by Warren Cormier
DCIIA Retirement Research Center
Estimated reading time: 2 minutes, 27 seconds
When it comes to employee behavior regarding DC enrollment, many employers might scratch their heads and conclude that employees behave irrationally. Why would employees (especially younger generations) pass up guaranteed, free money in the form of a DC match?
This is our view from the supply side of the DC industry. However, from the employees’ perspective, deferring income today for a possible gain in the long-distant future may run counter to their psychology. Dr. Daniel Kahneman’s “Prospect Theory” (for which he won a Nobel Prize) helps us understand this phenomenon.
First, we need to consider if making a contribution to their retirement account is seen as a gain or a loss. To assess if something is a gain or a loss, there needs to be a reference point or neutral point against which all outcomes will be assessed. In the employee’s mind, that reference point is their take-home pay before participation in a DC plan. Upon learning about the DC plan, the employee may see a loss relative to their reference point of take-home pay.
“But wait,” we say. “The participant keeps the money and also receives a gain in the form of the match.” From the employee’s point of view, this exchange may be considered a loss. Why? Because for the typical human, Dr. Kahneman explains, the pain of a loss has more than twice the psychological impact as the joy of a gain of an equal amount (loss aversion). So right off the bat, if the match is less than 100% of the contributed amount, the employee will see this potentially as a loss and avoid it due to loss aversion.
There is another powerful phenomenon that reinforces this sense of loss. It is called “hyperbolic discounting.” What is this, exactly?
In hyperbolic discounting, people typically intend to forfeit small, immediate gains for larger rewards in the future, but often fail to make the optimal choice at decision time. The decision maker values the small, immediate reward more than the larger future reward – e.g., "Would you prefer a dollar today or three dollars next year?" Combined with loss aversion, hyperbolic discounting can easily offset the incentive of a match.
In a potential “worst-case scenario” of these combined forces of loss aversion and hyperbolic discounting, the employee either declines the invitation to participate in their DC plan at all or minimizes their deferral rate in an attempt to minimize the pain of a loss. Furthermore, if employees evaluate their plan in terms of gains and losses relative to their take home pay rather than the potential value of the DC account many years in the future, the DC plan doesn't look nearly as good to the employee as it does to the employer. When designing DC communications, it may make sense to take this into account and consider that for some employees, the match may not be seen as a great deal.