The best retirement savings plans empower participants to benefit from long-term returns — and deliberate plan design is one crucial way to help deliver this outcome. A well-designed retirement savings plan will help ensure participants start saving and investing early, stay invested, have enough retirement income based on their retirement goals, and make smart decisions along the way.
In recent decades, the field of behavioural finance, the study of psychology related to how people make economic decisions, has emerged as a driving force in retirement plan design. Because human tendency is not always rational, it can be challenging to stay committed to a savings plan, and it can be easy to be influenced by biases. Good retirement plan design today incorporates behavioural finance findings so that retirement plans work with, and not against, how human beings are “wired.”
Common Wealth has incorporated some of the best behavioural finance thinking to help deliver retirement income success. Here are three foundational lessons from the field of behavioural finance and an overview of how these insights are incorporated into Common Wealth’s plans.
Insight #1: Make it automatic
Retirement savings plans from previous decades may have been designed on the premise that financially rational savers will figure out on their own how much to save for retirement, and then carefully implement their plan, month by month, until retirement. However, from a behavioural finance perspective, it is difficult to pay close attention to seemingly distant financial matters, such as retirement — and thus “nudges” may be necessary to help you save appropriately for retirement.
The idea of “nudges” is central to the work of Richard H. Thaler, an American economist who was awarded the 2017 Nobel Prize for Economics for his contributions to behavioural economics. Retirement savings plans, built on insights from Thaler and his colleagues about human financial behaviour, prompt — or “nudge” — participants to establish retirement savings goals, and then ensure that their contributions are set at a level designed to fulfill these long-term goals. As an example, nudges can take the form of offering a default option for you to automatically increase your savings contributions over time.
How Common Wealth incorporates this insight: it incorporates a feature called “automatic escalation” or “auto-escalation,” which will automatically increase contributions each year to help you achieve your retirement income goals. This feature is especially useful if you want to reach a certain savings target but aren’t able to save that much today and would like to ramp up your savings over time as your earnings increase. This feature is entirely voluntary, and you can opt out of it at any time.
Learn more: Save More Tomorrow: Practical Behavioral Finance Solutions to Improve 401(k) Plans – Shlomo Benartzi (2012)
Insight #2: Focus on retirement income
When you’re saving for retirement, the value of your investments will fluctuate over time. As part of setting retirement goals, you will need to figure out how much fluctuation you can tolerate. Many investors, however, tend to not treat gains and losses in the same way. That’s the finding of Daniel Kahneman, an Israeli-American psychologist and economist who is known for his work on how people make decisions, and who was awarded the 2002 Nobel Prize for Economics.
Kahneman’s research demonstrates that investors “overweight” losses relative to gains, making many overly risk averse and fearful. This can lead to adopting retirement investment strategies that are overly conservative, instead of adopting a balanced approach to investment risk and return. Retirement plans that incorporate Kahneman’s research on loss aversion will help participants choose an investment allocation that strikes an appropriate balance between investment risk and return likely needed to achieve long-term retirement goals.
Just as retirement savers need to balance the trade-offs between investment risk and investment return, they need to balance the needs and priorities of the present and the future. But similar to how many struggle to find the appropriate balance between risk and reward, there can be a tendency to choose smaller, immediate rewards rather than larger, later rewards.
This phenomenon is driven by something called “temporal myopia,” which causes settling for smaller payoffs now, rather than larger payoffs later. That’s because clarity in perceiving the future decreases the further it seems away. When an event is far away in time, it seems less clear and pressing, and so there can be a tendency to “underweight” the importance of the future in decision-making. This can pose a problem in saving up enough for retirement, which can seem very far away.
How Common Wealth incorporates this insight: The plan helps members focus on their target retirement income versus what you can expect in retirement income if you continue to save as you have to date, rather than on how markets and investments are performing day to day. Whenever you visit your Common Wealth dashboard, you will see your long-term goal – generating enough income later in life so that you can enjoy your retirement – and if you’re on track to meet it.
Learn more: Thinking, Fast and Slow – Daniel Kahneman (2013)
Insight #3: Less is more
When you’re saving for retirement, you might think that having many options is better than having only a few options. But what you may not realize is that having too many choices often leaves to worse outcomes.
Decision-making takes up your psychological resources. Just as you reach fatigue at a certain point when you’re engaged in activity that requires effort, when you need to make many different decisions at once, it’s easy to hit “decision fatigue.” Behavioural scientists call this “choice overload.” Research shows that the saver who is faced with selecting among too many different investment options may struggle to select an option they’re satisfied with or may not make a choice at all until later.1
Choosing from a few good, thoughtful options within a retirement savings plan — including a good “default” option — is usually much more effective for retirement savers than having to choose from many different options.2 Of course, it’s essential that these few good options available are meaningfully different in order to meet the needs of investors with diverse preferences and circumstances.
How Common Wealth incorporates this insight: it provides target date funds and suggested options for many of the key choices you will need to make in participating in the plan, including your investment path, your savings rate, and the allocation of your savings to TFSAs and RRSPs.
Learn more: Choosing Not to Choose: Understanding the Value of Choice – Cass R. Sunstein (2015)
1 Donald B. Keim and Olivia S. Mitchell, “Simplifying Choices in Defined Contribution Retirement Plan Design”. Pension Research Council, Wharton School, University of Pennsylvania (2015).
2 Choi, Laibson & Madrian, “The Importance of Default Options for Retirement Saving Outcomes: Evidence from the United States” (2009).