Pay Now - Pay Later, Why Our Staff Need Our Help

Can behavioral finance solve the problems with retirement planning?

Yes, do “it” for them!
Our staff face very different challenges today in planning for lifetime financial security from what previous generations did.

The Pension Protection Act of 2006 was the biggest pension reform legislation enacted in more that 30 years. What made it so different was its recognition of behavioral finance. I’m talking about the accumulation phase of retirement savings and the realization of how difficult it is to build a nest egg.

The problem, specifically, is that 1/3 of those eligible to participate in a 401(k) or other employer sponsored savings plan, do not enroll. The Pension Protection Act was designed to change that.

But first, why is it so difficult to have a savings plan?

Why is it Americans have no savings? It is because of the consumer-based culture (better to buy than to save) and here is the evidence.

1) Savings provides no short-term benefit unlike a mortgage, which results in being able to buy a home.
2) In contrast to an unavoidable chore, i.e. taxes, there are no deadlines.
3) Unlike penalties that can come from, for example, failing to have car insurance; failing to structure financial planning entails no penalties.
4) Education is not enough. Research has shown that there is a substantial disconnect between what financial seminar participants intend to do and actually do end up doing. In fact, there is very little difference in activity between those who do take educational seminars and those who do not (7% vs. 14% - 2001 study: working paper University of Chicago)

What are some of the reasons given for not saving?
- To little money available for savings after paying for basic living expenses
- Money needed to pay off debt
- Unexpected drop in income
- Changing one’s mind
- Lack of self-control
- Loss aversion – risk

And when they do make a decision to save, they follow the path of least resistance when choosing plan options – often least risky and not necessarily in the person’s long-term best interest. Once they choose an option, they are reluctant to revisit it, or to increase contributions as salaries rise, for example. To make matters worse, employees may become paralyzed by having too many options, which prolongs any decision and can reduce their ability to make a rational decision.

The bottom line is this, how employees respond depends upon how retirement plans are presented. For example, automatically enrolling in an employer sponsored plan results in a higher rate of participation. Employers who actually increase employee contribution rate over time actually find employees go along and overcome the “psychological factors” to do nothing that comes from procrastination, lack of inertia, status quo bias, and a general unwillingness to make small sacrifices today for a greater gain down the road.

The reality is that very few people actually achieve all their goals. According to the 2007 Fidelity Research Institute, a typical US household was in track to replace only 58% of its income in retirement, not the suggested 85%. And among retirees 55 years of age and older who were surveyed, more that half (53%) retired earlier than planned. Further, employees who expected retirement income to account for 28% of income in retirement reported it only accounted for 6%.

So there you have it, too often decision-making biases and shortcoming get in the way of your employee’s ability to choose the “right” things. It is up to you as the “protector/employer” to do the right thing and get together with a financial planner and minimize the behavioral variables by, for example, automatic enrollment, escalating contributions rates and age appropriate investment plans.

Our staff need us to do this for them, it is complicated stuff and we all have a tendency to put it off because it is not fun, don’t we.

Employees know that aside from what they create for themselves, there are few, if any, financial safety nets available to them in old age. The retirement plan is only a hope, and Social Security is uncertain. Longevity and health care costs are increasing. Family support is not as available as in prior generations, and arguably, there are also unrealistic expectations about appropriate savings rates and expected investment returns.
The realty is that the employee’s central concern about how to maintain his or her standard of living into old age is not adequately addressed; the additional risks of longevity, inflation, and principal loss remain for the employee. In a Wealth Management 101 exam, the financial industry would—or should—get an F; as they have not proposed a solution that truly meets the employee’s needs.

How can you help?
With respect to age appropriate investing, there has been a shift as big, exciting, and challenging as when Markowitz’s work first forced investment professionals to recognize the importance of investment diversification or asset allocation. And that shift has been into hedging and insurance as additional means to an investment’s return.
Employees now have access to inflation-indexed annuities for their IRA accounts through a new distribution channel that offers meaningful competition: real-time, apples-to-apples quotes from several top insurance companies. This development may be as big in investing industry as the shift from loaded to no-load mutual funds or from the commissioned broker to the fee-only planner model.

So, your role is to provide retirement planning counsel to your employees for the intangible return of being recognized as a caring, supportive leader in your practice. It is already a win-win; why not make it a win-win-win. Do it now, pay now or pay later.