How Behavioral Finance Can Inform Retirement Plan Design
15 Pages Posted: 16 Nov 2006
Several key lessons for pension design have emerged in the last decade from behavioral economics and finance research. This article analyzes the insights from this literature on how workers decide to save, manage their retirement investments, and draw down their assets in retirement. The aim is to understand how workers and retirees deviate from the rational, well-informed agents that underpin economic theory, public policy, and often retirement plan design.
The evidence suggests that many people save too little, others make poor investment decisions, and still others spend their accumulated assets too quickly in retirement. The "behavioral" reasons for such tendencies include overconfidence, limited self-control, the overvaluation of the present at the expense of the future, susceptibility to "framing," and an aversion to realizing losses.
By shedding light on why people fail to achieve an ideal outcome on their own, this literature offers practical guidance to plan sponsors and policymakers who must design, regulate, and evaluate the institutions that help provide for economic security in old age. More specifically, the literature suggests that the plan design should be made automatic for the many individuals unwilling to exercise full control over their retirement savings choices. Recommended design features include automatic enrollment, scheduled annual savings increases, and default investment options or managed account programs that represent optimal portfolio choices.
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