For those tasked with managing plan sponsor relationships for employer sponsored retirement plans, choice architecture is becoming common practice. If you aren’t familiar with the term, choice architecture is when behavioral finance principles are used to create an environment that influences and nudges the choices consumers make. When it comes to retirement plan administration, this comes in the form of increasing plan enrollments and savings rates as well as improving asset allocations.
Many who work in this segment of the financial services industry have read books like Shlomo Benartzi’s Save More Tomorrow: Practical Behavioral Finance Solutions to Improve 401(k) Plans. In addition to being armed with supporting data on increased savings rates and better asset allocations, most relationship managers can cite a well-known go-to case study on Austrian organ donation rates. Recordkeeping systems, asset advisory services, participant and plan sponsor communication as well as sales decks are now being designed to leverage choice architecture.
In short, the retirement industry has eagerly worked to adopt behavioral finance principles into their plan designs through features like opt-out provisions, auto-escalation and default investment options. Still, there is a lack of understanding regarding the behavioral finance principles underpinning choice architecture.
Those servicing employer sponsored retirement plans, from client services and financial representative to relationship managers, often know the what and how of their work. In other words, relationship managers know what choice architecture is and what it does as well as how to implement it and how it will benefit plan sponsors and their employees. But, without a strong understanding of behavioral finance principles, it is hard to understand why choice architecture is so critical to helping plan sponsors and participants to achieve optimal retirement outcomes. And it is the why that drives core beliefs in both plan sponsors and those who service them.
What follows is an attempt to provide insight into a few of the behavioral finance principles that demonstrate why choice architecture is so important to designing an optimal retirement plan. Three topics will be covered: risk framing, status quo bias and choice. For each topic, you will be provided with key behavioral takeaways as well as how they apply to choice architecture features.
Retirement planning is a process of taking actions in the present in order to increase the likelihood of a desirable outcome in the future. Potential positive and negative consequences to decisions are weighed and compared. When considering positive consequences, people are assessing possible gains, while negative consequences entail loss considerations. Human beings place far more value on the potential of loss than the potential of gain – as much as two and a half times more, to be more precise. Risk influences our actions more than opportunity.
For example, consider someone who has $500 to invest in an opportunity, but there is the potential of losing it all. What would they need to have a chance to earn in order to consider risking their money? According to a strong body of research, roughly $1,250. This is because the emotional impact of loss far outweighs the excitement for a gain. It also means that the emotional impact to losing $500 would be far greater than if someone were to win $500. This is referred to as loss aversion.
As a result of loss aversion, whether information is presented to someone as a loss or a gain will significantly influence the decisions they make. The below example illustrates this framing effect on decision making. I originally presented this example in a more extensive review of framing and loss aversion in a previous post. It is a reworking of a study presented by Daniel Kahneman in his excellent book, Thinking Fast and Slow.
Imagine that you are advising a client during a volatile market, where analysts expect crashing declines of 40 percent. The client has a short time horizon before needing to access their funds. You present two alternative plans.
- If plan A is adopted, 80% of their current account value will be saved.
- If plan B is adopted, there is a one-third probability that 100% of their account will be saved and a two-thirds probability that nothing will be saved – they will incur the full brunt of the 40% market drop.
If you are like most people, you chose plan A. Certainty reduces risk, and program A presents a sure bet, while plan B has an unknown, riskier outcome. Due to this risk aversion, most people seek the safety of certainty. Let’s try another one:
- If plan A is adopted, they will lose 20% of their value.
- If plan B is adopted, there is a one-third probability they will not lose anything and a two-thirds probability they will lose the full 40%.
How about now? Did you choose plan A or B? Most people choose option B in this adjusted scenario. But, look a little closer. Options A and B in each of the scenarios are the same. Yet, most people choose A in the first scenario and B in the second. So, what gives?
The reason is due to how the information is framed and presented. The first scenario focuses on how much of the account value will be saved; in other words, what will be gained. The second scenario frames things differently, addressing potential losses.
Key Behavioral Takeaways:
- Loss has far more emotional impact and influence on a person’s decision than the possibility of a gain.
- How communication is framed in terms of risk, will influence the decisions someone makes and the actions they take.
- Options framed in terms of gains will influence people to become risk-averse as they seek certainty.
- Options framed in terms of loss will influence people to engage in risk-seeking behavior.
Choice Architecture Example:
An important characteristic of a well designed retirement plan that uses risk framing in their choice architecture is to drive savings rates. Historically, plan contributions were encouraged through account balance projections, i.e. save “$X” more and your account is projected to be “$Y” in “Z” years.
Information was framed in terms of gains, which, as we’ve learned, influences risk averse behavior. The most prevalent risk to be avoided in this scenario is living on less income in the present, resulting in inaction. Future account balances also lack a tangible motivator that outweighs the relatable needs of present income. It is difficult to translate what that future balance actually provides.
