[MUSIC] Last on the countdown, power of defaults. What do I mean by the power of defaults? Well, it's really been one of the biggest changes in the pension plan design landscape in the last decade, so it's a great way to guide participants to reasonable investment decisions and overcome behavioral biases, while still allowing people choice if they really want to make that choice. So people can kind of have the best of both worlds, let me be guided into a reasonable choice, but I know that I can always kind of change it if I want to later. The evidence is based on inertia, people generally don't undo the initial default, okay? Again, this can be good or bad, the key question that then comes up, very important to select the appropriate default outcome. There's then questions about paternalism, right? What are the incentives of the people that are setting up the default policy, okay? So that raises a whole another can of worms, the bottom line is, the default you set has big influence on behavior, that can then, like anything else, be good or bad. If people are set on a glide path for a great investment outcome, then good to have that as a default. If they're set on a too conservative investment path, not so good, okay? So let's look at one of the fundamental studies here that had a great effect on the retirement plan laid landscape done by Brigitte Madrian and Dennis Shea in 2001. They looked at data of one Fortune 500 company, it was in the health care and insurance industry, that had a change in their default policy, okay? So, it used to be, the default was, you are not in the retirement savings plan unless you sign a form to get in it, or click something on the internet to get in it. When that was the case, you see very low participation rates here. So for example, across all these different kind of demographics, gender, racial groups, age, you see participation rates all except for the very, the older people, you see participation rates south of 50%. 37% on average, particularly low participation rates among young people in this retirement plan. What happens when you make a slight change? Now the default when you join the firm is you're in the retirement plan. You can simply sign a form to get out of it, or go to the Internet, click a few buttons and you're out of the plan, but the default is you're in it. Now an economist would say, given it's so easy to sign up or sign out, should influence behavior, but behaviorly it has a gigantic effect because of inertia. Look at these participation rates now, they're all way north of 50% and most of them are 80 or 90%. The average participation rate in the plan when the default was you're out unless you sign to be in was 37%. When the default is you're in the plan, unless you sign a form to get out, it jumps to 86%. And particularly encouraging for policy makers who want people to start to save for retirement at an early age, look at these retirement plan participation rates among people under 40, 70, 80, 86%. Huge effect on behavior, and, by the way, when you look over time, you don't see these participation rates reversed, you don't see people, they're in the plan one year and then they drop out after that, no, these high participation rates persist and I just couldn't get it all onto one slide. You also see these impressive changes across kind of the income spectrum as well, particularly for lower income folks here, when the default is you're out of the plan, you see very low participation rates. Now when the default is you're in the plan, then participation rates are 80, 90%. Now I should mention, there's one potential caviot. If, for kind of the lower income folks, if you're liquidity constrained, and maybe you have some high debts to pay off, or what have you, maybe actually being in the plan in certain scenarios might not actually be the best for you, okay? So you'd have to kind of look at case by case, but generally, policy makers would be encouraged that we're getting people all across the income spectrum here participating in the retirement plan with just a subtle change in the default policy. A more up to date study here by Utkus and Young looking across the income spectrum, and looking at what our participation rates by the darker line when you have voluntary enrollment. So the default is you're out of the plan unless you voluntarily sign up, versus automatic enrollment, the lighter gray line, which are automatically in the plan, unless you sign a form to get out, you see among high income folks, it doesn't make that much difference, people are participating either way, but there still is a little uptick if there's a default that year in the plan. But look at for the lower income people, look at this gigantic increase in participation from kind of mid-thirties to almost 80% here. So the default's still having a dramatic effect on people's behavior here. And, I mentioned this is very influential work by Madrian and Shea, you can just see this in the time series growth in auto enrollment from 7% of plans in 1999 to almost half a plan in 2000, so talk about academic research having an effect on real world. You don't see really any better example of that then the behavioral finance issues in the retirement plan landscape and default policy is right at the top of that list. Now if you auto enroll employees in a plan, you also need to have a default contribution level and asset allocation. So you can't just say you're automatically in the plan and you're done, well they're automatically saving you need to specify how much are they saving and how are they saving. So prior to 2006, often times the default investment would be a very conservative money market fund, basically cash, which is way, is not aggressive enough, right? If people are saving for retirement, we're not saying everyone should be 100% in stocks, but being 100% in cash is not a great long term strategy. Why were firms doing that? Well they were afraid if they picked a more aggressive asset allocation, they'd run the potential of being sued, like I invest people in some stocks, if stocks go down, can they sue me next year, okay? So in 2006, there was a Pension Protection Act, that allows firms to offer balance funds, called lifecycle or target date funds as a default investment option. So a lifecycle fund, or a target date fund, that's a balance fund that has investments both in stocks and bonds, and these are nice funds in that they will change the asset mix as a person nears retirement. So as a person nears retirement, they may be getting more risk-adverse, so the financial portfolio automatically adjusts and becomes more conservative. So as a person ages, gets closer to retirement and these target-date funds, or life-cycle funds, you'll see the equity exposure go down as a person's aging and getting closer to retirement, okay? So, so far all sounds kind of great about the default as long as you have kind of reasonable things set up in the default, in terms of getting people to save, but then also Saw a reasonable allocation in that. Prior to 2006, good people are saving, but bad if they're saving everything in a money market fund, which is way too conservative. What are some potential