The human mind is an amazing thing, but it’s certainly not infallible. Sometimes assumptions, misconceptions and biases shape our decisions in ways that run counter to our best interests.
A few months ago, I joined a couple of my colleagues for a fascinating conversation about the cognitive biases that shape our financial decisions, and specifically those related to saving for retirement. By recognizing these biases and actively working to overcome them, you have the power to affect your financial outcomes.
Default bias
In recent years, many employers have begun automatically enrolling their employees into the 401(k) plan. This is a great way to kick-start retirement savings, helping workers to push past the inertia that might have kept them from joining the plan on their own. However, this setup often leads people to assume, incorrectly, that the savings rate their employer picks for them during automatic enrollment will be enough to meet their retirement savings needs.
A recent survey of 401(k) participants found that a third of those who were auto-enrolled in their employer’s 401(k) plan have never increased their savings rate. You’d be wise to follow the example of the 47% of total respondents who have gradually increased their contribution level in the past two years.
When companies use automatic enrollment, many start people out at a 3% savings rate as the default. This is a place to start, but for most of us, that’s not going to get us to the retirement that we want. Recognizing that defaults are a starting point, it’s important to do your homework and make sure that your contribution level will ultimately help you meet your retirement savings goals.
Status quo bias
After enrolling, most people don’t spend a lot of time thinking about ways to monitor their 401(k) until it’s time to change jobs, thinking things are fine as they are. This is known as status quo bias. This bias creates a sort of paralysis, because sticking with what you have is easier than taking action. Even though there are so many things you could do, often times you end up doing nothing, which means you passively accept what might be a suboptimal situation.
Thinking about this concept in terms of retirement can remind all of us how important it is to regularly monitor our 401(k) plans to make sure they still align with our financial targets. According to that same survey, a large portion of those who were auto-enrolled into their 401(k) plan (44%) have never changed their investment choices, showing the power of the status quo bias.
Instead of taking a “set it and forget it” approach to your 401(k), perform some regular maintenance. You may need to rebalance periodically to make sure your asset allocation — the mix of investments in your account — is still on track, assuming that isn’t done for you automatically.
Again, you should consider increasing your savings rate at regular intervals — such as every year on your enrollment anniversary, or when you get a raise — if your plan doesn’t automatically increase your savings rate for you. Finally, if you were defaulted into a target-date fund, look into whether your plan offers personalized advice or a managed account service, which can help you arrive at a more tailored investment mix to get you closer to meeting your individual goals.
Round number bias
A third stumbling block is people’s natural preference for round numbers. This bias shows up in retirement planning because people often choose 401(k) savings rates in multiples of 5%, which might keep them from making smaller increases at more regular intervals. For example, you might be at 5% now, but don’t stay there because you can’t afford to go to 10%. Even a bump from 5% to 6% is an improvement, and every little bit helps.
Present bias
Humans have a pesky inclination to value immediate rewards over future gains, a concept known as present bias. If you feel disconnected from your future self and have trouble conceptualizing your retirement, it may be hard to justify reigning in your spending now to save for a far-off, abstract period in your life.
But this bias can ultimately lead to regret. Another survey showed that two-thirds of 401(k) participants wish they had spent less in the past to save more for retirement, particularly on meals out, expensive clothing, new cars and vacations.
An effective way to overcome this bias — as silly as it might seem at first blush — is to imagine your future self and then ask your present self what you are doing for him or her. In terms of concrete next steps, you can make it a priority to learn about your 401(k) plan’s options.
Next, and at the very least, increase your savings rate so you’re taking advantage of all matching dollars offered by your employer. And again, increase your savings rate beyond that level and at regular intervals. It’s also important to make sure the investments in your account are diversified and not concentrated too much in any one sector or asset class. As previously noted, you’ll want to rebalance on an ongoing basis so your asset mix stays in line with your risk tolerance in each phase of your life. Most plans offer help in these areas, so don’t be afraid to ask.
Of course, when our brains are working at cross-purposes with our goals, it can be helpful to get another opinion. In the case of retirement planning, ask a professional. Financial advice is available through many 401(k) plans or your company’s broader financial wellness resources. Our experience shows that people tend to take action after receiving 401(k) investment advice, and their confidence also increases.
As they say, “We don’t know what we don’t know.” But now that you’re aware of some of the biases that may be holding you back from a comfortable retirement, you can begin to take proactive steps to overcome them and take more control over your financial future.
Catherine Golladay is chief operating officer of Schwab Retirement Plan Services.
12019 401(k) Participant Survey conducted by Logica Research for Schwab Retirement Plan Services, Inc. Logica Research is not affiliated with Schwab Retirement Plan Services, Inc.
22018 401(k) Participant Survey conducted by Logica Research for Schwab Retirement Plan Services, Inc. Logica Research is not affiliated with Schwab Retirement Plan Services, Inc.
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