In the first article of this series, we focused on the implications of behavioral finance and their impact on defined contribution (DC) plan participation, as well as some measures that trustees and sponsors could take to counter any negative effects. This article focuses on how understanding member behavior can help sponsors and trustees structure their DC plans during the accumulation or growth phase of a member’s working lifetime.

Accumulation phase: Lessons learned from behavioral finance

To consider how member decision making may change during the accumulation period, it is worth reviewing how people make decisions. Research has shown that decisions are based on a number of factors, including past experience, logical processing and emotion. The relative weighting of these factors will vary with the decision being made.  It also follows that as experience and education increase, emotion plays an increasingly smaller part. As people age, they become more experienced (or wiser) and have the potential to become better educated, learning from their previous mistakes and the financial decisions they may have made in the past. Ultimately, they should become better at making logical decisions, such that emotions will have a smaller impact as they age. However, people also tend to use mental shortcuts to make automatic decisions rather than think them through. Even though circumstances change, mental rules may not be updated. Therefore, the emotional component of members’ behaviors, while reduced, will still have an impact on the decisions they make throughout their working years.

With a DC plan, the longer a member has been paying contributions, the larger the fund will be and the greater the impact will be of any investment decisions the member makes. At the same time, the larger the fund, the more likely it will be that some members will want to exercise control. Our analysis of DC plans, as shown in Figure 1, indicates  that while contributions are the most significant factor in the growth of the fund for the first 10 –15 years, the investment return earned becomes increasingly important later on, as does the risk associated with the underlying funds. Plan sponsors deal with a complex world: Many plan members will use default options, so it is also important to structure defaults so they work well over an individual’s lifetime, but at the same time, offer options to enable plan members to tailor their choices to meet their specific needs. Choices that provide diversified options are preferable to those that require too much analysis of the details of the different choices. It is best to offer choices that can be clearly differentiated. While opinions differ on the optimal number of choices to provide, there is agreement that offering too many choices is counterproductive.

Given the growing importance of stable investment returns as account balances grow, it is increasingly important for members to review their investment fund choices along with the contributions being paid, to ensure that their pension fund continues to meet their original objectives. In addition, members should be encouraged to regularly review their investment funds, while checking new investment opportunities. At the same time, as members progress through their working lives, their own financial circumstances will change, and many of the factors initially considered when joining the plan may no longer be appropriate. The choices offered should, therefore, be reviewed periodically to ensure that they can accommodate these changing needs. The impact of behavior should be factored in when offering choices to members. The following are some examples of what employers need to consider.
 
Inertia – Once a contribution rate is determined upon joining a plan, most members never think to increase it, even though their circumstances will have changed and their salaries (and disposable incomes) will have increased. To counter this, members could be encouraged to make decisions upon joining a plan to automatically increase their contribution rates at subsequent salary reviews (known as SMarT saving). (See box below.) They could even be automatically enrolled into this strategy upon joining the plan. This concept overcomes inertia as well as capitalizes on the optimism of members as to their future salary progression.

Another impact of inertia is that members are more likely to make changes following a communication by the trustees or sponsor. Accordingly, it is important that the key messages are clear and that the potential impact of any communication has been weighed. For example, a communication explaining the reasons behind a market fall should be balanced by a positive explanation of the benefits of the plan outlook for the future. Framing information can be used to negate any potential knee-jerk reactions that could have a negative impact in the long term. (And of course, country-specific legal requirements for disclosure must be considered in structuring any communications.)

Prospect theory – The theory states that people value gains and losses differently in that they are likely to take more risk to make up a loss than if they had made an immediate gain. Investors are known to hold depressed stocks too long and sell winning stocks too early. For DC members, this translates into holding poorly performing provider funds for too long in the expectation that the performance will pick up. One solution is to offer generic-named (or white-labeled) funds, where trustees or a governance committee utilizes expert advice to monitor and replace managers. This role could also be delegated to a third party, such as a “manager of managers” or a managed fund. While the alternative of passive fund investment offers a lower cost solution, it is not a no-risk solution, as plans are limited to “following the herd” for a particular market, which may not provide the most efficient strategy for members’ needs. The potential for outperformance compared to other managers will also be removed.   

