Richard Thaler is the guy to thank for the now almost universal 401(k) plan. He was also one of the rare breed of Noble Prize winning economists who had a substantial effect on the paychecks of millions. His contribution is also the more important one if one considers the specter of the US employers terminating pensions of their employees. The latter was then forced to accept retirement plans like 401(k). Defined contributions became the norm instead of defined benefits.
Theory and practice
Voluntary retirement accounts work excellently in theory. It assumes that employees will act in a rational manner when it comes to retirement. They would not only save but also invest in a rational manner so that they would be able to spend a comfortable post-retirement life. Thaler, along with other behavioral economists, disagreed with such a hypothesis.
Thaler pointed out that employees entrusted with retirement savings on their own will turn out to be their own enemies. The Nobel Prize-winning economist surmised correctly that, left to their own devices, the same employees will tend to believe that they will never retire. The significant impact of behavioral economics is changing the manner retirement plans get administered. Thaler promoted the idea that employees should be pushed into joining the retirement plans. This concept is termed automatic enrollment. Employers must automatically sign the worker for retirement 401(k) schemes, and not wait for the employee to fill out the due paperwork. In case an employee is not interested, they can take themselves out from the plan.
Automatic enrollment and escalation
According to Thaler, the automatic enrollment was not his initial idea. He, however, assisted in popularizing the scheme in a 2008-published economics book co-written with Cass Sunstein. He developed the idea of automatic escalation, also known as 'save more tomorrow'. He was assisted in his work by another behavioral economist, Shlomo Benartzi of the Los Angeles' University of California.
Automatic escalation boosts the amount of money employees save for their retirement. About 15 percent of the salary cannot be kept aside for retirement. Automatic escalation solves this problem by pushing the workers to increase the savings rates, generally by one percentage point every year.
Thaler was found to be correct. In a Plan Sponsor Council of America survey, about 58 percent of total plans consisted of workers who were automatically signed up for 401(k). This is an uptick of only 8.1 percent from 2000.