MARK RIEPE: Welcome to Financial Decoder, an original podcast from Charles Schwab. I’m your host, Mark Riepe. On this podcast we breakdown the cognitive and emotional biases that influence your financial decisions and offer strategies to help mitigate those biases and help improve your financial outcomes.
In the year 13 BCE, the Roman Emperor Augustus had a problem, what would he do if his army revolted? This wasn’t an idle concern. His soldiers could be rowdy and unpredictable, and there had been rebellions in the past. His solution was to prevent the revolt from ever happening by providing for his employees after they retired. If one of Augustus’s legionnaires was in active service for 16 years and in the reserves for another four years, he would receive a one-time payment worth about 12 times his annual wage. This was an extremely valuable benefit, and the soldiers did not revolt after Augustus put this plan into place. For you native Latin speakers, Augustus’s plan was called the “aerarium militare,” and it may well have been the beginning of what we call defined benefit plans.
But one problem then as now is that you have to stay with the same company long enough to be eligible for the benefits to kick in. Back then the emperor could be killed or the whole empire could be defeated, and then all those legionnaires would lose their benefits.
In the late 1980s, as traditional pensions became increasingly expensive for companies to maintain, corporate America transitioned to the 401(k) plan as the primary benefit for retirement savings. These accounts are extremely important. In fact, 88% of respondents to a recent survey by Schwab Retirement Plan Services considered the availability of a 401(k) a must have when looking for a job, ranking almost as high as health insurance. And 62% of respondents said that they expect their 401(k) account to be their largest source of income for their retirement.
So today we’ll tackle the question "What should you do with the 401(k) you already own?" You know how important it is, but you may not know just how to take care of it and help it grow. The first thing to consider is that there are a few biases that can get in the way of maximizing the benefits of these accounts. The first involves the way that defaults can nudge you into certain decisions. In fact, Nobel Prize winner and guest on the “Temptation of Now” episode of Choiceology Richard Thaler pioneered the study of how companies and governments can make small changes to rules and laws to encourage people to make better decisions. In the case of 401(k)s, participation rates were too low. Then in 2006, lawmakers, building on Thaler’s research, reformed America’s 401(k) system. The Pension Protection Act made it much easier for companies to enroll workers in a plan automatically and offer the right to opt out, rather than just asking employees to sign up for a 401(k).
It’s great that so many companies default their employees into retirement plans, but once you accept a default it can be hard to escape the status quo bias, which favors keeping things the way they are instead of making a change. That’s better than nothing, but people are different and one size can’t fit all. Status quo bias creates a sort of paralysis because sticking with what you have is easier than taking action. There are lots of things you could do, but you end up doing nothing, which means you passively accept a sub-optimal situation.
When you start a new job and your employer offers to match your contributions to your 401(k), it seems like a no-brainer to contribute at the level necessary to get the full matching funds. In fact, often people contribute at exactly that rate and no more, but the average company match is less than 5%. It would be fine to stop there if that rate were high enough to achieve retirement security, but it generally isn’t, and changing the status quo can be difficult. One study showed that when the default savings percentage was set at 2%, after four months, 74% of participants were still at that really low savings rate. After four years, 43% were still at that point. Just think about how much more you would have at retirement if the default option were to increase the savings rate by, let’s say, 1% each year until you reach the maximum allowable contribution.
Another bias to consider is present bias, which is our tendency to value future rewards less than immediate rewards. If you’ve ever tried to bargain with a child, you probably have first-hand experience with present bias. We’ll come back to this bias and explore a few others and explain how you can mitigate their effects. But first let’s talk to some experts from the world of retirement planning.
To help explain 401(k)s in more detail, I have two guests with me today. Catherine Golladay is a senior vice president at Charles Schwab, and she’s the chief operating officer for Schwab’s Retirement Plan Services. Nathan Voris is a managing director of business strategy, also with Retirement Plan Services. Welcome, Catherine and Nathan.
CATHERINE GOLLADAY: Oh, thanks so much for having us.
NATHAN VORIS: Glad to be here.
MARK: So on many episodes we suggest that awareness of a bias helps, the idea being that you can’t really fix a problem if you don’t even know one exists. My guess is that when it comes to 401(k) plans, there’s another type of awareness issue, and that is that employees don’t really fully understand their plan. Is that, in fact, a problem, as you see it?
CATHERINE: You know, Mark, that really is a problem. I think you hit the nail on the head, and that’s probably a really good place to start.
