Imagine a recent college grad on his first day of work. One of the many choices he’ll have to make is how much of his salary to contribute to his retirement account. He might think to himself, “Five percent seems like a good number; not too much and not too little.” Sound familiar?
Now let’s fast forward 40 years. Assuming (with a few simplifying assumptions) our college grad contributed five percent of his $3,000 per month salary, his employer matches this amount, and he earned an average annual yield of five percent, he will have amassed $458,000. But what if he made a different choice on his first day of work and decided to contribute eight percent? With the same assumptions, he would have saved $732,000. That’s almost 60 percent more.
The difference is more than just a number. It will hugely impact his basic quality of life as well as whether he can afford to travel or play golf, cover medical care, or pay for a retirement home. The simple matter of choosing a “round” number like five instead of a more specific number like eight can have life-altering consequences.
Our tendency to prefer round numbers has been observed in many areas, from stock prices and tips in restaurants to baseball batting averages and how much gas drivers choose to put in their cars. But why do we prefer round numbers?
Research has found that round numbers occur more frequently in various texts and are easier to remember, process, and perform mathematical operations on. Combined with our tendency to prefer familiar stimuli over unfamiliar stimuli, we develop an automatic, implicit preference for round numbers. As a result, we are also more likely to use round numbers when guessing and estimating.
In 2002, Hewitt Financial Services revealed that people rely on mental shortcuts when they select pension plan contribution rates. This may be a reference point or an anchor that guides employees’ decisions (e.g., the maximum rate matched by the employer, the maximum rate allowed by the plan, or a round number). The study hints at a round number bias, since the most commonly selected rates of contributions are round numbers such as five percent and 10 percent. Benartzi and Thaler came to a similar conclusion: Employees in pension plans with no threshold or anchor most often choose contribution rates that are multiples of five percent (i.e., round numbers).
To test these findings, I conducted an empirical analysis of contribution rates of an individual pension plan managed by Pokojninska družba A, a Slovenian pension fund. The analysis, which included four years of data and 5,678 monthly contributions, revealed members chose monthly contributions that were round numbers and multiples of five far more frequently than would be expected by chance. Two levels of contributions in particular—€50 and €100—stood out (see graph).
The analysis also revealed the power of anchoring. The plan’s minimum monthly contribution, €26.8, was stated on the form and was also among the most frequent contributions. (The pension fund did accept contributions of less than €26.8 per month without penalty; €20.0 for instance.)
What can we do to avoid this bias? Automatic escalation of savings rates, pioneered by Benartzi and Thaler in their original Save More Tomorrow program, have proven effective in not only getting employees to start saving but also in increasing their contributions automatically over time. By automatically escalating contributions, we can not only avoid loss aversion but also reduce the effects of round number bias. The college grad that would start with a five percent contribution rate would, if enrolled in a pension plan with automatic escalation, likely be able to afford those golf outings or medical care.
Special websites designed to help employees enroll in workplace pension plans can help. With the use of smart decision tools like Voya Financial’s myOrangeMoney, an employee can calculate how much he needs to contribute in order to have a comfortable retirement. Increased use of online retirement planners and mobile apps that help employees enroll in pension plans, incorporating the right default contribution rate for each individual, and shifting focus from the contributions to the end result (a comfortable retirement) seems to be the right way forward.
So the next time you’re presented with a financial-contribution decision like retirement or a charitable donation, pause for a moment and ask yourself, “Is the round number right for me, or does it just feel right?”
Correction: A previous version of this article incorrectly stated the difference between $458,000 and $732,000 was almost 40 percent. It has been corrected to almost 60 percent.