The solution was to reframe the discussion from future account balances to current income needs. Instead of representatives, websites and statements focusing on projected future balances, they presented income replacement projections in present dollars. In doing so, the retirement income shortfall and need became front and center. Doing this, frames the conversation in terms of risk, thus influencing risk-seeking behavior.
Status Quo Bias
In her contribution to the book, Client Psychology, HanNa Lim writes:
“Individuals have a strong tendency to do nothing or maintain their current or previous decision. This tendency is called status quo bias.”
In other words, people have a strong resistance to change, even if the status quo is not a desirable place. So, why is this?
The answer, as it so often is with behavioral psychology, comes down to risk. The status quo, even if not desirable, is familiar and known. Venturing into the unknown is perceived as a risky proposition, and people seek and prefer safety and security. This is also why the known present holds far more weight in a person’s decision making than the unknown future.
People require nudges to pull them away from the status quo, which explains why framing risk in terms of loss is so effective. It shifts the risk and instability to present activities by emphasizing the need to act in order to avoid a negative consequence. People are then more likely to take the risk of venturing away from the status quo.
Key Behavioral Takeaways:
- The present holds more weight in decision making than future considerations.
- People perceive a change from the known status quo as a risk, even if status quo behaviors are risky.
- People will seek security and safety over uncertainty and risk unless nudged.
Choice Architecture Example:
Status quo bias is a key reason for the effectiveness of opt-out provisions. If someone starts a new position, there are certain features that instantly create a new and accepted status quo. Benefits are one of these features. When contributions into a retirement plan are automatic, it instantly represents the new norm. This means that opting out actually presents the risk. Conversely, when people are required to opt-in, the risk is in enrolling. Remember, in behavioral finance and decision making, risk is often more a matter of perception than reality. It is this perceived risk that influences actions and decisions, regardless of whether it is an objectively real risk.
As a rule, people need to feel confident and in control in order to take action and make decisions that move them away from their known status quo. A key factor to feeling confident and in control is having choices to decide between. Choices, however, follow the goldilocks principle. There can’t be too few or too many options; there needs to be just the right amount.
A singular option limits a person’s ability to feel in control, which also minimizes their sense of safety and security. This is the result of a cognitive bias called single option aversion, which tells us that consumers are often not willing to purchase or invest in a product or service, no matter how attractive, if not contrasted with other options. It is this process of comparison that allows a person to identify and determine value. Single option aversion is so powerful, in fact, that one study from a professor at Tulane University demonstrated that adding a second option when trying to sell DVD players increased the number of customer who made a purchase from 10 to 66%. That’s an increase of 660% just from providing customers with a second option to choose from.
The reverse is also true. When faced with too many decisions, people are subject to choice overload. In his book, Benartzi writes:
“…there is a growing body of research in psychology and economics (from laboratory experiments and real-world observations) indicating that there is such a thing as too much choice…a large array of choices can simply be overwhelming.”
When people are overwhelmed, they do not feel confident or in control. Generally, providing people with two or three option is optimal. This can sometimes be difficult when there are a lot of options to choose from. In these cases, it is important to do two things: 1) Ask questions to identify what is important that should be focused on, and 2) Break options into chunks, so people are only deciding between two or three things at a time.
There is a caveat to prioritizing choice, however. When inaction and the status quo are desirable, single-option aversion is preferred, i.e. opt-out provisions.
Key Behavioral Takeaways:
- People need to feel confident and in control to make buying and investing decisions.
- Choice is a key factor to people feeling confident and in control.
- The optimal number of options to motivate action is two or three.
- The exception is when inaction is preferred, in which case a single option is appropriate.
Choice Architecture Example:
In his book, Benartzi discusses a study that demonstrates how increasing the number of available funds beyond a small number correlates to a reduction in 401(k) plan enrollments. Specifically, for every additional 10 funds offered, enrollment decreased by 1.5 to 2%. This further illustrates the importance of a very deliberate choice architecture.
Choice architecture is not a short lived industry fad. It is a reaction to fundamental principles that drive human behavior. These core human drivers are why choice architecture is so important in designing a retirement plan. This matters, because, when effectively administered, choice architecture changes lives by bettering the prospects and outcomes people will face in retirement.
Choice architecture isn’t just for plan design. Relationship managers can utilize these principles to influence the their plan sponsor’s decisions.
The risk they face is by leaving the perceived safety of their status quo. By helping them to understand the why of choice architecture, you are shifting the risk to where it belongs: inaction. In doing so, they are more likely to make the necessary risk-seeking decisions to benefit their plans and employees.
How do you use choice architecture in your work?