consequences of automatic enrollment? Well, there's research that I've done with some co-authors, Jeff Brown and Andy Farrell, looking at some of the determinants and consequences of default policy in the context of something near and dear to University of Illinois employees' hearts, the participation and the choice of the state university retirement system pension plan. So in Illinois, for our retirement plan, we can pick among three different plans, Self-Managed DC plan, Self-Managed Defined Contribution plan, kind of like a 401K plan, Traditional Defined Benefit plan, kind of your traditional, you retire, the benefit you get is based on a formula that factors in years of service and final average salary, and then this Portable Defined Benefit plan. Now the key thing is if you make no choice within six months of being hired, you are automatically defaulted in the Traditional Defined Benefit plan, and this is an irrevocable decision, you can't go back and change it. Even if you leave the University of Illinois, then come back, you're still stuck in that same original pension plan choice, so this is a big choice that you can't revisit. So we find one of the strong predictors of people defaulting is simply, are you a procrastinator? And we're able to measure procrastination tendencies by looking at the psychology literature, taking questions and putting them in a survey that are meant to measure your tendency to be a procrastinator, and we find people who are likely to be procrastinators, by the way they answered these questions, are more likely to default. Kind of makes sense, people who put things off are more likely to miss the six month deadline, and then are automatically defaulted into this Traditional Defined Benefit plan, which probably isn't the best choice for people who like to be aggressive in investing, or people who maybe have a short term horizon at the university, or people who are concerned about state government risk, which, given you're from Illinois, come on, don't need to say anything more about that. We also find that people that were defaulted in the traditional DB plan are also less likely to hypothetically choose the same plan today than if they made an active choice, okay? And this is especially true among procrastinators, so we're able to do a survey, we can see what people selected when they joined the university, we ask them today, what plan would you pick today? Those that were defaulted into the Traditional Defined Benefit plan were more likely to say, I would pick something else, and this was particularly true among procrastinators. Okay, so let's look at kind of some of the numbers to back up that conclusion. So we asked people based on kind of what plan they were in, were you in the Traditional Defined Benefit plan and had been defaulted into that? Did you make an active choice of plan? You know, any of the three plans. And we just simply ask them, what plan would you pick today? 60% of those that were defaulted into the Traditional plan would say, I want a different plan or don't know. I would pick a different plan today or I don't know. Only 40% said yes, I'd like to to be in the Traditional Defined Benefit plan. When you look among all those who actively made a choice, they didn't default, they made a choice, only about 40% say they'd want a different plan or don't know, 60% would pick the same plan. Now what's interesting is do the comparison of those who picked the Traditional Defined Benefit plan versus those that were defaulted in it? So that's kind of the first bar versus the third, and again you see this big kind of difference here. Those that were defaulted into their Traditional Defined Benefit plan are more likely to kind of want to be in a different plan or don't know if they're happy with their current plan. A much higher fraction, a much higher dark bar than if you look at those that actively picked to be in the Traditional Defined Benefit plan, those folks are much more happy with their choice. Another question here is, would you strongly desire to be in a different plan if you were making the choice today? Among those that were defaulted into the Traditional Defined Benefit plan, that was about one out of six people, or 17, a little over 16%, among those who made an active choice of their plan, they weren't defaulted, this was less than half of that, only 8%. And among those who were in the Traditional Defined Benefit plan, you might say, given concern about government finances in Illinois, everyone in the Defined Benefit plan is concerned with the choice. Well, that turns out it's not the case, those that were defaulted into that plan, maybe because they were procrastinators and this plan really isn't right for them, they're, again, about twice as likely to say, I strongly want to be in a different plan than those that are also on the Traditional Defined Benefit plan, but were, kind of made that active choice. So the bottom line is, you should always have a concern about using a default policy when you have a heterogeneous population, an irrevocable decision. So this kind of analysis here pointing out some of the potential downsides of defaults when you have an environment where you have a lot of different people with different preferences, and it's a one time, one shot choice that can't be revisited later, they're the defaults, you have to be more careful with them. Maybe you should think about trying to force people to make an active choice somehow. This discussion actually foreshadows our faculty focus interview we'll be doing with Dean Jeff Brown later in module two when we talk about the annuitization decision, the decision to convert a stock of wealth into a flow of annuity payments. There that also is going to pretty much have a one-shot deal, like once you buy the annuity, you can't really back out of it very easily, and we can think about does it make sense to have defaults for the annuitization process as well. So always trying to provide this foreshadowing of coming attractions here in this course here. So wrapping up power of defaults, just like we had at the beginning, but worth mentioning again, one of the biggest changes in the pension plan design over the last decade has been this using the default that you're in the plan as opposed to out of it. It's a great way to guide participants to reasonable investment decisions and to help them overcome behavioral biases, while at the same time still allowing choice to the people who really want it. The bottom line is, these defaults are very important because of inertia, people rarely undo the default. So that raises a question with potential paternalism, a lot of responsibilities going to those that picked the default outcome, because that's going to influence behavior dramatically because of inertia. And you always want to think about, what are the incentives of the people who are setting the default allocation? What do they have in the back of their minds? So, defaults, big impact on behavior, inertia makes that so, think about what are the incentives of the people who are setting up the defaults, given they know they can guide behavior, are they trying to guide it in a certain direction? [NOISE]
