Opinions November 10, 2021

Using Nudges to Improve Employee Decisionmaking

Indirect, tactical ways to move employees to make the best retirement savings decisions can help overcome behavioral biases.

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We have all heard the drumbeat on automation in defined contribution (DC) plans. However, automation has its limits.

It may result in short-term changes, but it does not necessarily improve overall financial wellness or change the nature of participants with respect to being spenders versus savers. To make bigger, longer-term changes, plan sponsors should consider using nudges.

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Nudges are a powerful tool that can be used to overcome cognitive errors or biases, influence employees’ behaviors and guide them to achieve their financial goals. Examples of cognitive biases are:

  • Status quo bias: People tend to stick with what they know or what they’re used to doing;
  • Heuristics (shortcuts): People have an impulse to simplify and seek to make decisions easily;
  • Herding: People tend to gravitate toward what others are doing, rather than being guided by their own instincts;
  • Choice overload: People often feel paralyzed when confronted with too much information at once;
  • Confirmation bias: People tend to believe or listen more carefully to information or beliefs they already agree with; and
  • Overconfidence bias: People tend to overestimate their own skills and ability and do not gauge the true risk of something.

We need nudges to counteract these cognitive biases to get people “unstuck” from bad decisionmaking practices and encourage them to go in the right direction. 

What Is a Nudge and Why Does It Work?

First widely popularized by Richard Thaler and Cass Sunstein and discussed in the 2008 book, “Nudge,” a “nudge” is an invisible hand that pushes someone toward a “better” decision. It uses behavioral biases to encourage cooperation and positive decisionmaking. Structurally, how choices are designed impacts how people make decisions. Nudge methods are indirect, tactical and not confrontational ways to structure choices with biases in mind.  

Nudges work because they leverage the three most powerful cognitive behavioral forces:

  • Trust: This is the foundation for all decisionmaking;
  • Loss aversion: This is the behavioral tendency in which people feel a loss more acutely than a gain of the same amount. People are generally more motivated to avoid losses than to achieve gains; and
  • Regret aversion: People generally dislike regret and work hard to avoid it. Individuals often tend to overweight small possibilities, which can lead to suboptimal choices.

The Power of Framing

Some nudges work through the power of framing, using choice architecture (i.e., how choices are presented to employees). There are ways to design the structure of choices with the goal of influencing decisions in a positive way. This framing is not threatening or disruptive, nor is it forcing employees; rather, it is pushing them in the “right” direction. Using the right framing can make employees’ cognitive challenges work for them, rather than against them.

Calculative versus intuitive thinking: Framing can also help with calculative versus intuitive thinking. Calculative thinking is more analytical, while intuitive thinking is quicker and often means going with one’s first instinct. We often see enrollment packages use calculative perspectives—showing lists of deferral rates and what employees could accumulate over time. Intuitive thinking, on the other hand, is more prevalent, can be highly risk-aware and is more automatic. Intuitive framing could use images to tell a story that will resonate quickly with employees.

Overconfidence: Overconfidence can also be managed with framing. Overconfidence is typically seen more among men than women, and framing can help to offset it and push people to understand their limits and the risks or consequences of their actions.

Hyperbolic discounting: Framing around the timing of decisions can help to address hyperbolic discounting, a bias where people tend to choose immediate gratification today, but plan to make better choices in the future. To overcome short-term gratification, we ask people to make decisions today about future behavior improvements.

Fear Versus Encouragement

DCIIA’s Retirement Research Center (RRC) recently studied framing and its effect on intended engagement in DC plans. The RRC report showed different types of messages to workers, with the same general content. Half were shown an encouraging message (“Great News! You’re on track”). The other half were shown a warning message (“Caution! We project you’re going to have a shortfall”).

The results illustrated that the cautionary message increased intended engagement slightly more than the encouraging message. The study’s implications were that both types of framing should be used to make sure we are getting the maximum impact on engagement through communications.

Enhanced Active Choice

Many plan sponsors are concerned that participants don’t understand the consequences of their choices. To combat this problem, enhanced active choice is predicated on creating a greater level of awareness of the consequences of choices. When potential outcomes are clear, people are more likely to make decisions that result in positive outcomes.

As researchers noted in a 2011 paper, “Enhanced Active Choice: A New Method to Motivate Behavior Change,” “Enhanced active choice may enhance self-efficacy or confidence that one can actually undertake the advocated behavior. Actively choosing may also produce higher levels of perceived responsibility and satisfaction than opt-out where control or choice is implicit and this may lead to longer-term rates of ongoing adherence.”

Conclusion

Strategies such as automatic enrollment and escalation, as well as target-date funds (TDFs) and managed accounts, have become embedded in defined contribution plans. However, as DC plans continue to evolve, all employee touchpoints can be evaluated and possibly enhanced by using nudges to further guide and improve decisionmaking.

