How Do We Make Retirement Decisions? The Psychology Behind Our Choices

We all like to think we understand why we take certain actions, but that’s not necessarily the case because of the psychology behind our decisions. Frequently, we choose actions that are based on emotion rather than facts, or we respond to even more subtle suggestions that guide our behavior. The field of behavioral finance investigates why people don’t always make the best financial decisions, like how much to save for retirement. That’s particularly important for retirement plan sponsors who want employees to make better decisions about their future. So, what does influence your employees’ decisions? Here are some of the factors:

Inertia . We often expect and even want things to continue the way they always have in the past. This inertia keeps us from making decisions that could improve our lives or even change previous decisions. For example, employees may avoid enrolling in a 401(k) plan because they never have done it before, so why start now? One way to overcome inertia is through automatic enrollment, in which employees are enrolled in the plan unless they opt out. That puts inertia on your side, since once employees are enrolled, they are less likely to make the effort to opt out.

Default bias. Many people automatically accept things that are presented to them “authoritatively.” For example, employees who enroll in a 401(k) plan might find that their employer has chosen a default contribution level of three percent. Many will simply accept that default, assuming that their employer has selected the “right” number for them. In fact, most retirement experts agree that people need to save about 15 percent of their income for retirement, so accepting the “default” can seriously impact their future. Similarly, people may react the same to employer-matching rates. If the employer matches three percent of contributions, they will “default” to that contribution. Employers should be aware of this bias and use to it help employees. Setting higher defaults for contributions and matching will encourage employees to increase those amounts.

Indecision . Too many options can paralyze people. After all, people struggle to pick from a dinner menu, and choosing investments is much more important than choosing appetizers. Trying to select from 20 or more investment options in a Retirement Plan Company confuses people, who choose poorly or refuse to choose at all. For example, a participant who is forced to choose among a large number of options may simply elect to put his or her contributions into Investment A, which may not offer enough growth to meet retirement needs. Retirement plan sponsors can address this by limiting the number of investment options.

Build your strategy around your participants’ behaviors

As retirement plan sponsors, we rely on behavioral finance to understand why your participants make certain decisions and how you can structure your plan to turn these psychological weaknesses (and many others) into strengths. We’d be happy to review your plan and suggest changes you can make to help your employees reach a successful retirement.