MARK: So what are the three most important things that an employee needs to know about their 401(k) plan?
NATHAN: Yeah, you can boil it down to a few things. I think the first is know what you’re saving and how you’re invested. So where do you stand today? I think the second is what are your fees? What are you paying? Is that reasonable? And then, third, is what are the resources available to you? You know, 401(k) providers and your employer are often much more than just a 401(k). And so there’s a lot of resources to help you with financial planning and all the other things that you need to get yourself on track.
MARK: So we’ve talked about in the past that using defaults to help counteract biases makes a lot of sense. Employers are starting to use defaults when it comes to 401(k) plans, and they’re automatically enrolling employees into these plans. That can be pretty powerful. So tell us a little bit more about what that means in the context of a plan.
CATHERINE: You know, there are really three typical defaults that employers use within the 401(k) plan, and the first is automatic enrollment, and the second being auto savings increase. I typically see many companies enrolling their employees at a 3% savings rate and then increasing it from there. The last thing that we see within 401(k) plans is default investment selections, and that’s typically into a target-date fund, or sometimes into a managed account solution.
MARK: So employers will automatically put the employee in, they’ll start withdrawing, say, 3% of their paycheck and put it into the account, and then it will start automatically investing it in a diversified portfolio. Is that more or less what’s happening?
CATHERINE: That’s exactly what’s happening.
MARK: This is a podcast about emotional and cognitive biases, and we tend to think about setting thoughtful defaults as a good thing, and it helps overcome decision-making errors. So is it possible that defaults can actually be a problem?
NATHAN: You know, defaults are a great place to start, but there is that bias that if you are defaulted into something, you assume that it’s the right thing for you, and that might not necessarily always be the case. You know, a 3% savings rate, that’s a great place to start, but for most of us, that’s not going to get us to the retirement that we want. You know, so recognizing that defaults are a starting point, that we also need to advocate for ourselves, do our homework, and make sure that we’re being invested and have the correct savings rate to get us, you know, to where we want to be. So that bias definitely exists. We need to evaluate those on an individual basis to really build a plan.
MARK: Yeah, so pay attention. If you’ve been defaulted into something, pay attention to that and adjust it for your own circumstances.
NATHAN: That’s exactly right.
MARK: So what do you tell that person who says, "Well, even 3%, that feels too high?" Should they even bother at all at that point?
CATHERINE: You know, what I think that they should contribute, and I think at a bare minimum, what you want to do is contribute up to the employer match. You know, the good news, though, is that we don’t see many people opting out of an automatic enrollment situation. So what I see, that is really putting inertia on your side.
MARK: So what’s your advice to the person who says that, you know, contributing up to the employer match, even that’s too high?
CATHERINE: Well, you’ve got to find a way to make it happen, right? If your employer is matching your contribution, you can think of that as 100% return on your investment. But if you can’t contribute at the match level, I would suggest that you start small, and you would time those increases perhaps with your pay raise. And if you do that, you can probably avoid that feeling of loss aversion because you haven’t seen it in the first place. That would be my advice.
MARK: Sure. Good advice. So when it comes to the investing part of the 401(k) decision, by that I mean what specific mutual funds or ETFs should the person buy—how should people approach that?
NATHAN: You can do it a few ways. One is the default investment option is typically very well diversified, either a target-date fund or the use of managed accounts. And so you’re automatically diversified right out of the gate. So that’s a great option, particularly for folks that are just starting out, or maybe they don’t have the time or desire to manage their own investments. Each 401(k) also comes with a core menu of options, some actively managed and some passively managed, that you can take the time to build your own portfolio to meet your specific needs, as well. And then they’re often, also, what’s called a brokerage window available. So if you are more of a do-it-yourself-er, or you have an advisor that’s helping you, you can use a brokerage window and really have access to almost the entire investment universe. So there’s a lot of options, depending on what’s best for you, but those target-date funds and managed accounts are a great way to start if you’re just learning how to do this.
MARK: So Nathan, you mentioned brokerage window. So what does that exactly mean, and how does a person use it?
NATHAN: A brokerage window is a great resource for folks that want to take a little bit more active role in choosing their investments and planning for their retirement. So it’s a product or a tool that really gives you access to the whole market. And so rather than just the 10 or 15 investment options that you have available to you inside your 401(k), you have the whole world of ETFs and mutual funds, and sometimes even stocks and bonds, to build your portfolio. So if you have outside assets and spouse or partner assets and you’re trying to build a holistic portfolio, often that brokerage window is a great way to do that, and just provide you with more resources and more options to invest in.
