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Grow Your 401(k) -- Automatically

By Robert Brokamp (TMF Bro)
September 29, 2003
Do you think you're not contributing enough toward retirement, but don't see how you could save more? Do you hear about people contributing as much as 15% of their paychecks to their 401(k)s, and wonder how they do it? A couple of professors might have the answers.

Behavioral economists Richard Thaler and Schlomo Benartzi created a program called Save More Tomorrow, or SMarT (which is probably better than SMuT, though the latter would generate more interest). According to a paper Thaler and Benartzi released this summer, the average savings rate of employees at a company that implemented the SMarT program jumped from 3.5% to 13.6% in 40 months.

The SMarT program gradually -- and automatically -- increases an employee's contribution rate to the company's retirement plan. But the timing of these increases and the enrollment period for the program are part of what makes this program so successful.

First of all, employees are informed about the SMarT plan months before their savings rates will be increased. This might increase participation because it's easier for people to delay future consumption than it is for people to reduce their disposable income immediately.

Secondly, the savings rates are automatically increased one to three percentage points each year at the same time the company hands out raises. Thus, even though more money is diverted to the retirement account, the paycheck might still be bigger, especially when the tax benefits are factored in. This forestalls the shock of less take-home pay.

More importantly, the SMarT program can help Americans provide a more comfortable retirement for themselves. Thaler and Benartzi present scenarios that display how various hypothetical groups could benefit from the program. For example, a 35-year-old with an annual salary of $50,000 who contributes 4% of his pay to a retirement account would be able to replace just 51% of his salary in retirement, assuming that he also received Social Security but did not receive a benefit from a traditional pension.

However, if this person participated in a SMarT program, his savings rate would gradually increase to 14%, and he would be able to replace 83% of his income in retirement. (Both scenarios assumed an employer match of 50 cents on the dollar up to 6%, and an investment mix of 60% stocks and 40% bonds.)

Of course, you don't need to be party to a SMarT program to reap such benefits -- you can do it yourself. Whenever you get a raise, increase the contribution rate to your retirement accounts. However -- and this is where the behavioral economics comes in -- you have to remember to do this, and you have to actually do it. The beauty of the SMarT plan is that all the work is done for participants, and studies show that once investors are set upon a path, inertia keeps them going -- and saving.

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