401(k)s

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In Australia, superannuation is a long-term savings and investment vehicle that, like the 401(k) in the U.S., provides tax-advantaged retirement benefits for individuals. Since summer 2005, a overwhelming majority of Australian workers have been able to choose an investment fund through superannuation. (Prior to 2005, fund selection was largely made by a trustee of some kind.) With more than 200 fund options to choose from, investors have been overwhelmed. (Just think how overwhelmed they would have been if they had lived in Sweden where a privatized version of social security yielded almost 800 fund options!) In a new report on the policy, the Australia Institute levels some harsh criticism.

The fact that fewer than ten per cent of workers actively choose a fund should not come as a surprise. Indeed, as little as four per cent of workers switch super funds each year and around half of this is ‘passive’ choice due to job change or fund closure. Because participation is compulsory, a great many fund members, and particularly those a long way from retirement, do not take a keen interest in their super. Being automatically enrolled in a retirement savings system is not conducive to active consumer decision-making.

Choice of Fund has also been largely unsuccessful in lowering the number of multiple accounts, one of the most serious problems for superannuation policy-makers. In fact, the number of accounts per employee has actually increased, suggesting that choice has not ‘empowered’ consumers to take even the most basic action to improve their superannuation arrangements. Three years on, the failure to promote consumer-centred competition has resulted in considerable waste across the super system. Average fees levied by fund managers have not fallen, remaining at around 1.25 per cent of funds under management (equating to around one per cent of GDP), and significant fee and performance variations persist between not-for-profit funds and for-profit (retail) funds. Moreover, it is estimated that Australians pay around $2.4 billion a year in commissions on superannuation assets, including $862 million on their compulsory superannuation contributions. Financial outcomes for workers can vary considerably depending on the fund that their employer nominates as the default fund.

Read the full paper for six design principles for a default rule, including a somewhat controversial argument that default options should “focus especially on the needs of people who are a long way from retirement, or whose accumulated benefits are relatively modest,” because of the poor decisions that people make in situations where the effects are not felt until well into the future. Because of the complexity of investment decisions, and the number of amatuers among all age groups, the default rule should be issue No. 1 for a choice architect regardless of whether the employee is 23 or 63.

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We have long advocated automatic enrollments in 401(k) plans as a way to help people save more for retirement. We (along with others) have produced research showing how poorly most people make investment decisions, either by naively diversifying, by chasing past performance, or by loading up on company stock.

As more companies adopt automatic 401(k) enrollment thanks to new congressional law, individual investment decisions (and biases) will become even more important. In today’s New York Times, benefits consultant Ted Benna says teaching people personal finance has been a tougher challenge than many financial advisers originally thought. “When 401(k)’s started, he said, ‘we thought we could educate most people to manage their retirement accounts.’ But as it has turned out, most people prefer a ‘set it and forget it approach,’ for which target-date funds are ideal.”

Target-date funds are ideal for younger investors and those without large retirement nest eggs. Rather than use a single form that requires individuals to choose individual mutual funds for their portfolio, should companies use two forms – a basic default form and an advanced form. After filling out basic demographic information, the basic form would ask one question: At what age, approximately, do you plan to retire? Individuals would be enrolled in the appropriate target-date fund based on their answers. More advanced investors could choose the form that allows the flexibility in picking funds.

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