VOL. 22, NO. 1 SPRING 2009 B ENEFITS L AW JOURNAL From the Editor Nudge: What Every Benefits Lawyer and Consultant Should Know About Human Nature sychology, economics, and neurology are being combined into P a highly practical new discipline focused on decision making— specifically, why even smart people sometimes do very foolish things, while others fail to make any choice at all. By harnessing this learn- ing, employers can help employees make better decisions on using their benefit options and preparing themselves for a strong financial future, while still allowing employees the freedom to make their own choices. The first fruit of this new “science of choice” is the highly effective 401(k) plan auto-enrollment program design. There is plenty of literature available that explains what we need to know about choice and why people frequently make poor deci- sions. An ideal place to start is Nudge , a highly readable new book by Richard Thaler and Cass Sunstein (Caravan books). It discusses how each of us has logical and rational decision-making powers, as well as more reactive, impulsive instincts—think Star Trek’s Mr. Spock versus Homer Simpson. Instincts are great in an emergency but often let us down when it comes to more analytical matters like saving and investing. If asked, many employees probably would say their personal decision making is akin to the more rational Vulcan perspec- tive. But especially when it comes to matters related to retirement, savings, and health and welfare plan enrollment, participants tend to act more like mortals, complete with some hard-wired characteristics that ultimately can lead to poor choices. For one thing, humans tend to be unrealistically optimistic. Most people rate themselves as having above-average abilities (which, of
From the Editor course, is mathematically impossible) and commonly overestimate what they can do, how fast they can do it, and why they won’t suc- cumb to the mistakes others have made before them. At the same time, most people are highly loss averse. Countless studies have shown the hurt experienced after a loss is about twice as great as the good feeling following a gain. The recent stock market is a perfect laboratory—just think about how much more emotional you felt on days your 401(k) account declined by 2 percent, as opposed to the days it grew by that amount. People also have a strong herd mentality. There’s real comfort in conforming with what everyone else is doing, and, even if it’s the wrong choice, you’ll be in good company. If you’ve ever been in a situation in which others were panicking, you know how hard it is to keep your own wits about you. Finally, and despite the constant focus on “change” in the recent presidential election, when push comes to shove, humans generally stick with the status quo. Inertia is a powerful force, which helps explain why employees change their 401(k) plan investments infrequently, if at all, and why folks tend to use the recent past to predict the future. On that basis, if house prices have been going up lately, they should continue rising indefinitely—unless, as it has turned out, they don’t. The Homer Simpson in us is most likely to overpower our inner Mr. Spock when we face issues about which we have little experi- ence, information, or feedback. For many employees, this precisely describes their decision making in regard to retirement planning, sav- ing, investing, and medical coverage. Even smart and well-educated employees generally do not necessarily have the time or knowledge needed to make decisions that are in their best interests. Important benefits decisions are made infrequently—open enrollment only comes once a year, and most people only retire once a lifetime, and there is little feedback available to make mid-course corrections. When you ask these overly optimistic, loss-averse, status quo - oriented, busy workers to make complex financial decisions, it can result in some poor choices being made. The authors of Nudge argue that some simple changes in what they call the “architecture of choice”—reframing how alternatives are presented—can help employees make better savings, investment, health, and other coverage decisions, without Big Brother’s choosing for them. The authors point to the typical school cafeteria (which is, after all, similar to a cafeteria plan) where the placement of various foods—whether at eye level, at the beginning or end of the line, and so forth—dramatically affects what ends up on students’ trays. Proper placement can, without in any manner limiting kids’ options, make it much more likely they will opt to take fruit and milk as opposed to soda and Ring Dings. BENEFITS LAW JOURNAL 2 VOL. 22, NO. 1, SPRING 2009
From the Editor The same principles can be applied to adults faced with decisions about how much of their earnings to set aside in savings, where to invest, which health plan option to select, how much life insurance to sign up for, and when to schedule retirement plan withdrawals. The authors persuasively demonstrate how, as with cafeteria food selections, even small changes in the manner benefits programs are presented can gently “nudge” employees to make smarter choices. To see how benefits programs can be tweaked to significantly improve participants’ elections, take a typical 401(k) plan which allows employees to contribute up to 60 percent of pay with a 100 percent match of the first 3 percent contributed and 50 percent of the next 2 percent. If employees are encouraged to contribute 5 percent of pay to get the free match, a certain percentage will get the message and contribute 5 percent. But if the employer instead urges employ- ees to contribute 5 percent so they don’t lose the company match, the loss aversion instinct will kick in and many more folks will decide to contribute 5 percent. Of course, including an auto-enrollment feature, whether at 3 per- cent, 4 percent, or more, would be a powerful nudge. One issue with auto-enrollment is that many participants view the default rate as the optimum contribution level carrying the expert’s seal of approval. That’s why it’s crucial to not set the default rate too low and to use auto-escalation to nudge employees to higher savings rates. Another technique would be informing employees (if true) that “most of your fellow employees contribute at least 6 percent of pay.” Herd mentality will push more employees to contribute 6 percent or even more, given their “I’m above average” instinct. Even some- thing as simple as reversing the order—saying, “You can contribute as much as 60 percent or as little as 1 percent—would nudge some participants to contribute more. The reason is that generally the first number presented has “framed” the employee’s starting thought proc- ess at 60 percent, not 1 percent. To create the maximum nudge, the employer could say something like, “If you do nothing, you will automatically save 3 percent, but you need to contribute at least 5 percent so you don’t lose the com- pany match. But, you should know that most of our employees do even better and save at least 6 percent of their pay.” Another way of encouraging higher 401(k) contributions is to create new reasons for employees to save more. Over two decades of expe- rience with 401(k) plans has shown that for many participants, the obvious benefits of having a more secure financial future are not suf- ficient to result in saving money in a retirement program. Retirement is just too far away to compete with the immediate rewards of a new car or even a night on the town. Gimmicks such as giving a can of cat food to employees who aren’t saving enough so they can “get used to BENEFITS LAW JOURNAL 3 VOL. 22, NO. 1, SPRING 2009
From the Editor their retirement diet” generally may not be effective. But that choice could be reframed to appeal to a spendthrift: “If you save an extra 2 percent of pay, you’ll have enough money to drive a nice car and eat out more often when you’re ready to retire.” That’s the kind of feedback a Homer Simpson needs to resist the impulse to spend instead of save. A similar message can help discourage plan with- drawals: “If you leave that $5,000 in the plan until you’re 65 and earn a 6 percent return, you’ll have enough money for a three-week luxury cruise to the tropics. Nudge shows that there is no such thing as a “neutral” design. One option has to be listed first on the election form, and there has to be a default option, even if it’s nonparticipation. When designing a benefits program, the choice architect must first figure out what the average employee would most likely choose if the logical, thinking part of his or her brain were in control, and nudge employees in that direction. That might include making the likely preferred choice the default option, providing prompt feedback and incentives for sound choices, keeping the choices simple, and finding ways to gently steer employees in the correct direction. I recommend reading at least enough of Nudge to understand more about the inner workings of the human mind that, with a gentle nudge, can lead employees to make wise choices. David E. Morse Editor-in-Chief K & L Gates LLP New York, NY Reprinted from Benefits Law Journal Spring 2009, Volume 22, Number 1, pages 1-4, with permission from Aspen Publishers, Inc., Wolters Kluwer Law & Business, New York, NY, 1-800-638-8437, www.aspenpublishers.com BENEFITS LAW JOURNAL 4 VOL. 22, NO. 1, SPRING 2009
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