The Power of Suggestion: Making Savings Automatic

Microeconomics for Management and Policy PADM 5211

Presentation by:

Eloisa Martinez and Isabelle Lachance

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Format of the Presentation

1. To provide the context for the topic of this presentation

2. To explain the study by Madrian and Shea (2001)

3. To analyze the study’s main findings

4. To discuss some of the policy implications

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Context Nudge’s Chapter 6 titled “Save More Tomorrow”

Article by Brigitte C. Madrian and Dennis F. Shea titled “The power of suggestion: inertia in 401(k) participation and savings behaviour” (2001)

Key features of the U.S. 401(k) vs. Canada’s Registered Retirement Savings Plan (RRSP) 401(k) is setup with the employer’s plan whereas an RRSP can

be setup with any financial institution; 401(k) contributions can only be made through payroll deductions whereas RRSP contributions can also be done as cash contributions (after tax) which then generate a tax rebate.

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The Study Methodology

Unit of study: U.S. company which implemented a change in 401(k) enrolment (automatic; moved from opt-in to opt-out ) and eligibility (upon hire and not after one year of service) on April 1st, 1998.

Time frame and objective: to look at savings decisions of employees (participation rate, contribution rate, and investment allocation) from June 1997 to June 1999.

Default plan: 3% contribution rate entirely allocated to the money market fund

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The Study Methodology cont’d (Madrian & Shea p.1154 Employee Cohorts)

COHORTS OLD (N = 3286)

WINDOW (N = 4257)

NEW (N = 5812)ATTRIBUTES

Dates of hire 4/1/1996 to 3/31/1997

4/1/1997 to 3/31/1998

4/1/1998 to 3/31/1999

Participation in 401(k) plan One year after date of hire

4/1/1998 Date of hire

Automatic enrolment No No Yes

Default Contribution rate None None 3%

Default Fund allocation None None Money market fund

Note: for all cohorts the employer’s match was 1 year after hire

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The Study Results of automatic enrolment

Higher participation rate; there is indeed a “suggestion to participate”

In most cases employees stay with the default option. There is a perceived message “to invest as suggested’ (3% rate and money market fund)

After 2 years the majority of employees will remain with the default option (but declines with tenure)

Even if employees do not stick with the default option, they are still likely to invest in default settings (anchoring)

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Analysis of Findings Rational factors

Transaction costs (direct or indirect) involved in switching to another alternative

Increasing complexity of decision-making = procrastination. More options = refusal to choose

Behavioural factors Problems with self-control: tendency to leave for tomorrow

what we can do today Status quo bias driven by the “endowment effect”:

asymmetry between perception of losses and gains; we tend to be loss averse vis-à-vis what we have

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Analysis of Findings Behavioural factors cont’d...

Anchoring: initial starting value (the default option) is used as a reference point from which to make adjustments

Framing of participation decision: how choices are presented. Default is participation after automatic enrolment

Tend to see the default option as implicit advice from the company e.g. 3% rate is the ‘advice’ of the company.

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Policy Implications It is important to understand why we observe differences

in savings behaviour so as to inform the discussion on how best to create savings incentives E.g. 1: If procrastination is a result of complexity of choices: offer

a menu of popular options E.g. 2: If procrastination is a result of inadequate information: offer

investment education

Pros of automatic enrolment: Tends to increase participation rate among groups with lowest

participation rate (Blacks & Hispanics, young, low-income, women)

Tends to equalize participation differences across various demographic groups

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Participation of Window Cohort on 6/30/98

Participation of New Cohort on 6/30/99

Overall 37.4% 85.9%

Gender: Male 42.3% 85.7% (+43.4%)

Female 35.9% 86% (+50.1%)

Race/ethnicity: White 42.7% 88.2% (+45.5%)

Black 21.7% 81.3% (+59.6%)

Hispanic 19% 75.1% (+56.1%)

Age: 20-29 25.3% 82.7% (+57.4%)

40-49 47.3% 90.1% (+42.8%)

60-64 60% 86% (+26%)

Compensation: <$20K 12.5% 79.5% (+67%*)

$30-$39K 42.2% 88.9% (+46.7%)

$50-$59K 61.6% 92.8% (+31.2%)

$80K+ 68.3% 94.2% (+25.9%) (Madrian & Shea, p.1154 Effect of Automatic Enrolment Only)

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Policy Implications Cons of automatic enrolment:

Participants’ inertia: tend to stick with the default option “Default savings behaviour under an automatic enrolment

may lead to lower individual total savings compared to traditional opt-in 401(k) plan that require an active savings decision” (Madrian & Shea, p.1185)

Ways to make automatic savings a win-win situation: Participants’ education Improve default options Increase the contribution rate in small increments in the

future Eg. use inertia to increase savings

Thank you!

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