MARK: And I guess to a certain extent the investing in a 401(k) is really not that different from investing in general right? Diversification, as you mentioned, pay attention to your fees, makes sure it matches up with your situation, is that right?
NATHAN: That’s right, and that’s a great point. You can’t think about your 401(k) in a vacuum. You may have IRA assets or spouse or partner assets that you’re using to build a retirement plan, as well. So thinking about that across all of your buckets of money is very, very important. You know, you have one asset allocation, essentially. You need to make sure that that’s correct and balanced across all of your assets.
MARK: Now, in some of the reading that I was doing prior to this episode, it seems that there’s a bit of a paradox when it comes to employees and their plans. They indicate in surveys that they want help, but when employers make that help available to them, as you were just talking about, Nathan, that plenty of help is available, they don’t tend to take advantage. Is that correct, and, if so, what’s driving that behavior?
CATHERINE: You know, Mark, that’s correct, and it’s something that we see often. In fact, in a survey that we did recently, over 80% of people said that they were interested in advice, but only half would take advantage of it or thought that their situation warranted it. And I think there could be a couple things going on. One, they might be embarrassed. You know, the second thing is they might not realize all the resources that they do have. But the way I look at it, no matter what your situation is, your wealth is your wealth, so let’s work to maximize it.
MARK: So there’s really no … if someone thinks, "Well, my account balance is only $15,000." You know, so what? I mean, it’s your money, it’s a big part of your retirement, take advantage of it, right?
CATHERINE: That’s exactly right. Your employer is offering that to you, and you should take a look at it.
MARK: So one thing that makes 401(k)s so interesting is that there is such a broad set of people who have these accounts, and I’m sure there are plenty of employees who really appreciate the importance of what goes into their plan, but they just don’t have the knowledge, they just aren’t interested in obtaining that knowledge. I mean, I own a car. I understand that car maintenance is important, but, you know, I’m not about to become a mechanic, so I pay people to do that for me. So tell us a little bit more specifically how is that employee supposed to be getting that help?
CATHERINE: Well, I think the first thing that you should consider if it’s available to you is advice or managed accounts. You know, as you mentioned, if, you know, you don’t spend a lot of time with your car and the maintenance on the car. I think a lot of people feel that way about their 401(k), as well. So the first thing that I would look into is whether that solution was available and if it was right for you.
I think the second thing, and this is maybe from a broader financial wellness perspective, I find that many individuals need some help making sense of all of the competing priorities that they have. And if you’re someone that that resonates with, I’d suggest that you take a look at our Schwab Savings Fundamentals. From a real broad perspective, that can help you make some sense of "Where do I start, and how do I balance, you know, all of the things that I have going on in my life?"
MARK: So Retirement Plan Services, you’re providing services to plans, you know, over a million participants. What do you find when employees do seek that advice, what happens to them? What, after they go through that process, what are they finding beneficial?
NATHAN: I think it’s pretty simple: Advice works. When people sit down with someone and have a conversation about their 401(k), their savings rates goes up. They’re more confident about the future.
CATHERINE: You know, Nathan, it’s interesting there. When I sit and talk with folks on the phone, what I hear time and time again is "How much should I save, how do I invest it, and how much do I need in retirement?" And as you described advice solutions there, I think it answers all three of those questions, right?
NATHAN: Yeah, there are only a handful of levers to pull, right? And so getting advice on those two or three things really can have an impact.
MARK: One of the problems with the old-style defined benefit plan was that if you didn’t stay at the company long enough, you didn’t get anything from that pension plan. And in the world today, people are switching jobs all the time, and one of the nice things about the 401(k) plan is that account is actually yours, no matter what happens. You can leave it at your old employer, you can move it to your new employer, you can cash it out, or you can convert it to an Individual Retirement Account. So let’s go through each of those, and tell me the mechanics and the strengths and weaknesses of each approach. Let’s start with leaving it at your own employer. When does that make sense and how do you do it?
NATHAN: You know, it’s, there’s some paperwork involved, but I’d say, philosophically, you need to ask a couple questions, and, in fact, I just had a friend ask me this a couple weeks ago. He was coming from a Fortune 50 company, a very large 401(k) plan, very low-cost investment options and low fees, and he changed jobs to a startup company—small plan, a million-dollar plan, so higher fees, not as institutional in nature. And so, for him, it made sense to keep his money at the old 401(k) because it was a really good, really low-cost plan. So every situation is a little different there. You really have to evaluate where you are today and what your new 401(k) plan will look like, and do some research there.
