Default Bias in Retirement Savings

Over the decade discussed in this account, defined-contribution plans had continued to grow in importance, and we are pleased with the directions in which they have evolved. The growing use of automatic enrollment, automatic escalation, and sensible default funds has created an environment that is a big improvement on what had existed. And we like the trends we are seeing. The ubiquitous and too-low default savings rate of 3 percent is less universal than it was before. A significant number of firms are starting employees off at 6 percent without seeing a significant increase in opt-out rates. And firms are no longer applying these policies just to new employees. Best practices now include “sweeping” seasoned employees into the enrollment process periodically. Someone who opted out at age twenty-two may have a different view at age twenty-seven or thirty-two.

Although the way defined-contribution plans are being run has improved a lot over the past decade, the biggest problem in the United States and many other countries is that many workers (perhaps half) do not have a retirement plan offered by their employer. This is a problem because the most effective way for people to save is to have the money withdrawn from their paycheck before they have a chance to spend it. It is just like moving that cashew bowl away. Among those who lack this basic benefit are the self-employed, those who work for small businesses, gig workers, and everyone in the informal economy. In many countries, that last segment can be very large indeed.

The Obama administration tried to introduce a nationwide system to alleviate this problem, but no bill was ever enacted by Congress. Aware of the issue, some states, including California, Oregon, Illinois, and others, have initiated programs at the state level. For other states or nations facing this problem, the basic outline of what is needed is illustrated by the National Employment Savings Trust (NEST) system that was created in the UK in 2008. The law required that all employers that do not offer a retirement plan automatically enroll their workers into NEST, with an opt-out option, of course. Both employees and employers make contributions, and the government administers the plan. The plan started out gently, with initial savings rates at just 2 percent of income. Much to the surprise of skeptics, less than 10 percent of workers opted out. After the initial rollout, the savings rate was increased in steps, first to 5 percent and then to 8 percent, and opt-out rates continued to be less than 10 percent. A small number of investment options are offered, the default being a target-date fund. Fees are reasonable.

The UK option is just one design among many. No one design is perfect for every country. But every country should be thinking hard about how to identify one that suits the needs of its citizens. A national plan can also help solve a serious leakage problem in the employer plans. When employees leave, they often cash out their pension benefits, especially if the account balance is small. Since turnover is high in low-paying jobs, this is a pernicious problem, but one that we can solve.