How do we save for retirement? Are we rational actors, putting aside precisely the amount we need to live comfortable lives in our later years? Or do we act irrationally, even irresponsibly, failing to account for our future needs by not saving enough in the present?
These are the questions that occupy the mind of economist Richard Thaler, a professor at the University of Chicago’s Booth School of Business. For decades now, Thaler has dedicated himself to understanding the decisions behind everyday actions. His work, and the contributions of other behavioral economists, has influenced everything from which foods are offered to children in school lunch lines, to how highways are designed, to how we make critical decisions about our hard-earned money.
Thaler outlines his thinking on the subject in his 2008 book Nudge: Improving Decision About Health, Wealth, and Happiness. Authored with his University of Chicago colleague Cass Sunstein (who now serves as President Obama’s administrator of the Office of Information and Regulatory Affairs), Thaler show us how the public and private sectors can “nudge” people into better decision making.
For his contributions to the field of retirement planning, Thaler will be honored at the 2011 Retirement Income Industry Association fall meeting in Boston. Research magazine will present Thaler with the 2011 Award for Achievement in Applied Retirement Research, recognizing his outstanding contributions to the field.
“Of course it is pleasing to be honored by an industry that I have spent some many years trying to ‘nudge,’” Thaler said in an e-mail interview. “I am glad they have taken to the lessons of behavioral economics.”
Behavorial economics is a field that occupies a place between economics and psychology. Economists of this ilk want to understand the way the world really works, not the way it should work.
In Nudge, Thaler rests his ideas about economic decision making on four main pillars. The first is understanding the difference between “Econs” and “Humans.” “Econs” are the fictional creation of the rational school of economics, people who should theoretically make good decisions most of the time for the right reasons. In fact, the University of Chicago — and specifically economist Milton Friedman — is the epicenter of this movement. While Thaler does not totally reject the rationalist school, he insists that people do not make perfect decisions. In fact, we all make “human” decisions, full of foibles and miscalculations and outright mistakes. Therefore, he argues, we need the public and private sectors to “nudge” us in the right direction to arrive at outcomes that benefit us individually and collectively.
To do so, he writes, we need skilled “choice architects,” people who design systems that help us arrive at beneficial outcomes. For instance, on a very small scale, I am acting as a choice architect as the writer of this article. I am deciding which information to include and which to exclude to best provide readers with the information they need to appreciate Richard Thaler’s contributions to the field of retirement research.
So, according to Thaler, “Humans” need “nudges” designed by “choice architects” to make good decisions. He calls this system of policy making “libertarian paternalism.” “Libertarian” because people deserve and expect choices to suit their particular circumstances and “paternalistic” because, try as we might to make perfect decisions ourselves, the presence of a guiding hand often helps.
This is nowhere truer than in the realm of retirement savings. Starting as far back as 1996, Thaler began outlining his ideas on the subject in a number of academic papers that sought to shift the ground in retirement planning. Ultimately, his work influenced the Pension Protection Act of 2006, a bill signed into law by President George W. Bush that offers employers an incentive to automatically enroll employees in a retirement plan and automatically increase their contributions over time.
Thaler’s thinking on the subject begins with a simple premise: Americans don’t save enough. From 1950 to 1980, for instance, Americans saved an average of 8 to 10 percent per year. However, even in those good times, savings didn’t come in the form of cash. Rather, people put their money in pensions, cash-value life insurance and mortgage payments to pare down debt. By 2005, for the first time since 1932-33, the savings rate in the United States was negative. Easy access to credit cards and loans didn’t help matters. In addition, 401(k) plans, unlike old-fashioned pensions, required employees both to sign up and make intelligent choices about how to invest their money.
Into this mess, Thaler arrives with two central recommendations: automatic savings plans and a scheme named the Save More Tomorrow program.
The first modern retirement plans were defined-benefit plans. After a certain number of years, a given employee would receive a predetermined income based on previous salary and number of years worked. Social Security is a good example of a defined-benefit plan. These plans have one huge advantage. The only decision to make is when to start collecting the benefit.
However, over the last few decades, public and private sector employees have begun offering defined-contribution plans like 401(k)s. While these plans are flexible and portable, they are not necessarily forgiving. Research shows that most people define a contribution amount and forget about it, despite variables like pay raises and years before retirement. Though many employers offer generous plans that match employee contributions, studies show that 30 percent of eligible employees fail to enroll in 401(k) plans. It’s as if people were turning down the opportunity to pocket free money.
That’s why Thaler suggests that people need a “nudge” in the form of automatic enrollment. Here’s how it works. Once an employee becomes eligible for a defined-contribution plan, he or she is automatically enrolled unless the choice is made to opt-out. In one study comparing opt-in to automatic enrollment, researchers found that participation rates in opt-in plans were just 20 percent after three months, increasing to 65 percent after 36 months. With automatic enrollment, by contrast, the rates were 90 percent and 98 percent, respectively.
Next, Thaler suggests that choice architects design plans that encourage higher savings rates. Studies find that most people save at a meager rate of 2 percent, nary enough to save for retirement expenses. By simply changing the match formula from 50 percent on the first 6 percent of pay to 30 percent on the first 10 percent of pay, employers could encourage greater savings rates.
Save More Tomorrow participants commit themselves to saving more by increasing their contributions when they receive a pay raise. According to Thaler, the plan (developed with UCLA’s Shlomo Benartzi) rests on three concepts of behavioral economics. “People have good intentions about the future,” he said, “but lack the self-control to implement the plans now, so [the plan] allow[s] people to commit themselves to save more later.” Furthermore, he adds, “there is massive inertia in [defined contribution] plans. We use that to help people by making future increases automatic until some cap is reached.” Lastly, “people are loss averse, so we tie savings increases to pay increases to eliminate any nominal pay cuts.”
Thaler’s research shows that participants in the program quadrupled their savings rate to 13.6 percent from 3.5 percent. Indeed, the program’s success has spurred major retirement plan administrators like Vanguard, T. Rowe Price, TIAA-CREF, Fidelity and Hewitt Associates to adopt the Save More Tomorrow concepts. As of 2007, the Profit Sharing Council of America found that 39 percent of large U.S. employers had adopted some kind of automatic escalation plan.
Decumulation and Company Stock
Thaler said the broker-dealer industry would be wise to focus on two areas that require reform and innovation: decumulation of assets after retirement and ownership of company stock.
“As it is,” he says, “most 401(k) investors are handed a pile of money when they retire and sent on their not-so-merry way. We need to give people more help on this phase, which is actually more difficult than the accumulation phase. I am working on those issues now.”
Over-accumulation of company stock would also benefit from a dose of libertarian paternalism, says Thaler. There are still employers who prevent employees from selling their match in company stock. Worse, there are employees who hold the majority of their savings in the stock of their employers. After the disasters of Enron and Bear Stearns, one might have thought that employees and employers alike would have learned their lessons. On the contrary, says Thaler.
“I have talked to the CFOs of companies with this problem and they will privately agree that it makes no sense for an employee to have so much invested in one company, especially their employer, but are afraid to do anything about it because it might seem like they had lost faith in their own stock.” Thaler explained. “[Shlomo] Benartzi and I have been pushing an idea we call Sell More Tomorrow to deal with this problem. Offer employees a plan where their company stock holdings are sold off gradually and invested in a diversified portfolio until the holdings reach some sensible proportion of savings such as 10 percent or less. So far we have not had any takers (though, as with Save More Tomorrow, we give these ideas away at no charge). Here is hoping that someone will take us up on this before the next company blows up.”