Pensions and the Tragedy of the Flypaper Effect

Arthur Okun showed that “money sticks where it hits,” just a flies do to flypaper.

Almost everyone has used flypaper from time to time. If you have flies in your house, you hang up a strip of flypaper, and the flies stick to it.

It turns out that as with flypaper, money is sticky too. When investors are given securities, they tend to hold onto those securities, and thereby fail to make effective portfolio allocation decisions. There are some interesting behavioral biases that drive the effect.

In “The Flypaper Effect in Individual Investor Asset Allocation,” by Choi, Laibson and Madrian, the authors review the flypaper effect, as it relates to a 401(k) plan for a large US retailer.

A copy of the paper can be found here:
http://www.hks.harvard.edu/fs/bmadria/Documents/Madrian%20Papers/The%20Flypaper%20Effect%20in%20Individual%20Investor%20Asset%20Allocation.pdf

Under the plan studied, whenever an employee contributes $1 (a “self-contribution”), the company matches that contribution with another $1 (a “matching contribution), with these contributions being made in separate accounts.

Next the researchers looked at several time periods, each with different prevailing conditions, in order to explore the asset allocation flypaper effect.

During Period 1, matching contributions were made in company stock, but employees could then, at their option, trade out of company stock and into other assets.

Given these parameters in Period 1, employees allocated 23% of their own contributions to company stock, but left fully 95% of their match contributions in employer stock.  Clearly, this failure to reallocate out of company stock constitutes an example of the flypaper effect. They were given company stock, and just kept it, instead of reallocating. But why did it occur?

The flypaper effect is driven by two factors: passivity (or status quo bias) and mental accounting.

The first effect, passivity, is powerful, since a mistake due to an action committed is more psychologically painful than a mistake produced by a failure to act. When we depart from a default option, we are setting ourselves up for regret (there’s also an element of procrastination involved).

In the next period of the study, Period 2, there was a change in conditions. During Period 2, employees had to explicitly choose an allocation for BOTH their self-contribution AND their matching contribution; if they did not, their matching contributions would be directed into employee stock.

Note that this time, people were not simply handed company stock (the default), which they then had to actively diversify out of, but instead had to make an up-front choice about the allocation of the matching contribution.

This time around, in Period 2, employees held 24% of their own contributions in company stock, and only 27% of their matching contributions in company stock.

As Joel Greenblatt would say, “Gee, that’s interesting.”

Instead of allocating 95% of the match via a default process, employees chose to allocate a mere 27%, which was much closer to the allocation they chose for the self-contribution.

The difference can be attributed to “narrow framing” or “mental accounting.”

Life is complex. Humans face many choices, but they are often innately averse to expending the mental resources required to make difficult choices. A heuristic exists to assist us: narrow framing. Rather than tackling a difficult very broad problem with lots of integrated decisions, we “narrow frame,” or focus down to individual decisions. (here’s a post about this: http://alphaarchitect.com/2011/12/06/the-framing-effect-and-your-portfolio/)

A corollary of narrow framing is “mental accounting.” Everyone keeps in their heads “budget” accounts for food, housing, entertainment, and so forth. The problem is that we often make decisions based on the narrow context of the choice, rather than on a broader basis.

In the context of choosing an allocation for a matching contribution, when faced with a default choice (or essentially no choice) instead of an explicit choice, you can see why a narrow frame might be the easier route. When decision-making is difficult, our finite minds use whatever information is available and readily accessed.

On the one hand, the narrow frame is easy: it’s a familiar asset, and we are often encouraged to “invest in what you know.” We may extrapolate our employer’s recent returns into the future. We may be overconfident. Our employers may also interpret purchases of company stock as a sign of loyalty, which reflects well on us. It’s a clean mental account, and one that doesn’t require complex thinking.

On the other hand, a broader, more comprehensive, integrated portfolio-level view would suggest that single securities are riskier than a diversified portfolio. Plus, we are ensuring a high correlation between career and asset risk. As Enron employees learned the hard way, it’s the worst of all possible outcomes when you lose your job and your retirement savings simultaneously. This is a more challenging thought process, and one that is easily circumvented by relying on the narrowly framed mental account, and preserving our precious mental resources.

In her paper, “Company Stock in Pension Plans: How Costly is It?”(a copy can be found here: http://www.pensions-institute.org/workingpapers/wp0205.pdf) Lisa Meullbroek estimates that employee investors sacrifice approximately 42% of their company stock’s value by assuming such diversifiable risk.

That’s a big sacrifice being made by a lot of people today. Unfortunately, extreme default choices can lead to suboptimal decision-making, and as a result it’s likely that a lot of these people are making a big mistake, largely due to the flypaper effect.