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Retirement Planning > Saving for Retirement

Five Good Questions for Behavioral Economist Dan Ariely

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Using simple experiments Dan Ariely studies how people actually act in the marketplace, as opposed to how they should or would perform if they were completely rational. His interests span a wide range of daily behaviors and his experiments are consistently interesting, amusing, and informative, demonstrating profound ideas that fly in the face of common wisdom.

Dan is the James B. Duke Professor of Psychology & Behavioral Economics at Duke University, where he holds appointments at the Fuqua School of Business, the Center for Cognitive Neuroscience, the School of Medicine, and the Department of Economics. He is also a founding member of the Center for Advanced Hindsight.

Dan earned a bachelor’s degree in psychology from Tel Aviv University, his master’s and doctorate degrees in cognitive psychology from the University of North Carolina, and a doctorate in Business Administration from Duke University. He is the author of The New York Times bestsellers Predictably Irrational: The Hidden Forces that Shape Our Decisions and The Upside of Irrationality: The Unexpected Ways We Defy Logic at Work and at Home. I am the proud owner of both and have benefitted from them both. 

His research has been published in leading psychology, economics, and business journals, and has been featured many times in the popular press. Dan has graciously agreed to answer what I hope are Five Good Questions

1.  In your work, you often argue that one’s “reasoning self” should set up “guardrails” to manage things during those times when one’s reason is not in charge.  Would you share a favorite example of a guardrail for decision-making and a favorite example of a substantive guardrail in the financial world?

One of the most underused interfaces in human decision-making is the calendar.  If you think about it, the calendar does many, many things wrong.  But one of the interesting things about the calendar is that when you have something there that is set there’s a good chance that you will actually go ahead and do it. 

So, for example, a few years ago before the elections we did a study where a few months in advance we emailed some people, and asked them to set up a time on Election Day to go and vote.  We asked them to set aside three hours for that activity.  Those people basically put the calendar meeting in their diary.  And what happened was they ended up going to vote much more often than people who did not set up a time on their calendars. 

Because if you don’t think about it in advance and you end up remembering two days before the election, all of a sudden the odds are that your calendar will be full with appointments and you’ll have to cancel lots of things to go to vote.  And therefore people might be less likely to do so.

From this basic principle I now try to use the calendar for things that would prevent me from doing things that I actually want to do.  So, I take projects that I really want to work on and need to work on, and I’m afraid that they will be delegated to some lower priority by the things that look like they’re emergencies.  And I set up times for me to meet them. 

I was hoping I would do the same thing for exercise but somehow I never got to do that.  But I think that will be my next move – to start creating time for exercise.  And who knows?  Maybe at some point my life will become so hectic I’ll even start to set up time when I need to go to sleep.

In terms of guardrails in the financial system, I think automatic saving for me is the best example for this.  You know the rational thing to do is to look at the end of each month and see how much money we had, how much expenses we had and then at the end of each month decide how much to send for our long-term savings. 

But, I think we all intuitively realize that if this was the case we would not save as much.  American savings rates are nothing to be proud of, but they will probably be even lower.  And it clearly doesn’t make rational sense because we have different levels of expenses in the winter and in the summer.  There are fluctuations.  There are things that come as emergencies. 

Saving should not be the same every possible month.  But we know that if we relied on our mediocre cognitive ability and thinking and demanded that every month we make this decision, the odds are we will never make this decision.  Or at least we’ll make it very infrequently.  So by creating a system that takes this decision out of our hands we actually do much better.

2.  You argue pretty consistently that one’s reasoning self should be in charge.  What, then, do you make of research suggesting that decision-making without an emotional component isn’t as good as a more balanced approach?  Is decision-making about money different?

I think there’s a bit of confusion in the perception of emotion and decision-making.  There is clearly evidence that people who don’t have an emotional input, who don’t have an emotional coding of information, do very badly in decision-making.  But the way to think about it is that emotion does two things.  Our emotional system provides a way to read information about the world.  It reads information about what we like to do and what we don’t like to do, what’s safe and what’s dangerous. 

