Optimal Defaults

Default options have an enormous impact on household “choices.” Such effects are documented in the literature on 401(k) plans (see Madrian and Dennis Shea, 2001; Choi et al., 2002, 2003b). Defaults affect 401(k) participation, savings rates, rollovers, and asset allocation. For example, when employees are automatically enrolled in their 401(k) plan, only a tiny fraction opt out, producing nearly 100-percent enrollment. But when employees are not automatically enrolled, less than half enroll on their own during their first year of employment. Defaults matter for three key reasons modeled in this paper. First, acts of commission (e.g., opting out of a default) are costly. Second, these costs vary over time, generating an option value of waiting for a low-cost period to opt out. Third, people are susceptible to procrastination. Even if they want to make a change, they have a tendency to delay that change longer than they should. These three effects imply that the choice of defaults can have significant welfare consequences. If all employees share a common optimal savings rate, selecting an optimal default is trivial. But the calculation of an optimal default is not straightforward if employees have heterogeneous optimal savings rates. In such a world, it may sometimes be optimal to set defaults that are far away from the mean optimal savings rate. This effect arises for two reasons. First, a default that is far from a procrastinating employee’s optimal savings rate may make the employee better off than a default that is closer to the employee’s optimal savings rate. A “bad” default is more likely to motivate opting out than a good but imperfect default, potentially overcoming procrastination and improving the agent’s welfare. Second, our theory implies that optimal defaults are highly sensitive to the actual distribution of optimal savings rates. In particular, optimal defaults are often associated with the modal optimal savings rate, which is sometimes extreme (e.g., the plan’s minimum or maximum contribution rate). At the end of our paper, we illustrate these effects with calculations of optimal defaults for employees at four different companies.