The Importance of Default Options for Retirement Saving Outcomes

This paper summarizes the empirical evidence on how defaults impact retirement savings outcomes. After outlining the salient features of the various sources of retirement income in the U.S., the paper presents the empirical evidence on how defaults impact retirement savings outcomes at all stages of the savings lifecycle, including savings plan participation, savings rates, asset allocation, and post-retirement savings distributions. The paper then discusses why defaults have such a tremendous impact on savings outcomes. The paper concludes with a discussion of the role of public policy towards retirement saving when defaults matter. John Beshears Department of Economics Harvard University Littauer Center Cambridge, MA 02138 beshears@fas.harvard.edu James J. Choi Yale School of Management 135 Prospect Street P.O. Box 208200 New Haven, CT 06520-8200 james.choi@yale.edu David Laibson Department of Economics Harvard University Littauer Center Cambridge, MA 02138 dlaibson@harvard.edu Brigitte C. Madrian Kennedy School of Government Harvard University 79 JFK Street Cambridge, MA 02138 Brigitte_Madrian@harvard.edu If transaction costs are small, standard economic theory would suggest that defaults should have little impact on economic outcomes. Agents with well-defined preferences will opt out of any default that does not maximize their utility, regardless of the nature of the default. In practice, however, defaults can have quite sizeable effects on economic outcomes. Recent research has highlighted the important role that defaults play in a wide range of settings: organ donation decisions (Johnson and Goldstein 2003, Abadie and Gay 2004), car insurance plan choices (Johnson et al. 1993), car option purchases (Park, Jun, and McInnis 2000), and consent to receive e-mail marketing (Johnson, Bellman, and Lohse 2003). This paper summarizes the empirical evidence on defaults in another economically important domain: savings outcomes. The evidence strongly suggests that defaults impact savings outcomes at every step along the way. To understand how defaults affect retirement savings outcomes, one must first understand the relevant institutions. Because the empirical literature on how defaults shape retirement savings outcomes focuses mostly on the United States, we begin by describing the different types of retirement income institutions in the United States and some of their salient characteristics. We then present empirical evidence from the United States and other countries, including Chile, Mexico and Sweden, on how defaults influence retirement savings outcomes at all stages of the savings lifecycle, including savings plan participation, savings rates, asset allocation, and post-retirement savings distributions. Next we examine why defaults have such a tremendous impact on savings outcomes. And finally, we consider the role of public policy towards retirement saving when defaults matter. I. Retirement income institutions in the United States There are four primary sources of retirement income for individuals in the United States: (1) social security payments from the government, (2) traditional employer-sponsored definedbenefit pension plans, (3) employer-sponsored defined-contribution savings plans, and (4) individual savings accounts that are tied neither to the government nor to private employers. We will briefly describe each of these institutions in turn. See the Employee Benefit Research Institute (2005) for a more detailed discussion of the U.S. retirement income system. The social security system in the United States provides retirement income to qualified workers and their spouses. While employed, workers and their firms make mandatory contributions to the social security system. Individuals are eligible to claim benefits when they reach age 62, although benefit amounts are higher if individuals postpone their receipt until a later age. Individuals must proactively enroll to begin receiving social security benefits, and most individuals do so no later than age 65. The level of benefits is primarily determined by either an individual’s own or his or her spouse’s earnings history, with higher earnings corresponding to greater monthly benefit amounts according to a progressive benefits formula. Benefits are also indexed to the cost of living and tend to increase over time because of this. They are paid until an individual dies, with a reduced benefit going to a surviving spouse until his or her death. On average, social security replaces about 40 percent of pre-retirement income, although this varies widely across individuals. Replacement rates tend to be negatively related to income due to the progressive structure of the benefits formula. Benefits are largely funded on a pay-asyou-go basis, with the contributions of workers and firms made today going to pay the benefits of currently retired individuals who worked and paid contributions in the past. There is no private account component to the U.S. social security system, although this is something that has received a great deal of discussion in recent years. Traditionally the second largest component of retirement income has come from employer-sponsored defined-benefit pension plans. These plans share many similarities with the social security system. Benefits are determined by a formula, usually linked to a worker’s compensation, age, and tenure. Benefits are usually paid out as a life annuity, or in the case of married individuals as a joint-and-survivor annuity, although workers do have some flexibility in selecting the type of annuity or in opting instead for a lump sum payout. Because traditional defined-benefit pension plans are costly for employers to administer and because they impose funding risk on employers, there has been a movement over the past two decades away from traditional pensions and towards defined-contribution savings plans. There are now more than twice as many active participants in employer-sponsored definedcontribution savings plans as in defined-benefit pension plans, with total assets in defined contribution plans exceeding those in defined benefit plans by more than 10 percent (U.S. Department of Labor 2005). These defined-contribution savings plans come in several different varieties. The most common one, the 401(k), is named after the section of the U.S. tax code that regulates these types of plans. The typical defined-contribution savings plan allows employees to make elective pre-tax contributions to an account over which the employee retains investment control. Many employers also provide matching contributions up to a certain level of employee contributions. The retirement income ultimately derived by the retirees depends on how much they elected to save while working, how generous the employer match was, and the performance of their selected investment portfolios. At retirement, benefits are usually paid in the form of a lump-sum distribution, although some employers offer the option of purchasing an annuity. Relative to traditional defined-benefit pension plans, defined-contribution savings plans impose substantially more risk on individuals while reducing the risks faced by employers. The final significant source of retirement income comes from personal savings accounts that are not tied to an employer (or the government). There are many different ways that individuals can save on their own for retirement, but one particular vehicle, the IRA (for Individual Retirement Account), is very popular because it receives favorable tax treatment. After IRAs were first created, the primary source of funding came from direct individual contributions. Over time, however, restrictions have been placed on the ability of higher-income individuals to make direct tax-favored contributions, and the primary source of IRA funding has shifted to rollovers—transfers of assets from a former employer’s defined-contribution savings plan into an IRA. In general, individuals employed at a firm with a defined-contribution savings plan that has an employer match would find that savings plan more attractive than directly contributing to an IRA. Direct IRA contributions largely come from individuals whose employers do not sponsor a defined-contribution savings plan, individuals who are not eligible for their employer’s savings plan, or individuals who are not working. The relatively low social security replacement rate (compared to other developed countries) in conjunction with the recent shift towards defined-contribution savings plans and IRAs in the United States has spurred much of the research interest into how defaults and other plan design parameters affect savings outcomes. With individuals bearing greater responsibility for ensuring their own retirement income security, understanding how to improve their savings outcomes has become an important issue both for individuals themselves and for society at large. II. The impact of defaults on retirement savings outcomes: Empirical evidence We now turn to the evidence on how defaults affect retirement savings outcomes, discussing first the effect of institutionally specified defaults, then ‘elective’ defaults— mechanisms that are not a pure default, but that share similar characteristics with the institutionally chosen defaults, in terms both of their structure and of their outcomes. A. Savings plan participation In a defined-contribution savings environment, savings plans—whether they are employer-sponsored, government-sponsored, or privately sponsored—are only a useful tool to the extent that employees actually participate. Recent research suggests that when it comes to savings plan participation, the key behavioral question is not whether or not individuals participate in a savings plan, but rather how long it takes before they actually sign up. The most compelling evidence on the impact of defaults on savings outcomes comes from changes in the default participation status of employees at firms