The goal is to employ techniques that improve outcomes as well as help people become better decisionmakers.

Warren Cormier is executive director of the Defined Contribution Institutional Investment Association (DCIIA) Retirement Research Center. Pam Hess, Chartered Financial Analyst (CFA), is vice president of research and member engagement, DCIIA Retirement Research Center.

This feature is to provide general information only, does not constitute legal or tax advice and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services Inc. (ISS) or its affiliates.

Data and Research November 10, 2021

Rebounding Markets Give DB Plan Funded Status a Boost in October

Improved funded status and a potential interest rate hike ahead signal a time for rebalancing and de-risking for corporate defined benefit plan sponsors.

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“Pension plans will generally see their funded status improve as higher liabilities are offset by stronger equity returns,” River and Mercantile says in its “US Pension Briefing – October 2021.”

Michael Clark, managing director in River and Mercantile’s Denver office, explains that the yield curve began to flatten out in October with the short end of the curve increasing and the long end coming down. He says this is an indication of the market view that the Federal Reserve will begin raising interest rates in 2022, along with an expectation that recent increases in inflation will subside.

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“What should pension plan sponsors look at with year-end in sight?” Clark asks. “Continue to watch market expectations on timing of the Fed rate increases, which will be affected primarily by unemployment, wage growth and the persistence of inflation relative to expectations. These will be the key drivers of where discount rates end up on December 31.”

Insight Investment says defined benefit (DB) plan funded status improved 1.5 percentage points to 94.6% in October. Assets increased by 2.3% and liabilities increased by 0.6%. “As the end of the fiscal year approaches for many plan sponsors, we may see this increase in funded status spur more discussions on de-risking and end-state objectives,” says Sweta Vaidya, North American head of solution design at Insight Investment.

The aggregate funded ratio for U.S. corporate DB plans sponsored by S&P 500 companies increased by an estimated 1.1 percentage points month-over-month in October to end the month at 94%, according to Wilshire.

The monthly change in funding resulted from a 2.3% increase in asset values partially offset by a 1% increase in liability values. The aggregate funded ratio is estimated to have increased by 6.2 and 11.3 percentage points year-to-date and over the trailing 12 months, respectively.

“October’s funded ratio increase nearly reversed all of September’s decline, driven by the monthly increase in nearly all asset classes led by U.S. equities,” says Ned McGuire, managing director, Wilshire.

According to Northern Trust Asset Management (NTAM), the average funded ratios for S&P 500 plans improved in October from 93.8% to 95.2%. Global equity market returns were up approximately 5.1% during the month. The average discount rate decreased from 2.56% to 2.46% during the month, leading to higher liabilities.

Funded Status Improvement by Plan Stage

Industry estimates show differences in funded status improvements based on a DB plan’s lifecycle and investments.

LGIM America estimates that pension funding ratios overall increased approximately 2% throughout October, primarily due to robust global equity performance. According to its October “Pension Solutions Monitor,” the firm’s calculations indicate the discount rate’s Treasury component declined 4 basis points (bps) while the credit component was relatively unchanged, resulting in a net decrease of 4 bps. Overall, liabilities for the average plan increased 0.8%, while plan assets with a traditional 60/40 asset allocation rose by approximately 3.1%.

In its “Pension Monitor,” NEPC says total-return plans with larger equity allocations and more intermediate-duration fixed income likely experienced a smaller improvement in funded status relative to liability-driven investing (LDI)-focused peers that hold longer-duration assets. Based on NEPC’s hypothetical open- and frozen-pension plans, the funded status of the total-return plan increased 1.5%, while the LDI-focused plan improved 2.5% last month.

“October provided a positive environment for pensions sponsors, as both equity markets and long-duration fixed income had positive returns. All investors should consider rebalancing as a risk management tool,” NEPC says. “With rates showing more volatility, plan sponsors should track their plan’s funded status to maintain desired hedge ratios and monitor LDI glide path triggers. NEPC maintains its recommendation to adhere to plan hedge ratios and long-term strategic target allocations.”

Both model plans October Three tracks improved last month. Plan A gained 2% in October and is now ahead more than 11% for the year, while the more conservative Plan B gained 1% last month and is now 3% up through the first 10 months of 2021. Plan A is a traditional plan (duration 12 at 5.5%) with a 60/40 asset allocation, while Plan B is a largely retired plan (duration 9 at 5.5%) with a 20/80 allocation and a greater emphasis on corporate and long-duration bonds.

Brian Donohue, a partner at October Three Consulting in Chicago, notes that pension funding relief was signed into law during March. “The new law substantially relaxes funding requirements over the next several years, providing welcome breathing room for beleaguered pension sponsors,” he says.

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