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Ideas for Leaders #680

Behavioural Economics Explains Employee Retirement Savings Choices

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Key Concept

A groundbreaking 2004 journal article showed how behavioural economics could explain self-defeating retirement savings decisions made by employees. It was an early example of the power of behavioural economics over standard economic theory by the ‘father of behavioural economics’.

Idea Summary

Why do employees make retirement savings decisions that go against their best interests? A 2004 paper by Nobel Prize-winning economist Richard Thaler of the University of Chicago, co-authored with fellow researcher Shlomo Benartzi of UCLA, showed how behavioural economics could explain what standard economic theory could not. 

As companies moved from defined benefit retirement savings plans, in which the employees had little or no action to take in order to participate, to defined contribution plans, in which employees must actively choose to participate and must choose as well their contribution rates, retirement savings declined sharply. In short, when employees had the opportunity to make choices related to their retirement savings, they made poor choices.

According to standard economic theory, there should have been no significant difference in participation rate between defined benefit and defined contribution plans. The reason is that according to standard economic theory, people act and react in the same way that economists would act and react — that is, they crunch the numbers and make the most beneficial decisions for themselves.

In their paper, Thaler and Benartzi identified several behavioural factors that led to poor retirement savings decisions. These behavioural factors, still relevant today, included:

  • Bounded rationality. Calculating the optimum savings rate to ensure enough money in retirement is not an easy exercise, even if one is intent on doing it.
  • Self-control. Many people engage in ‘hyperbolic discounting’, which refers to the psychological bias that the value of something today is greater than the value of something in the future. As a result, they are willing to put aside money in the future for retirement, but not today. Only those with superior self-control recognize that what they buy today is not any more valuable than what they might be able to buy in the future.
  • Procrastination and Inertia. Many people also intend to do something about improving their retirement savings situation, but don’t get around to it. Procrastination is closely related to self-control. Over time, procrastination leads to inertia: nothing gets done. This is also known as status quo bias: people eventually feel satisfied with the way things are.
  • Loss aversion. Research shows unequivocally that people weigh losses more heavily than gains. Income reduction, for example, is felt more deeply than income increase. As a result, people have difficulty deliberately deciding to reduce their take-home pay by putting more of their income into savings.

In response to their research, Thaler and Benartzi developed a retirement savings plan that took into account these behavioural factors. Their plan, called Save More Tomorrow™ (known as the SMarT program), called for employees to commit to increasing their savings contribution by a certain percentage every time they received a raise. The increases-per-pay raises would continue until a pre-set maximum contribution rate was achieved. 

This approach helped employees overcome the behavioural hurdles described above.

First, the future commitment that the SMarT program required disarmed hyberbolic discounting. In fact, Thaler and Benartzi urged program administrators to have a significant time lag between when the program was offered and when the next pay raise was scheduled. 

Second, implementing an increase in savings with a pay raise overcame loss aversion because there was no nominal reduction in income. 

Third, having the contribution rate automatically increase with each pay raise actually leveraged the inertia and status quo bias of people to their benefit: there was the possibility of opting out of the plan, but this required taking an action; thanks to inertia, however, once people were in the plan, they tend to stay in the plan.

Business Application

Early implementations of the SMarT program, as described in the original article, confirmed the impact of retirement savings plans incorporating insights from behavioural economics.

In the years since the article, Thaler and Benartzi continued to advocate for retirement savings policies and plans driven by behavioural economics, notably plans based on auto-enrollment and auto-escalation. A recent article suggested that their ideas may have increased retirement savings in the U.S. by nearly $300 billion.

Thaler continued to advocate for behavioural economics through numerous articles and books. In 2017, this ‘founding father of behavioural economics’ won the Nobel Prize in Economics.

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Authors

Institutions

Source

Idea conceived

  • February 2004

Idea posted

  • October 2017

DOI number

10.13007/680

Subject

Real Time Analytics