Framing – The way information is presented can affect how it is interpreted by members and their subsequent actions. For example, in accordance with "prospect theory", a positive or negative slant to the same information can produce very different results. Another example is how the plans were described in Mercer’s Work and Savings Survey of member decision making in the UK. 2006 (see Figure 2) showed that members felt more comfortable with names that reflected risk or return rather than the underlying asset classes. Similarly, research by Vanguard during the recent market turmoil showed that members who were in named funds were less likely to switch from these funds than if they had been invested in equities.

It is worth noting that many members will not actively review their investment choices but will rely on the default fund chosen by the trustees/ sponsors, thus becoming “framed” toward the investment strategy chosen for them. It is, therefore, important for trustees / sponsors to communicate to members the reasons behind the investment options chosen, including an indication of the types of members for whom specific options may be most appropriate. Members can then determine which options best fit their requirements and adjust their fund choices accordingly.
 
Myopic loss aversion - Members tend to focus emotionally more on short-term market movements than on longer-term results, which they should be targeting. This was evidenced in the US market crash in 2002, when after the crash a higher proportion of new contributions were invested in bonds rather than in equities than was the case before the crash (see Figure 3). Therefore, investors were locked into the falling equity markets and relinquished the opportunity to gain from any subsequent rise in equities. By consistently focusing on longer-term returns – say, three to five years or longer – in communications, trustees can encourage members to act against their emotions, even in times of uncertainty in the markets.

Interestingly, in the same research Vanguard found that many of the members who were invested in equities at the time of the market fall retained their allocations in equities on existing balances, but reduced their allocations to equities for new contributions. This suggests that members treated decisions they had already made differently from decisions about the future, indicating a somewhat irrational investment strategy.   

Home bias – People naturally favor information or choices with which they are more familiar. This may vary from choosing their own company shares to having a heavier weighting of their home country’s asset classes. This means that their asset allocations may not be as diversified as they could be, and ultimately, that they may end up taking more risk as a result. Trustees and sponsors should be conscious that despite requests by members to offer certain types of funds, these members may over-allocate their funds to these asset classes and thus take greater overall risk as a result. Trustees and sponsors should also be aware that members may not understand the relative risks of a diversified portfolio or of their own company shares. A series of studies in the US indicate that respondents view their own company shares as less risky than a diversified portfolio. To combat this, one method being suggested is to limit the amount members can invest in their own company shares (although this may conflict with corporate aims to increase share ownership).
 
Choice overload – Research shows us that more choices may not increase satisfaction or quality of investment decision making. Research conducted by Iyengar and Lepper in 2000 in a US grocery store showed that while choice is attractive, too much choice can be detrimental. They set up two stands offering a choice of jams independently – six in one stand and 24 in the other. More people stopped to taste the jam where there were more options (60 percent vs. 40 percent), but more people bought jam when there were fewer options (30 percent vs. 3 percent).  The key point is that the number of choices needs to be sufficient but not excessive.

Too much choice can lead to underperformance. The Swedish social security system, upon privatization, initially offered 456 funds. From plan inception in Oct. 31 2000, through July 2007, the return on the default option was 21.5 percent compared with an average return of 5.1 percent for plan members who chose their own funds. While members may value choice, few have the necessary skills and understanding to choose optimal asset allocations.

Encouraging engagement: What can trustees/sponsors do?

Plan trustees and sponsors need to address governance and fiduciary requirements, which vary by country. The basics of good governance require that trustees and sponsors pay attention to best practice and structure the plan to meet participants’ needs in light of realities that have emerged. Financial institutions worldwide are required by their respective regulators to “Know Your Customers.” In a similar way, trustees and sponsors should get to know their customers by recognizing the impact of member behavior and taking measures to mitigate it. These may include:

Introducing an “auto-increase” mechanism for contributions – The SMarT saving concept provides employees with a plan that automatically increases savings when they get a pay increase, unless they opt out. This can lead to more contributions to the plan and better retirement security for members, in fact utilizing the power of inertia. 

Structuring the default investment options – Experience shows that many plan members will use a default option, and often stay there even if encouraged to make a change. To the extent permitted, it makes sense to focus on default options that include diversification, a balance between different types of investment funds, and some adjustment for changing time horizons. Trustees should communicate how they derived the default funds to enable members to understand the principles and apply them to their own circumstances to choose their own funds.

