Simplifying Information in 401(k) Plans Doesn’t Lead to Better Decisions

Because 45% of U.S. households with heads between the ages of 25 and 64 have insufficient retirement savings, and for working households about to retire, the median savings is a mere $12,000, IZA Institute of Labor Economics conducted a study to find out how to encourage better savings behaviors. Specifically, the “Less Is Not More” study set out to determine whether presenting retirement plan information in a more compact and accessible way increases participation and results in better investment decisions.

IZA conducted a study among newly hired employees by giving them either a short form or a long form description about a hypothetical employer-sponsored 401(k) plan. The participants were then asked a series of questions about their planned choices: whether or not they would enroll in the plan, how much they would contribute and how they would allocate their funds. IZA found no difference between those given the short and those given the long forms.

IZA then conducted a second study among business school students, who were expected to have less familiarity with a 401(k) plan, and found the same results.

When enrolling in a retirement plan is optional, IZA says, the factors that determine whether or not a worker will do so depend on their age, education level, job tenure, income, financial knowledge, plan features, peer effects and planning horizon. Automatic enrollment has been very effective, IZA says. Using data from Fortune 500 companies, auto enrollment increases participation by 85%.

By comparison, another study found that educating new hires about the potential for future earnings by participating in a 401(k) plan increased enrollment by a single percentage point.

When a company match is offered, the likelihood of enrollment is 25% higher than when no match is offered. When the participation rate of colleagues increases by one percentage point, other workers’ enrollment increases by two percentage points. As people age, are better educated, have financial knowledge or work longer at a job, they are more likely to participate in a 401(k) plan, IZA says. In addition, people with a planning horizon of less than five years are less likely to participate than those with a planning horizon of five years or more.

When automatically enrolled, the majority of participants stick with the default deferral rate. One study found that 61% of participants do so. Another study found that by asking people to commit to using pay raises to increase their 401(k) contributions boosted deferral rates from 3.5% to 13.6% by the fourth pay raise.

IZA points to another study that found when a plan permits people to take out loans, this increases contribution rates by 2.6 percentage points.

Two different studies found that people spent between 36 minutes and one hour to decide how to allocate their money.

Framing investment information also impacts decisions. When shown one-year returns on stock funds, people assigned 41% of their portfolio to stocks. When shown 30-year simulated returns, people upped that allocation to 82%.

Another study found that 42.5% of males have at least some of their portfolio allocated to stocks, compared to 33.3% of females.

In conclusion, IZA says, “the data do not support the idea that presenting optional 401(k) plan information in a simpler, more compact way will improve employees’ retirement planning choices. However, we did find that financial literacy was positively associated with better choices. This suggests that increasing financial literacy would improve decision making regarding 401(k) plans. In addition, given that so many people choose the default options, it may be ideal to design those defaults in such a way as to improve individuals’ outcomes.”

IZA’s full report can be downloaded from here.