Rule No. 1: Inertia dominates human actions. Rule No. 2: People fear loss more than they value gain.
As two tenets of behavioral finance, these principles are still largely confined to being studied in the world’s business schools. But the twin theories already serve as the underpinning of a 401(k) plan design that some providers feel may soon catch on with sponsoring companies.
The approach is the “automatic” 401(k) account, sometimes called an autopilot plan. And it bypasses Rule No. 1 by setting “default” plan participation levels for employees who make no choice about their 401(k) investing options. First developed in the 1990s by private industry and researchers at the U.S. Treasury Department, the concept has found its way into plans being offered by Vanguard Group, Principal Financial Group, Prudential Financial Inc., and others, as well as into some self-administered corporate plans.
“When we started this process back in April 1997, our participation rate was at 71 percent. It’s steady at around 86 percent now,” says Philip Perez, retirement delivery manager for Plano, Texas-based J.C. Penney Co. Under Penney’s current plan, workers with a year’s service automatically have 4 percent of their pretax salary diverted to a 401(k) account, unless they specifically say they don’t want to participate. Penney, which administers its own plan of 22 funds and matches up to 6 percent of employee compensation, has boosted the minimum contribution percentage twice in eight years. “A number of plan members have thanked us for enrolling them, because they really wanted to increase their participation,” says Perez, even if they concede that they wouldn’t have signed up on their own, as most other plans require.
Penney hopes the higher participation will help more employees avoid retiring with insufficient savings. The nation’s more than 400,000 401(k) or similar defined-contribution plans now have a total of 42 million members, which in 2001 constituted around 58 percent of workers covered by company-sponsored pensions. But according to statistics cited in a recent Brookings Institution/Georgetown University study, half of the 401(k) plan members between the ages of 55 and 59 had balances of $50,000 or less.
Faced with difficult choices about whether to set aside precious salary dollars for the future on a tax-advantaged basis, many new employees “simply procrastinate, and thereby avoid dealing with the issues altogether, which dramatically raises the likelihood that they will save inadequate amounts for retirement,” according to the Brookings/Georgetown study. And many employees simply cash out of smaller plans when they change companies. Calling the autopilot concept “disarmingly simple,” the study says that it “has the potential to cut through this Gordian knot and improve retirement security for millions of workers via a set of commonsense reforms.”
The Profit Sharing/401(k) Council of America (PSCA) calculates that about 8 percent of companies, mostly larger corporations, have adopted some form of automatic plan membership. Enrollment, however, represents only the first of four autopilot steps that some plan designers envision for helping participants boost their balances—in part by counteracting the inertia principle.