People with present bias may delay saving for the future, while those with exponential-growth bias may underestimate the returns on savings, a study finds.
Just how much do biases affect retirement savings? According to a study, “The Role of Time Preferences and Exponential-Growth Bias in Retirement Savings,” present bias and exponential-growth bias in particular can wreak havoc on future funds.
Present bias is the tendency to focus on the present rather than the future; and exponential-growth bias is the tendency to neglect compounding investment returns. People who have present bias may intend to save more for the future but never do, or they may procrastinate enrolling in a tax-deferred savings plan. A person with exponential-growth bias tends to underestimate the returns on savings and the costs of having debt. Those who are unaware of these biases tend to save less money for retirement, the study found.
If biases are eliminated, however, it can result in a retirement savings increase anywhere from 12% to 70%.
The researchers from Stanford University, the London School of Economics and Political Science, the University of Minnesota and Claremont Graduate University tested the association between a direct measure of self-awareness about these biases and the economic outcomes of them.
As part of the study, they asked respondents questions including whether (and when) they would be willing to complete an hour of paperwork to change their retirement plan based on their company’s new matching contribution (they would also get a $50 bonus for completing the paperwork).
Researchers found that if they gave a deadline for completing the paperwork, it increased the chances that respondents would change their contributions by 8.3 percentage points. If they didn’t give a deadline and just provided a cash incentive, the chances only increased by 4.3 percentage points.
The survey also asked questions about the value of an asset. For example, what would the value of an asset be after 20 periods if it experienced growth at an interest rate of 10% each period? The study found that overconfidence regarding exponential estimation has an additional negative effect on retirement savings.
Present bias and exponential-growth bias therefore have a profound effect on an individual’s retirement savings, the study concluded.
When the Department of Labor’s
(DOL) fiduciary rule proposal came out last year, there was some concern
that it would affect plan sponsors by requiring Best Interest Contracts
(BICs) from advisers, even with one-time projects, such as defined
benefit (DB) plan annuity purchases, that it would affect retirement
education for participants, and even affect advice relating to health
savings accounts (HSAs).
The final rule released this week, made some important changes in response to these concerns.
In
a statement, Rich McHugh, vice president of Washington Affairs for the
Plan Sponsor Council or America (PSCA), said, “Based on an initial
review, it appears that the DOL has made some changes in the rule that
should be helpful with respect to providing needed investment education
to retirement plan participants, reforming the best interest contract
exemption and making the rule more helpful to small employers.”
In
discussing the final rule, Labor Secretary Thomas Perez said, “[F]or
firms that have millions of existing customers that would require a BIC
under the final rule, there are also changes. Unlike in the proposed
version, firms can now simply send a notice that tells these clients
that the firm has taken on new obligations for them as a result of the
new fiduciary standard. An email or letter will suffice when it comes to
alerting existing customers of the change.”
Robyn Credico, North
America leader of defined contribution consulting at Willis Towers
Watson in Arlington, Virginia, explains that under the final rule,
recommendations to plan sponsors managing more than $50 million in
assets (vs. $100 million in the proposed rule) will not be considered
investment advice if certain conditions are met and hence will not
require an exemption. There must be a written validation that the plan
sponsor has the wherewithal to make investment decisions.
However,
for plans with $50 million in assets or less, the plan sponsor and
adviser will have to enter into a BIC explaining there are no conflicts
of interest and the appropriate fees, Credico says.
NEXT: Education and rollovers
As for the one time use of an
adviser for specific projects, such as DB risk transfer, the rule
remains the same. These advisers are considered fiduciaries. Lynn
Dudley, SVP, global retirement and compensation policy at American
Benefits Council in Washington, D.C., explains that the fundamental redefinition of fiduciary that was put forth in the rule proposal
still stands in the final rule. The previous five-part test for
determining if a person or entity is providing fiduciary investment
advice is gone, eliminating the “on a regular basis” standard, she tells
PLANSPONSOR.
Credico says requirements about participant
retirement investment education have been improved. Advisers, plan
sponsors, or providers holding retirement plan education meetings can
talk about the investments in the plan. “This was not allowed before,”
she points out.
Dudley explains that specific funds can be
mentioned, but only if each fund is named. For example, if a participant
asks, “Can you tell me about the small cap fund I’m invested in and
whether most people my age use that fund,” the plan sponsor, adviser or
provider can respond, but must talk about every small cap fund in the
plan. “You can’t suggest whether the participant is doing right or wrong
by investing in that fund,” she says.
The DOL rule exempted
health and welfare plans from its final rule requirements except where
they have an investment component, Dudley adds. So if an HSA has an
investment component, anyone giving advice about those investments will
need to enter into a BIC with the plan sponsor or participant.
According
to Credico, advisers helping with rollover decisions are subject to
BICs. “Providers and adviser will have to provide participants comfort
that there are no conflicts of interest or receive a document about
conflicts, and the adviser fee must be independent of the investments
selected,” she says.
Even if a participant has been working with
the plan sponsor’s adviser for years, at the point of rollover, there
has to be a BIC. “It’s a whole new relationship once the participant
takes money out of the plan,” Credico says.
NEXT: What should plan sponsors do?
Credico recommends that plan sponsors with more than $50 million in
plan assets look at the education provided to participants and the
advice they and participants receive to make sure they meet the new
requirements. For advice solutions, someone should be identified as a
fiduciary.
She also recommends these plan sponsors have an
investment committee with the appropriate people in place. To get the
exemption, they have to make a statement that they have appropriate
people in place to make investment decisions.
As for education,
Dudley says in group meetings, there will be a lot of caveats. More
general information will be offered and there may be a reluctance to
answer individual-specific situations, but educators can direct
participants to where they can find answers.
Credico adds that
plan sponsors should make sure they are not responsible for plan
advisers once a participant takes a distribution. “Make sure you’re not
endorsing the plan’s adviser. Make a written communication that once a
person leaves a plan, the plan sponsor is not responsible for what the
employee does with assets,” she says.
Credico concludes that as
sponsors, providers and advisers review the new rule more thoroughly,
there will be more questions. But, for plan sponsors it seems the new
rule is not as much a big deal as the proposal.
“It’s a lot to process and a big change, and people are figuring out the
best way to comply, but the DOL has made it workable,” Dudley says.