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Why 401(k) investors are thankful for behavioral finance.

IN THE BEGINNING, the 401(k) world was easy and fun. Its movement away from the shackles of company-controlled pension and profit sharing plans allowed employees to make simple choices between three obviously different investment options. It was not unlike a three-ring circus. Everyone wanted to go to the 401(k) and everyone had a great time once they got there. They didn't need to memorize reams of investment theory, they just needed an ounce of common sense.

As more service providers saw the lucrative advantages of entering the 401(k) market, Modern Portfolio Theory descended upon the retirement plan world like a dark cloud. Gone was the child-like joy of the three options. Entire the complex paradigm of the style box. Choices multiplied and trying to do well in your retirement plan required the equivalent time and effort of studying for a calculus BC exam. The 401(k) was no longer a three-ring circus you could visit every so often. It was complicated Rubik's Cube you needed to solve every day.

Right around the turn of the millennium, however, a light appeared at the end of the tunnel. This was about the time behavioral finance researchers discovered how useful it was to examine 401 (k) decision making.

In the case of too little participation, behavioral finance revealed how opt-out models could be more successful than the standard opt-in model. Employees still had a choice whether to participate or not, but the choice was now reframed. In the old model, a "no-action" decision kept an employee out of the plan. In today's models, based on what we've learned from behavioral finance, a "no-action" decision keeps an employee in the plan.

It gets even better.

Using the advantage of inertia (i.e., "no-action"), plan sponsors have helped address the two next greatest problems of 401 (k) participants--not contributing enough and not investing in long-term investments.

In the first case, researchers found employees who increased their contribution rate with every raise benefited. While those who did not increase their contribution rate with every raise found their contribution rate remained the same, those who did increase their contribution rate with every raise saw their contribution rate go up from 3.5 percent to 13.6 percent after four raises.

In the second case, the same two researchers found that by merely limiting the number of fixed-income options in a plan, the amount invested in long-term securities (i.e., equities) increased.

By applying behavioral finance techniques to 401 (k) plan design and implementation, plan sponsors have found they can successfully address many of the challenges presented by participant choice plans.

This is something all employees can be thankful for.

Add it up

37.4%

The participation rate before automatic enrollment

85.9%

The participation rate after automatic enrollment

75% The amount of plan assets invested in equities when a plan offers 5 stock funds and one fixed income fund

35

The amount of plan assets invested in equities when a plan offers one stock funds and 5 fixed income funds

Sources Quarterly Journal of Economics; researchers Richard Thaler and Shlomo Benartzi

TICKER The move away from emphasizing Modern Portfolio Theory towards emphasizing the lessons of Behavioral finance has helped 401(k) investors tremendously.

Christopher Carosa, CTFA, is chief contributing editor for FiduciaryNews.com.
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Title Annotation:retirement redefined
Author:Carosa, Christoper
Publication:Benefits Selling
Date:Nov 1, 2013
Words:549
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