Question

You have been hired as a consultant by a company to develop the company's retirement plan, taking into account different types of predictably irrational behavior commonly displayed by employees. State at least two types of irrational behavior employees might display with regard to the retirement plan and the steps you would take to forestall such behavior.

Short answer

Two irrational behaviors might include Present Bias (preferring immediate gratification, leading to under-contribution) and Overconfidence Bias (misjudging saving abilities or needs). To combat these, introduce automatic enrollment systems and increasing default contribution rates, along with educational resources to realistically project retirement needs.

Step-by-step solution

Identify Irrational Behaviors

The first step is to identify common predictably irrational behaviors that employees might display when dealing with retirement plans. Two common types are: 1) Present Bias, where employees prioritize immediate rewards over future benefits, possibly under-contributing to retirement savings. 2) Overconfidence Bias, where employees might overestimate their ability to save later or underestimate the amount needed for retirement.

Create Strategies to Combat Present Bias

To combat the present bias, one strategy could be to implement automatic enrollment in the retirement plan. This ensures that employees are contributing from the start. Another tactic can be to use default contribution rates that automatically increase over time, or set up an opt-out system where employees are saving by default, but can choose to adjust their savings rate or opt-out if they actively decide to.

Develop Methods to Address Overconfidence Bias

To mitigate overconfidence bias, provide educational resources and tools that help employees better estimate their retirement needs. Use personalized retirement planning sessions that demonstrate the potential consequences of under-saving. Offer retirement savings projections that incorporate realistic growth rates and life expectancies to help employees set appropriate savings goals.

Key concepts

Present Bias

When considering retirement planning, present bias is a fundamental concept from the realm of behavioral economics that can significantly hinder the growth of retirement savings. Present bias is where individuals prioritize immediate rewards over longer-term gains. In the context of retirement, this means employees might choose to spend money now rather than save it for the future.

To counteract this, implementing structures that promote automatic saving is essential. For instance, retirement plans could introduce auto-escalation, where the contribution percentage automatically increases annually. This allows savings to grow gradually without the individual having to consciously make the decision to save more each year.

Overconfidence Bias

Another behavioral quirk that can adversely affect retirement planning is the overconfidence bias. This bias can lead employees to overestimate their ability to save for retirement later in life or underestimate how much they will need after they retire. To overcome this, explicit educational programs emphasizing realistic retirement goals and the risks associated with delaying savings are beneficial.

Providing interactive tools that enable employees to visualize the impact of their current savings habits on their future financial state can also be an effective strategy. By encouraging them to partake in financial literacy programs, companies can help employees create a more robust and informed retirement strategy.

Predictably Irrational Behavior

Humans often exhibit predictably irrational behavior, where their actions do not align with their best-interests or rational financial models. In the retirement planning context, this includes behaviors like the aforementioned present bias and overconfidence bias, but also extends to others like inertia or the status quo bias.

Understanding these behaviors helps in designing retirement plans that, for example, take into account employees' propensity to stick with default options. Therefore, setting the default option to be in the best long-term interest of the employee can leverage these behavioral tendencies towards positive outcomes.

Retirement Savings Strategies

Effective retirement savings strategies are necessary for ensuring employees are well-prepared for the future. Beyond simply saving a portion of one's income, it is vital to consider a diversified portfolio that can withstand market fluctuations and inflation. Employers can aid in this by offering a variety of investment options within their retirement plans.

Additionally, employers might consider offering matching contributions to encourage higher employee participation rates. Financial advisors can then work with employees to tailor individual investment choices that best fit their time horizon and risk tolerance.

Automatic Enrollment

One of the most effective techniques for increasing retirement savings among employees is automatic enrollment. This approach enrolls employees in a retirement savings plan by default, requiring them to opt out if they do not wish to participate, rather than opt in if they do. Research shows that automatic enrollment increases participation rates, as it removes the barrier of taking the initial action to enroll.

Additionally, including an automatic escalation feature can help employees gradually save more over time without having to manually adjust their contribution rates.

Employee Financial Education

Lastly, employee financial education is a cornerstone of any effective retirement planning strategy. An educated workforce is better equipped to make informed decisions about their own retirement savings. Offering workshops, one-on-one counseling sessions, and online resources including calculators and budgeting tools can dramatically improve employees' financial literacy.

By investing in the financial wellbeing of their employees through comprehensive education, companies not only foster a culture of savings but also help to ensure that their workforce is prepared for retirement, thereby mitigating many of the issues stemming from irrational financial behaviors.