MARK: So if your old plan is better, leave it alone, as opposed to moving it?
NATHAN: That’s right. That’s right. That could be … that could be a … a smart option.
MARK: So talk to me a little bit about, then, if you decide that your new employer has a better plan or you just feel better having it with your current employer, when does that make sense, and how do you go about doing that?
NATHAN: It’s pretty easy to do. You know, most employers who hire companies like Schwab to help with their plans, we all have processes and programs, online forms to fill out, and really move that money from your old 401(k) to your new 401(k) pretty seamlessly. So there is some paperwork to fill out, but it’s a pretty well-oiled machine at this point. We’ve been doing it for a long time.
MARK: What about the person who wants to just roll it over, as we sort of say in the industry, into an Individual Retirement Account? First of all, what does "rollover" mean, and then, secondly, how do you go about doing that, and when does that make sense?
CATHERINE: Right. A rollover is often a really good solution for people. When we say "rollover," what we mean is moving your 401(k) directly from your employer plan into your IRA. And, again, you know, most organizations like Schwab and others make that a very simple process. I think that could make a lot of sense if you’re looking to consolidate your retirement accounts. One of the things that we often find with people that change jobs often is they have 401(k) balances with numerous previous employers, and that can be a little bit difficult to keep track of and to make sense. The IRA can also offer you a little bit more flexibility, and depending on what investments are available in your employer plan, as Nathan talked about, the IRA might also give you just a really wide breadth of investment options to consider, as well.
NATHAN: I like the IRA option, as well, because it opens up a whole other bucket of resources to you. If you have your 401(k) at a company and you have your IRA sort of outside of that, you sort of double the amount of advice and guidance you can get by working with potentially two companies. So it’s a … I do like that diversification of thought and advice, as well.
MARK: So what about the cash-out option for people who just say, "I’m leaving, and I’m just going to take that money out, and start doing something with it, spending it, whatever"?
CATHERINE: Boy, that’s never a good idea. It is possible, though, when you leave your employer. We call that a distributable event, and you are able to cash-out your 401(k). But I think you pay a very high price when you do that. First, you’re going to pay ordinary income tax, and then the second thing, depending on your age, is you’ll have a 10% early withdraw penalty, and those can be, you know, very painful. However, if it’s a last resort and you need to use some of those funds, what I see some people doing is cashing out a very small portion of their account, what they need in the moment, and then rolling over the rest of it. So I guess that’s kind of making the best of a tough situation.
MARK: Let’s talk about other ways to get at the money in the account if you need it pre-retirement. So I think the most popular method is to take a loan. So typically, you have the option to borrow from your account. In effect, you’re borrowing from yourself. Is that a good idea?
CATHERINE: You know, a lot of people take a look at that "borrowing from yourself" and think that it’s a good idea. But in fact, I always look at it as a last resort. I think it really can put you in a hole. And the other thing that I tend to see with individuals is if they’re taking a loan from their 401(k) account, it often isn’t the first time that they’ve done that. So again, if you find yourself in a situation where you have to borrow from your 401(k), it is the last resort, I would really advise people to think through, again, from the financial wellness, "What things do I need to do so I’m not in this situation a second time?"
MARK: Yeah, one of the reasons these accounts were created was to kind of counteract that present bias that many of us feel, where we’re worried about now and not our long-term term, and that’s the whole point of these accounts. And if you’re borrowing or cashing out, you’re kind of defeating the whole purpose, right?
CATHERINE: Exactly. Exactly.
MARK: So when it comes to making contributions, there are limits on the amount you can contribute to your account. For 2019, what are those limits, and are those limits the same for everybody?
NATHAN: Yeah, so the fourth quarter of every year, the IRS puts out the updated limits. This year, it’s $19,000 for everyone. And then if you’re over age 50, there’s what’s called a catch-up contribution that you can do, and that amount this year is $6,000. So all told, if you’re over 50, $25,000; if you’re under 50, up to $19,000. I will add that almost every company like Schwab that helps run 401(k) plans have tools and calculators to help you figure out what that means from a savings rate perspective. So if you’re really trying to max-out the plan, we can tell you exactly what percentage to save based upon your salary to get you there before the end of the year.