Encouraging members to engage by linking their pension savings to their other financial circumstances – for example, salary, house, car – and make financial decisions in a similar way. This would also help them recognize how other finances may be affected by their fund as it grows and particularly, the impact a fall in value would have on them as they approach retirement.

Promoting a long-term view of pension savings – Communicate the importance of longer-term performance figures rather than short-term results to reduce the impact of volatility of returns to prevent knee-jerk reactions. Communications to members should include:

• An emphasis on the future prospects of a manager rather than a focus on past performance
• A consideration that the long-term risk of the fund may not keep pace with inflation
• An understanding that targeting a higher return necessarily involves the risk of short- term volatility, with no guarantees that a higher return will be achieved long term
• An understanding that, if lower-risk funds are chosen, members should expect to pay higher contributions to compensate for the lower expected return

Limiting the number and nature of choices – The fund range should be sufficiently diverse and presented in a systematic way so that plan members can easily differentiate between them. Too much choice is likely to confuse. Too few choices could result in suboptimal allocation of funds, as members adopt a “1/n” heuristic approach, allocating their assets in equal proportions to the number of funds (n) available to them.

Beyond structuring of investments: Providing the right messages

Behavioral finance gives us clues about how to structure investments, and it also gives us clues about how to structure information that will be helpful to members. Regular communication is likely to reduce the impact of inertia, but may provide too much focus on the short term. Communications, therefore, need to set up the context well, focus on the purpose of the program and link it to the interests of plan members at different stages of their lifecycles. This would ensure that members relate the information to their own personal circumstances. Relevant information at the appropriate time can reduce the impact of behavioral finance.

Some of the communication issues to be addressed include:

• What to include on regular statements – what will be useful to whom? Customized information to the specific membership is very important and can encourage progressive understanding. Should amounts be communicated as lump sums and also as income? In some countries, DC benefits are paid primarily as income; in others, as lump sums; and in some countries, participants have a choice. What is communicated about how assets are building and how likely they are to provide adequate retirement benefits can help encourage more savings.

• How can the right emphasis be given to the long term when presenting performance figures to balance members’ natural focus on the short term?  Where longer-term returns, such as index returns, are available, these could be presented first, with current returns provided later in the document, say, on the second page. Consideration should also be made of where members are in their working lifecycles.

• How to communicate honestly about negative as well as positive results – A slight positive bias could counter the impact of loss aversion. But is there a fiduciary risk with knowingly biasing communication? Communicating at regular times during the year should counter the potential impact of adverse timing of communication.

• Finally, trustees/sponsors should monitor member activity at least annually, and preferably after a communication exercise to ensure that members’ actions are consistent with the guidance being provided. Monitoring can also be used to identify any particular behavior that may need to be addressed.

Educating employees

The nature of modern DC plans is that they offer choice and transfer responsibility and risk to the individual. Plan members need to be reminded that the decisions they make throughout their lives will define their retirement security. Key choices as assets accumulate include whether to save, how much to save each year and how to invest the contributions.

For plan sponsors, there is a tremendous opportunity to assist employees in their choices – both through plan design and in creating the appropriate context for employee decision making through communications. Once this process is set up they must decide whether to remain involved or to leave the design and communications to the recordkeeper or plan administrator. In many cases, once this decision is made, it is not one they can easily reverse if they change their minds. Detailed application of the ideas we have raised will require careful and specific actions, but the value added in terms of participant outcomes, the ability of employees to retire and the overall positive effect on employee relations should add up to a more productive workforce. 

This article follows the earlier article focusing on joining the plan (SeeThe psychology behind pension plan decisions – Part 1: Enrollment ). A later article will cover retirement and the payment of DC benefits and how member behavior can affect these decisions.

With thanks to the following academics whose research into the field of behavioral finance, including articles and papers, has been utilized in the views set out in this article: Shlomo Benartzi, Gur Huberman, Sheena Iyengar, Wei Jiang, Daniel Kahneman, Olivia Mitchell, Hersh Shefrin, Robert Shiller, Richard H. Thaler, Amos Tversky and Stephen Utkus