The Power of Suggestion:

Inertia in 401(k) Participation

and Savings Behavior
BRIGITTE C. MADRIAN AND DENNIS F. SHEA

Presented by Aditeya Ramasubramanian & Arihant Krishna

 Flow
Introduction The Default Effect of
automatic enrollment

Effect Of Automatic Enrollment on

Features of the plan 401(k) Savings Behaviour

Data Conclusions

Effect on Participation,
Contribution rates and fund
allocations
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 01. The Power of Suggestion
Intro

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Overview
What is a 401(k) savings plan?

★ Company sponsored retirement savings plan offered by

many American companies
★ Employees agree to have a certain percentage from the
paycheck go into the savings account.
★ Also has tax benefits.

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★ This paper analyses the impact in 401(k) savings, participation
rate and fund allocation after the study firm decides to change
from a opt in to opt out system.

★ This move brought about significant changes given that none of

the economic features of the plan were changed.

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 Features of the Plan
02. at a large US Corporation

a. Limited to individuals with one or more years of

employment at the firm

b. Eligible individuals had the option of contributing up

to 15% to the plan, with the first 6% of the
contribution receiving a 50% employer match.

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 Original Enrollment Process

03 Step 3

Choose investment allocation

of combined employee and
employer contributions
Step 1
Authorise the payroll deduction
of their employee contributions

01 02

Step 2
Select a contribution rate

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 Comparison
before after

Eligibility upon hire

Default contribution rate

Default fund allocation

Employer match*
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 03 DATA

OLD NEW

WINDOW

● OLD cohort: April 1, 1996- March 31, 1997

● WINDOW cohort: April 1, 1997- March 31, 1998
● NEW cohort: April 1, 1998- March 31, 1999
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 Sample constraints

A few conditions have been imposed so as to make the analysis

accurate and meaningful

1. Employees over the age of 65 are excluded from the sample

2. Only employees with at least 3 months of tenure are considered.
Comparison of worker characteristics
 04. A Effect on Participation

- The difference between black and white participation has

decreased significantly
- Equalizes participation rates among various demographic
groups.

- Participation rate increases with increase in tenure

- Highest participation rate so far is from the new cohort
- Almost only half of the window cohort participate in 401(k).
 04. B Effect on Contribution rate

- Important observation is that more than 75% of the new cohort retain the given
contribution rate.

This is due to default bias exhibited from the employees

Most of us went with whatever group was allotted to us and did not go out of our way to
make changes to it. This is also an example of default bias!
 04. C Effect on Fund Allocations

Nine funds are available for the employees to choose from

- Money market fund

- Bond fund
- Stable value fund
- Combination stock/bond balanced fund
- Several stock mutual funds
- Foreign stock fund

More than 90% of the new cohort have some of their fund balances in the money market.
In addition to that, 75% have all of their fund balances in the money market.

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05. 401(k) Default effect of Automatic enrolment

401(k) default” rate: the fraction of employees whose 401(k) savings behaviour corresponds to
the default under automatic enrolment.

● Participation in the 401(k) plan at

● 3 percent contribution rate that is
● Invested 100 percent in the money market
fund.

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● Individuals in the 3+, WINDOW, and OLD cohorts who became plan
participants before switching to automatic enrollment for new employees
have a low probability of having any balances in the money market fund or
of having all of their contributions allocated to the money market fund.
● In contrast, individuals belonging to these cohorts who delayed plan
participation until after the switch to automatic enrollment are much more
likely to have some of their balances invested in the money market fund
and to have all of their balances invested in the money market fund.

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 06. EFFECT OF AUTOMATIC ENROLLMENT ON 401(k) SAVINGS BEHAVIOUR

● Automatic enrollment increases the average 401(k) participation rate.

● A substantial fraction of 401(k) participants hired under automatic enrollment exhibit
default savings behavior, with a contribution rate and asset allocation
corresponding to the automatic enrollment default.
● The fraction of automatic enrollees with default savings behavior declines with
tenure, but is still large after two years.
● 401(k) participants hired under automatic enrollment who change their savings
behavior are more likely to invest in the automatic enrollment default fund than
employees hired before automatic enrollment.
● 401(k) participants hired before automatic enrollment who do not become
participants until after the switch to automatic enrollment are substantially more
likely to invest in the automatic enrollment default fund.

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 Status quo bias resulting from employee procrastination

Involvement of transaction costs in switching to other alternatives

Two fold cost

1. Direct cost of implementing a desired change

2. Indirect costs of learning about 401(k) plan features and evaluating the various
saving options

Two sources of complexity to making an optimal savings decision

3. Array of Participation options are immense (must choose the fraction of

compensation 1-15%)
4. How to allocate those contributions between the 9 available fund options.

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 Effects (continuation)

● Employees have more time to become financially literate, to gather information on the
details of the 401(k) plan, and to evaluate the options that are available, we would
expect to see increases in 401(k) participation.
● Relationship between income and 401(k) participation before automatic enrollment and
non default 401(k) participation after automatic enrollment is also suggestive of
transactions costs as an explanation for procrastination.
● Absence of automatic enrollment will have no reference point for investment allocation
(6% before automatic enrollment and 3% during and post)
● Cost of making decision prior to automatic enrollment:

The foregone tax benefit & Value of employer match (both of which increases with
income)

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 07. Interesting Takeaways

- Individuals may never reallocate their portfolios away from poor- performing
investments even when the direct transactions costs of doing so are relatively small.
- 401 (k) participation prior to automatic enrollment never exceeds the one under or after.
Many continue to remain at a 3% contribution rate after a year even when they are
eligible for a 50% employer match on contributions up to 6% of pay.
- For automatic enrollees, the gain from opting out is increased current consumption and the loss is
reduced retirement savings.

Status quo bias - (Samuelson and Zeckhauser, 1988) - Default saving behaviour

- Increase in savings participation

- Reducing the choice set (Samuelson and Zeckhauser, 1988)
- Switching cost

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 Key Findings

Participation is significantly
#1 higher under automatic
enrollment

Substantial percentage of
participants hired under automatic
#2 enrollment retain both default
contribution rate and fund
allocation 23
Question: 401(k) participants hired before automatic enrollment who do not become participants
until after the switch to automatic enrollment are substantially more likely to invest in the
automatic enrollment default fund

Possible explanations:

- Viewing default automatic enrollment as implicit advice (3% contribution rate).

- No impact on savings - automatic enrollment is merely reallocation of assets from other
saving vehicles.

Win-lose approach to a win-win approach

Win aspect being the dramatic increase in savings participation due to automatic enrolment
(help women, blacks, hispanics others etc.) The lose part is people staying back at the
default auto enrolled rates even when they are eligible for better. Turning this into a win-win
approach by either improving the default or automatically increasing the contributions in
small increments.

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