MARK: Yeah, I think that catch-up provision is pretty important. So if you’re getting into your 50s, you’re starting to take retirement a little bit more seriously, and you realize you’re a little bit short, there’s some help available by taking advantage of that catch-up provision, right?
MARK: So final question. Catherine, you’re a prolific tweeter. You regularly share lots of great insights. What’s your Twitter handle?
CATHERINE: Oh, OK, it’s @CGolladaycs.
MARK: Great. Catherine, Nathan, this is great advice. Thanks for stopping by.
NATHAN: Thanks for having us.
CATHERINE: Thanks for having us.
MARK: A survey by Schwab Retirement Plan Services found that 64% of current 401(k) plan participants regretted that they hadn’t saved as much for retirement as they wanted. What’s even more interesting is that when asked, "If you could go back in time, what would you spend less on in order to put more money in your 401(k)?" the answers were dining out, expensive clothing, new cars, vacations and the newest tech gadgets. Every one of those items offers instant gratification, but saving for retirement doesn’t. The gratification from savings accrues slowly over time as you consistently save and leverage the power of compound growth along with monitoring and adjusting as you go.
But when we think about 401(k)s and achieving our retirement goals, there are four big stumbling blocks that we face.
The first is regret. People typically like to avoid it. Interestingly, they are more prone to regret when they make an active decision to make a change and it doesn’t seem to go well than when things just happen to them passively. This is where defaults can be useful. If your company automatically enrolls you in a 401(k) plan, you didn’t make the decision on how much to invest. That was a passive event for you. So if the stock market falters and your account drops in value, it can feel like you didn’t really have anything to do with that. One solution, which Nathan mentioned, is that many retirement plans will default your portfolio into a target-date fund. This kind of mutual fund is based on your expected retirement date and rebalances over time. As the fund rebalances each year, it helps you avoid making snap decisions that can affect your plan, like buying when the markets are rising or selling when they fall.
But don’t be lulled into complacency with target-date funds. If you adopt a set-it-and-forget-it mindset, you could be more susceptible to the second trap, status quo bias. Most people don’t think about the best thing for their 401(k) until it’s time to change jobs. Instead of letting your 401(k) just sit there and gather dust, check it on a regular schedule. You may need to rebalance periodically into your target asset allocation if that isn’t done automatically for you. And you should also consider increasing your savings rate every year if it doesn’t auto-escalate. Finally, if you were defaulted into a target-date fund, investigate whether your plan offers managed accounts, which will often provide more customized portfolios that may be closer to your needs.
The third stumbling block is the preference for round numbers. This bias shows up in retirement savings because people often defer to savings rates in multiples of 5%. Those are big jumps. It makes no sense to restrict yourself to 5%, 10%, or 15%. You can pick any number that makes sense for you. You might be at 5% now, but don’t stay at 5% because you can’t afford to go to 10%. A small jump from 5 to 6% is a huge improvement. Take advantage of it.
The fourth is present bias, which affects the way we think about our future selves. To a person who feels no connection to their future self, not spending today in order to save for tomorrow feels like throwing money away.
In one study, people were given computer-generated renderings of their appearance far into the future. Participants were asked to imagine they were given $1,000, and that they had to allocate the money among four options—put it in a checking account, put it into a retirement account, give it away, or spend it on something fun today. The control group, which didn’t see the renderings of their future selves, allocated $80, on average, to their retirement account. The group who saw a rendering of their future selves allocated $172 to the retirement account, over twice as much as the control group. So try imagining your future self and ask your present self what are you going to do for him or her? One of the first things you can do is to educate yourself about your plan’s options. Do you have access to professional advice? Can you invest in a brokerage window? How do your plan’s investment options compare to other investment products? Another way of helping your future self is to increase your savings rate to your employer match at a bare minimum. Don’t stick with the default rate if it doesn’t make sense for you. It’s also important to make sure your portfolio is diversified and that your investments aren’t relying too much on any one particular sector or asset class.
If you’d like to learn more about how 401(k)s work, visit workplace.schwab.com.
That’s it for Season 1 of Financial Decoder. We’ll be back in late March with more episodes. I’d like to invite you to share your thoughts and ideas on the direction of the show. Please visit schwab.com/survey to have your say. I’ve also put a link in the show notes to that survey. If you’re new to the series, there are seven more episodes available for listening anytime, for free, at schwab.com/financialdecoder.
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For important disclosures and a transcript, see the show notes and schwab.com/financialdecoder.