Today's American workers are being forced to shoulder a much higher level of responsibility regarding their retirement finances than past generations.
With Social Security projections showing significant shortfalls relative to promised benefits, and with most private businesses having switched away from offering traditional pensions and toward employee-driven 401(k)-style plans, two legs of the traditional "three-legged stool" of retirement income look a bit wobbly.
If Social Security and a traditional pension aren't going to carry as much weight for the next generation of retirees, personal savings will have to take up the slack.
That is a troubling prospect, given the well-documented struggles Americans have saving money. Workers know they should be saving — some surveys indicate two-thirds of 401(k) participants believe their savings rate is too low. Unfortunately, good intentions aren't enough — procrastination and a lack of willpower are tough obstacles for many would-be savers to overcome.
In recent years, a new wave of economists has been studying these "behavioral" obstacles to sound financial decision-making. One pair of these behavioral economists decided to tackle the problem of trying to get people to contribute more to their own retirement plans. Their findings can be applied as a blueprint for almost any would-be saver or investor.
These economists, Richard Thaler of the University of Chicago and Shlomo Benartzi of UCLA, created a plan they named Save More Tomorrow — or SMarT, for short. Their stated goal: helping those who want to save, but lack the willpower to act on this desire.
The SMarT plan involves four simple steps to boost 401(k) savings rates:
1. A considerable time before the next scheduled raise, an employee is asked to agree to increase his or her contribution rate when the next raise takes effect. By doing this, the decision carries no immediate financial ramifications.
2. If the employee agrees, the contributions are increased beginning with the first paycheck after their next raise. This generally allows the worker to still see an increase in take-home pay from the raise, while also boosting his or her retirement plan contribution rate.
3. The employee's contribution rate continues to increase with each future raise until it reaches a preset maximum. This takes advantage of inertia — the scheduled increases happen automatically — instead of inertia working against the employee.
4. The employee can opt out of the plan at any time. Of course, the hope is the employee won't, and relatively few do. But having that escape hatch is a key ingredient to getting employees to sign up in the first place.
That's it. Pretty simple stuff, really. But does it work?
The first implementation of the SMarT plan was at a midsize manufacturing company. First, employees were able to meet with a financial advisor who offered recommendations regarding boosting their savings rate. Not surprisingly, only 28% of employees were willing to immediately boost their savings rate. But 78% of those who weren't willing to boost their savings now were willing to increase their savings rate in the future.
The results over the next four years were stunning. On average, those who did not join the SMarT plan saw their average contribution rate stay more or less unchanged. But the SMarT group raised its average contribution rate all the way from 3.5% to 13.6% — almost quadrupling their savings rate in only four years! (This wasn't due to large raises either — annual raises averaged just 3.25%-3.5% during this period.)
Obviously the SMarT plan tapped into some powerful ideas. The great news is that you can implement this approach whether you work for a company that is actively promoting it or not. Here's how.
First, you need to commit to doing it. The best way to do this is to give your company's HR department detailed instructions to increase your 401(k) contribution rate beginning with the first paycheck after your next raise. Be specific — give them actual rates to use.
Here's an example of what this might look like in practice. John makes $50,000 and figures he's likely to get a 4% raise this year. John has been contributing 4% to his 401(k) plan, but wants to raise it. To follow the SMarT plan, John could tell his HR department to boost his contribution rate from 4% to 6% beginning with the first paycheck after his next raise. If John gets that 4% raise, his annual salary will rise from $50,000 to $52,000. His pay after 401(k) contributions (but before payroll taxes) will also increase, from the current $48,000 he receives with a 4% contribution rate, to the $48,880 he'll receive after bumping up to a 6% contribution rate. Best of all, his 401(k) contributions will rise from $2,000 per year to $3,120 — without John feeling any pain at all.
Remember, the SMarT plan works in part because you are putting "positive" inertia to work for you. Once you give your HR department a schedule of contribution increases, you will have to take action to stop those increases from happening. Given your good intentions to continue boosting your retirement savings, chances are you won't take that negative action once the plan is set up, unless something truly significant forces you to.
Implementing a plan like that is relatively easy for those who work for a company offering a 401(k) or other retirement plan. But what if you don't? Take heart. It will take a little more diligence to put your plan in place and make it a reality, but it can be done.
The best way for most people to proceed in this situation is to open an IRA account (or perhaps separate IRAs for you and your spouse, if you're married and plan to contribute more than the $6,000 — $7,000 for people 55 and older — allowed into one IRA each year). See Making Sense of Your IRA Options, the cover article in SMI's March 2019 issue, for details on choosing the best type of IRA.
This next step is crucial — set up an automatic deduction plan to move money from your checking account to your IRA with each paycheck, or at least monthly. This is usually as easy as filling out a form provided by your IRA custodian, (if it isn't part of the actual IRA application itself). By setting up this automatic deduction, you're simulating and automating the regular, periodic investing of a company-provided plan. In other words, you're making your IRA work like a 401(k).
Next, you need to write down your schedule of future contribution rate increases. And lastly, since you don't have an HR department to deliver these instructions to, recruit a trusted friend to fill this role. Explain exactly what you're doing and why, and ask your friend to hold you accountable to follow through as you receive each subsequent raise. Then give your friend a copy of your contribution schedule. This accountability will greatly improve your likelihood of sticking with the program.
Ideally, you will start contributing to the IRA right away. But even if you can't afford to start your contributions to the IRA right now, you should still open the IRA account. Fill out the form to establish the automated investment plan (just don't send it in yet). Write down exactly what percentage of your income you will begin contributing to the IRA when you get your next raise (as well as the percentages you will increase your contribution to when you get your next two raises after that). In other words, do everything possible to make the path of least resistance the positive path of boosting your savings amount, rather than the negative path of simply boosting your spending each time you get a raise.
Setting up your own "self-directed" SMarT plan may not be as fool-proof as having your instructions delivered and on file with your company's HR department. But be realistic — you've got to work with what you've got. The SMarT plan doesn't guarantee success, and it will require a little self-control to make it work. But by eliminating common mental obstacles to saving, it's a significant improvement over merely hoping your good intentions will someday lead to action.
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