In s i d e
t h e
p l an
part i c i pant ’ s
m i n d
Explaining Participant Behavior
via Prospect Theory
Exploring the true meaning of rationality and
irrationality, and their application to participants’
decisions.
Warren Cormier
W
hile preparing to teach a 2-day
course in behavioral finance,
I found myself more closely
studying and reflecting on
Daniel Kahneman’s Prospect
Theory. As you may know, he
was awarded a Nobel Prize for
this theory. What essentially is Prospect
Theory and why would I be writing about
it in column dedicated to the “Mind of the
Participant”? Because I believe it provides
great insight into participation and deferral
rate decisions.
The essential ideas in Kahneman’s Prospect Theory are that:
• People do not always behave rationally.
• There are persistent biases motivated
by psychological factors that influence
people’s choices under conditions of
uncertainty.
• Prospect theory considers preferences
as a function of “decision weights.”
• It assumes that these weights do not
always match with probabilities.
• These decision weights tend to overweigh small probabilities and underweigh moderate and high probabilities.
• Investors tend to evaluate prospects or
possible outcomes in terms of gains and
losses relative to some reference point
rather than the final states of wealth.
A simple example serves to clarify
what this all means. Consider the following
choice. Which of the two options would
you choose?
• Option 1: a sure profit (gain) of
$5,000; or
• Option 2: an 80% possibility of
gaining $7,000, with a 20% chance of
16
n a p a
n e t
t h e
For the typical human,
the pain of a loss is
twice as powerful as the
joy of a gain.”
receiving nothing.
In actual experimentation, the vast
majority select Option 1, a sure profit of
$5,000. However, the rational (defined by
economists as “reasonable”) choice would
be an 80% chance to gain $7,000, which
has an expected value of $5,600.
This simple thought experiment can tell
us a great deal about the mind of the participant. When we look at participant behavior we often scratch our heads and conclude
they are behaving irrationally. Why would
they pass up guaranteed free money in the
form of a match? But this is our view from
the supply side of the DC industry. From
the participant’s view, it runs counter to
their psychology.
First, we need to consider whether
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 factoring in
participation in a DC plan. Upon learning
about the DC plan, the participant may see
m a g a z i n e
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, the pain of a loss is twice
as powerful as the joy of a gain. (If you are
wondering, yes, this has been measured
by scholars.) So right off the bat, if the
match is less than 100% of the contributed
amount, the employee will see this, according to prospect theory, potentially as a loss
and avoid it due to loss aversion. But there
is another powerful force that is reinforcing
this sense of loss. It is called “hyperbolic
discounting.” What is this, exactly?
Hyperbolic discounting is a phenomenon where 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. “Would
you prefer a dollar today or three dollars
next year?”
When combined with loss aversion,
hyperbolic discounting can easily offset the
incentive of a match. In effect, we are asking
employees to receive less take-home pay and
defer immediate gratification so they can
fund the expenditures of a retired person
(themselves) whom they may not be able
to relate to today. In that the employee discounts deeply the future rewards (retirement
income) relative to the immediate “loss,” the
employee either declines the invitation to
participate at all or minimizes the deferral
rate in an attempt to minimize the pain of a
loss.
Furthermore, in that people tend to
evaluate prospects or possible outcomes in
terms of gains and losses relative to some
reference point (their take-home pay) rather
than the final states of wealth (the value of
the DC account many years in the future),
the DC plan doesn’t look as good as we
believe it to be — especially if we compare it
to a DB plan in which there is certainty of a
gain and no probability of a loss.
Now let’s assume the employee enrolls
anyway. Let’s also bring in the fact that
investment decisions must now be made and
that those decisions are made against a backdrop of warnings that the employee could
lose all of his or her account balance. Loss
aversion kicks in to do double duty. As the
example above shows and the theory states,
people tend to overweight the lower probabilities and underweight the larger probabilities. Although the risk of losing $7,000 in
the example is only 20%, in order to make
the two choices equal in value (i.e., for the
person to be indifferent), the probability of
winning was weighted down, emotionally,
from 80% to 71% (or $7,000 X .71).
Investors tend to
evaluate prospects
or possible outcomes
in terms of gains and
losses relative to some
reference point rather
than the final states of
wealth.”
Throw in on top of that a healthy dose
of regret aversion and ambiguity aversion
(fear of unknown risks) on a lack of investing experience/confidence and you have a
dysfunctional investor. As a result, herding
behavior appears, in which participants
begin asking co-workers what they did or
asking HR staffers what they should do. This
often results in bad advice for the participant.
Enter the advisor. A high percentage of
participants say they want advice from a
trustworthy and knowledgeable source.
However, most participants don’t trust
themselves to pick the right advisor and
inflate the probability (in their minds) of
picking a bad one. They obviously need
your help and need to feel that they made
the right choice.
When trustworthy and knowledgeable
advice is offered through the plan sponsor,
why do so few participants take advantage
of it? Prospect theory is at work.
Finally, keep in mind that participants
are not acting irrationally. Economists typically equate “rational” with “reasonable.”
In his book, Thinking, Fast and Slow,
Kahneman points out that, “The only test
of rationality is not whether a person’s
beliefs and preferences are reasonable, but
whether they are internally consistent …
rationality is logical coherence — reasonable or not.” N
» Warren Cormier is president and CEO of Boston Research Group, author of the DCP suite of
satisfaction and loyalty studies, and director of the
NAPA Research Institute. He also is cofounder of
the Rand Behavioral Finance Forum, along with Dr.
Shlomo Bernartzi.
NAPA Net – The Magazine is one benefit of being a NAPA
member… here are some others.
NAPAnet
THE OFFICIAL MAGAZINE OF THE
NATIONAL ASSOCIATION OF PLAN ADVISORS
the magazine
Powered by ASPPA
Practice
Management
and Networking
• NAPA – 7,000+ members
and 100+ Firm Partners
• NAPA 401(k) SUMMIT
• NAPA DC Fly-In Forum
• Committee Leadership
Business
Intelligence
• NAPA Net Daily
• NAPA Net Online Portal
• NAPA Net–The Magazine
• NAPA quarterly webcasts
Advocacy
Your Voice
on Capitol Hill and in the
DOL, Treasury and IRS
Whether you join as an individual member or through a NAPA Firm Partner (like your broker
dealer or company), NAPA helps you manage your practice, grow your AUM and identify business
opportunities and vital plan management services.
DC POWER HITTERS
FALL 2013 // NAPANET.ORG
If you’re not already a member,
what are you waiting for?
Contact: Lisa Allen at 703-516-9300 x127 · [email protected]