What the Tax Man Can Teach Us About Participant Behavior
Public response to the 2017 Tax Cuts and Jobs Act provided insight into a financial idiosyncrasy: invisible incrementalism. While people gained more in their monthly paycheck, they received less in their annual refunds — an outcome that created frustration. But what if the equation were reversed? If incremental additions (and conversely subtractions) can go unnoticed, then can sponsors nudge harder for savings in pursuit of a larger participant payout?
In 2017, Congress passed the Tax Cuts and Jobs Act (TCJA) with great fanfare. The sweeping legislation remade large sections of the U.S. tax code, slashing taxes on corporations and delivering lower rates for many income tax brackets.
But taxpayers paid most attention to just one part of that complicated equation: the TCJA’s impact on their own tax bills. From that perspective, the news was good. The average household was expected to pay roughly $1,600 less in taxes, according to the Tax Policy Center; middle-income households could see their tax bills fall by about $900.1
Fast forward to early 2019, and taxpayers’ reactions were decidedly less positive. So why had many taxpayers soured on legislation designed to put more money in their pockets? To answer that question, it’s worth considering the fundamental tenet of behavioral economics: People often don’t act rationally when it comes to money.
Understanding our biases
Our decisions often are influenced by emotional and cognitive factors. These tendencies worked well for our prehistorical ancestors, whose instincts kicked in to help save them from predators. But these days, letting emotional or cognitive biases affect our decision-making process can lead to bad outcomes — especially when it comes to money. For instance, investors’ emotional reactions to stock market movements often lead them to sell at market lows and buy at peaks.
Our biases also lead us to place outsized importance on recent events. This recency bias may be what’s fueling some taxpayers’ dissatisfaction with the new tax rules. The TCJA has indeed lowered tax bills for most taxpayers. The problem, however, is that many taxpayers didn’t see those tax savings where they expected to see them — at the bottom of their tax return. As people finished their 2018 returns, social media lit up with stories of lower-than-expected refunds and bigger-than-expected tax bills. By mid-February, the average tax refund in 2018 was nearly 17% lower than in the previous year, according to the Internal Revenue Service.2
The drop in refunds is due in part to a change in the IRS’ withholding tables to account for many of the TCJA’s new provisions. That change meant workers kept more of their money from each paycheck. In effect, their tax savings were spread out over the year, rather than showing up as a lump-sum refund.
Unfortunately, our behavioral tendencies make us much more likely to respond positively to a big lump-sum tax refund than to smaller tax savings spread out over a full year. For many taxpayers, the annual tax refund is an every-year stimulus package that they can use to bolster savings, pay down debt or fund a big purchase or vacation. Meanwhile, the extra money in many workers’ paychecks was simply absorbed and then spent on regular daily expenses.
The big impact of small changes
What can the DC industry take away from taxpayers’ response to the new tax rules? One lesson is that small changes over time can have a relatively minor emotional impact — meaning plan sponsors can encourage participants to save more without fear of a backlash.
Consider participants who take advantage of automatic escalation plan features that increase their contributions by 1% or 2% a year. They quickly adjust to the effect these increases have on their paycheck. But over years or decades, those regular increases can help participants accumulate considerably more retirement savings than if they’d kept a static contribution level.
Thoughtful plan design and communications strategies can help promote the big impact of small changes to participants. Consider adopting one or more of the following strategies:
- Auto-escalation. Automatic plan design features can help participants overcome a common behavioral stumbling block: inertia. With an auto-escalation feature, plan participants decide only once to increase their contributions. Thereafter, the plan does it automatically, boosting contributions on a regular but gradual basis.
- An annual campaign promoting 1% to 2% contribution rate increases. Consider running these campaigns early in the new year, when participants are especially receptive to messages about saving and long-term financial discipline.
- An end-of-year “windfall” statement. A special statement can illustrate how much extra a participant has saved during the year as a result of his or her increased contribution rates. This approach can help reinforce participants’ positive decisions by highlighting the larger annual savings figure instead of the smaller, per-paycheck contributions.
In many ways, the behavioral instincts we’ve inherited from our ancestors serve us well. They keep us safe and help us develop strong bonds with loved ones. But in some situations, our natural wiring can lead us toward decisions that simply aren’t in our best interest. Fortunately, plan sponsors can take advantage of powerful tools and strategies to help participants make rational decisions for their future.