Optimal Defaults and Active Decisions

Abstract

Defaults often have a large influence on consumer decisions. We identify an overlooked but practical alternative to defaults: requiring individuals to make an explicit choice for themselves. We study such "active decisions" in the context of 401(k) saving. We find that compelling new hires to make active decisions about 401(k) enrollment raises the initial fraction that enroll by 28 percentage points relative to a standard opt-in enrollment procedure, producing a savings distribution three months after hire that would take 30 months to achieve under standard enrollment. We also present a model of 401(k) enrollment and derive conditions under which the optimal enrollment regime is automatic enrollment (i.e., default enrollment), standard enrollment (i.e., default non-enrollment), or active decisions (i.e., no default and compulsory choice). Active decisions are optimal when consumers have a strong propensity to procrastinate and savings preferences are highly heterogeneous. Financial illiteracy, however, favors default enrollment over active decision enrollment.

Figure I. Fraction of Employees Enrolled in the 401(k), by Hire Month

The fraction displayed is as of the third month of tenure at the company. The active decision cohort was hired between January and July 1997. The standard enrollment cohort was hired between January and July 1998.

Figure II. Fraction of Employees Enrolled in the 401(k) Plan, by Tenure at Company

An employee is counted enrolled in the 401(k) even if he or she has stopped contributing to the plan. The series are not monotonically rising because they are constructed from multiple cross-sections, so the samples are not fixed over time.

Figure III. Average 401(k) Contribution Rate, by Tenure at Company

At each point, the averages include employees not currently contributing to the 401(k) plan; their contribution rate is zero. The active decision cohort's contribution rate data are not available prior to month nine.

Figure IV. Average 401(k) Contribution Rate Conditional on Participating, by Tenure at Company

At each point, the averages exclude employees not currently contributing a positive amount to the 401(k) plan. The active decision cohort's contribution rate data are not available prior to month nine.

Figure V. 401(k) Balance-to-Base Pay Ratios at Different Balance-to-Base Pay Percentiles

Balances exclude outstanding loan principal and any money rolled into the account from a former employer. The percentile breakpoints are calculated separately for each cohort at each point in time. The active decision series starts in month thirteen because our salary data start in January 1998.

Figure VI. Mean Time Between Hire Date and Enrollment by Contribution Rate Chosen Upon Enrollment in the Standard Enrollment Cohort

The area of each bubble is proportional to the number of employees it represents. The sample consists of all employees in the standard enrollment cohort who worked at the company for at least thirty months and enrolled within thirty months of hire.

Figure VII. Employee's Total Expected Loss Φ as a Function of the Distance Between the Default and the Employee's Optimum

The parameters specific to each panel, the quasi-hyperbolic discount factor β, is shown beneath each graph. In all three panels, the opt-out cost is uniformly distributed between 0.25 and 1.75, and the loss function scaling factor κ = 100. The left and center panels have the same y-axis scale, but the right panel has a different y-axis scale.

Figure VIII. Possible Optimal Default Regimes

The panels illustrate parameter values that support the three classes of optimal defaults: the center default, the offset default, and active decisions. The shaded area in each panel represents the social welfare losses generated by the corresponding default regime. The parameters specific to each panel, the quasi-hyperbolic discount factor β and the range of optimal savings rates s̄−s, appear below each figure. In all three panels, the opt-out cost is uniformly distributed between 0.25 and 1.75, and the loss function scaling factor κ=100. The left and center panels have the same y-axis scale, but the right panel has a different y-axis scale.

Figure IX. Characterization of Optimal Default Regimes

This figure shows the boundaries of the optimal default regimes as a function of the quasi-hyperbolic discount factor β and the range of optimal savings rates s̄−s when the opt-out cost is uniformly distributed between 2/3 and 4/3, and the loss function scaling factor κ=100.