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Designing 401(k) Plans That Encourage Retirement Savings: Lessons from Behavioral Finance

The United States has a voluntary pension system in which employers are not required to provide pensions. With this approach, the amount of responsibility placed on workers differs considerably between defined benefit and defined contribution pensions. With a defined benefit plan, if the employer provides a pension to a worker, the worker automatically participates. With a defined contribution plan, most often a 401(k), participation frequently depends on whether the worker chooses to contribute.

A weakness of the voluntary system is that many individuals make poor choices, resulting in retirement income that is insufficient to maintain their preretirement living standards Behavioral finance theorists have used their insight into the roles that inertia and procrastination play in worker behavior to propose solutions that preserve worker choice while arguably achieving better long-run outcomes for many workers. This approach expands on the methodology of traditional finance and economics, which focuses on the behavior of well-informed persons who are psychologically capable of implementing the decisions they make.

This AARP Public Policy Institute Issue Brief addresses policy issues related to workers' choices concerning (1) pension participation, (2) contribution rates, (3) investments, and (4) benefit receipt. Each section contains an introduction that provides background, a discussion of information problems, and an analysis of policy options. (19 pages)

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