What Buying Jam Can Teach Us About Saving for Retirement
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Classical economics assumes we're all rational consumers making logical choices based on the best financial information. But behavioral economics adds psychology and an understanding of human nature to the mix, recognizing us as emotional—and at times irrational—human beings.
Let's examine the concept of choice. Today's consumers have far more choices—for everything from mayonnaise to mutual funds—than existed in the past. In 1949, a typical American supermarket carried fewer than 4,000 items. Today, the number is closer to 45,000.
When it comes to selecting investments, choices have multiplied as well. A recent survey by WorldatWork and the American Benefits Institute found that more than half of the companies offering 401(k) plans reported offering 16 or more investment options to employees.
So, how does the brain work when faced with many choices?
Dr. Sheena Iyengar, a social psychologist and business professor at Columbia University, is considered one of the leading experts on consumer choice. To examine scientifically how we react to this overload of choice, Professor Iyengar had her subjects make choices about something seemingly uncomplicated—buying jam.
In a landmark study—discussed in the new FINRA Foundation documentary "Thinking Money: The Psychology Behind Our Best and Worst Financial Decisions"—Dr. Iyengar set up two tables in a local supermarket. She placed 24 flavors of jam on one table. On another, just six different flavors.
Dr. Iyengar was looking at two things. First, were people more likely to stop and sample jam at the table with 24 flavors or the one with six? Second, were people more likely to buy a jar of jam at one table over the other?
On average people tasted two jams, regardless of which table the jams were displayed on. And when there were 24 on display, more people stopped to take a sample (60 percent) than when there were just six jars (40 percent).
But when it came to actually buying a jar of jam, only three percent bought from the table with two-dozen varieties. But thirty percent of customers bought a jar at the table with just six varieties. Based on her study, Dr. Iyengar concluded that less choice means more purchases—and more than a decade after she published her results, her findings have held true.
Retirement Plan Choices
Dr. Iyengar was also curious to see if this behavior applies to something else we find sticky: company retirement plan choice. She and her colleagues reviewed 650 company 401(k) plans, and the behavior of nearly 800,000 eligible employees. In all of these plans, the companies were matching at least 50 percent of employee contributions (essentially giving free money to employees who participated). So if employees chose not to participate, they were throwing away money in the garbage can.
And yet, research found that the more options a retirement plan offered, the fewer employees participated.
The lesson? Excessive choice is an invitation to inertia.
"Choice Architecture" and the Power of Defaults
Behavioral economists have identified a powerful tool to help us overcome inertia and make decisions. In the same way beautiful architecture can inspire mood and feelings, "choice architecture" takes knowledge of human behavior and re-frames how information is presented to influence how we make choices.
We have all experienced choice architecture. Take the shopping cart. Over the past generation, it has grown 30 percent larger. The bigger size encourages you to fill it with more items so it doesn't appear so empty.
The same is true with plates. If you are given a plain white plate in a buffet line, the tendency is to fill it up with food. But research shows that if you use a plate with a pattern around it, the plate will look smaller, and it will take less food to make us feel like the plate is full. Customers who used the patterned plate, on average, put 20 percent less food on it.
When it comes to using choice architecture in the retirement savings area, a potent strategy is being employed—the power of defaults. In short, a default option is made for you in case you can't or won't choose between two or more options.
Companies are using defaults to help employees save for retirement by automatically enrolling employees in the organization's retirement plan. Participation in these plans is automatic at a pre-set contribution rate into a pre-selected investment fund. If you don't want a piece of your salary going into the plan, it's up to you to tell your company. But through the magic of procrastination, most people stay with the program and reap the benefits.
Many companies take this a step further. They automatically increase the amount you save each year. For most employees, these increases in savings are timed to coincide with increases in pay. The money you don't see is the money you don't miss.
What Can You Do?
Now that you know an overloaded "plate" of choices can lead to some poor financial decisions—or a paralysis of decision-making—there are some ways to manage the situation.
One way is to narrow the financial choices you allow yourself to consider, grouping your options into different categories and excluding from your decision any category that doesn't fit your needs or situation. For instance, you can choose to concentrate on mutual funds instead of individual stocks and bonds, thereby creating a smaller "plate" of financial options.
A financial professional can also help you sift through the many financial products you come into contact with. When it comes to a company retirement plan, talk to your employer's plan administrator, who can help you understand your investment options (though he or she will generally not give you specific investment recommendations).
And look for so-called life-cycle, or age-based, investment options. Many employer plans now offer these "one stop" funds, which have the added benefit of automatically reallocating your assets as you age.
If you are automatically enrolled, find out the default contribution amount and the default investment you have been put into. Keep in mind that the default may be at a relatively low rate of retirement savings. If your contributions are not automatically set to increase each year (automatic escalation), consider doing it yourself. Set a calendar reminder for the first of each year to increase the amount you contribute to your plan.