Optimal Defaults

Abstract

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

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