia is often a behavioral challenge or an obstacle that prevents employees from saving for their future. While inertia is generally thought of as a behavioral challenge, Behavioral Finance 2.0 is about turning inertia into a behavioral opportunity.
For instance, one could make good use of inertia by changing the default so that employees are automatically enrolled in the retirement saving plan, unless they actively opt-out. With automatic enrollment, taking no action results in saving for retirement, which is what the majority of people say they want. Inertia is now an ally – not an enemy.
This seemingly minor change dramatically affects plan participation. The first study of this issue found that plan participation of new employees jumped immediately to close to 90%, compared with 64% for employees who had been on the plan for between three and five years (Madrian and Shea, 2001). By now more than a dozen such studies have been reported, and all show a similar boost. Automatic enrollment not only works, it is also extremely powerful.
The Pension Protection Act of 2006 encouraged plan sponsors to adopt automatic enrollment, and its popularity is growing. In 2010, 34.4% of plans had automatic enrollment for new hires and a further 7.4% offered it to existing, non-participating employees (PSCA, 2011). (Participation varies according to plan size; it is highest in large plans.)
Automatic enrollment is by far the most effective tool identified to date to increase plan participation. However, its strength is also a potential weakness, compounded by other psychological factors. Progressive plan sponsors who adopted automatic enrollment early on typically set the savings rate at 3%. Some feared a higher rate might provoke more participants to opt out. However, research shows that this is ungrounded (Beshears et al., 2009). A low initial deferral remains common today. In 2010, 61.8% of plans with automatic enrollment had an initial deferral rate of 3% (PSCA, 2011).
Of course, saving just 3% will not provide anyone with a comfortable retirement. The expectation was that plan participants would gradually raise their saving rate to a more adequate figure – 10 to 15%, for example. My colleague Richard Thaler and I predicted, however, that because of inertia most participants would stick with that initial low saving rate and fail to increase it. Indeed, an article in the 7 July 2011 issue of the Wall Street Journal reported that 40% of new hires who were automatically enrolled in their company’s 401(k) plan are now saving less than if they had actively opted into their plans (Tergesen, 2011). We therefore designed a behavioral solution to help employees save more – tomorrow