We also have a system to make decisions, and I think we need to separate those two.  We need to separate the input part where emotion is a very quick, effective way to give us information about the world — again, what we like, what we don’t like, what we’re afraid of.  And there’s a second system in which emotion is being used for making decisions, not just for input.  When it comes to making decisions using emotions, that’s where emotions are likely to be unsuccessful or lead us astray.  Money isn’t unique in that regard. 

Think about buying a house.  You go to a house.  You go and look at different houses and you feel emotionally good about some and not emotionally good about other ones.  And this provides you some information that you can’t quantify.  You’re not sure exactly which one of those is making you happy.  Is it the tall ceilings or the big glass window?  Is it the trees outside?  You know it’s hard to figure out which ones it is but your emotions are giving you information about that.  Now that’s on the good side because it gives you information that you can’t quantify. 

If you were going to make a decision about buying a house and you were in an emotional state — you’re really angry or revengeful or you just had a fight or you’re hungry — Is your decision about how to negotiate for the house going to be in any way better?  I don’t think so.  So you want to use emotional information as a cue.  You don’t want to use it for decision-making. 

3.  In the financial world, risk and uncertainty are not identical and are often confused.  How does your research relate to this problem?

My research does very little on risk and uncertainty.  However, risk and uncertainty have basically been the building blocks for behavioral economics and sort of the “fruit fly” of behavioral economics.  But my own research doesn’t deal with this that much. 

One of the most, I think, amusing pieces of research I’ve done that would have to do with the perception of risk was research on how men perceive the risk of STDs when they are and when they are not sexually aroused.  And this of course goes back to our earlier discussion about using emotions.  So this effect has to do also with the effect of emotions on decision-making.  And what we find is in line with the Robin Williams joke that God gave men two organs that need a lot of blood but only enough blood for one of them at a time. 

The perceptions of risk about STDs for example, vary dramatically when people are aroused and not aroused.  When men are not aroused they think the risk is very high.  When they’re aroused they think the risk is very low.  And of course accordingly different actions ensue.  This, by the way, is one of those cases where we thought in advance that there’s a good probability that we will find this result. 

Sometimes people ask why you do some research papers that look so trivial, that when you find out the results people say oh I knew that all along, of course this is the case.  Well it turns out that it happens from time to time that we show things that we thought would actually be the case. 

But it also happens sometimes that we don’t show those things.  So science’s role is to try to separate when our intuitions are correct and when our intuitions are not correct.  Of course when they’re correct we are blessed with the hindsight of saying, oh, yes, I knew that all along.  But that’s not always the case.  Anyway, in this case it turns out what we expected is actually what we found.

4. You have criticized the annuity market generally but suggested the need for a “good annuity market.”  In your view, what would a good annuity market look like? 

I think the overall market for annuities is bad, because it is very obscure.  It is hard to price.  And annuity companies can use lots of hidden fees and costs.  If you think about it, it’s a market where most people who sell annuities get their commissions upfront which tells you that it’s probably (a) a hard thing to sell, but (b) that the companies need to incentivize sales people to sell them, which I think suggests (c) that there has to be something quirky about the whole system. 

I personally like two approaches.  I like the Chilean approach, which is as follows.  In Chile, they force all citizens to save eleven percent of their income.  And they allow a few paths of risk.  But as people get older the risk that they can take is decreased by mandate.  Then when people turn 65 the government takes the pool of money from that group of people and gets insurance companies to bid to create annuities for them. 

This creates a situation in which annuity companies compete against each other in the market.  So the cost is decreased.  And they cannot discriminate against individuals.  So it can’t cost you more or less than somebody else.  Plus there’s no self-selection problem, which is that only the people who think that they will live longer and have some private information buy annuities.  So it also makes more sense for the insurance companies to get into this business. 

So that’s one kind of solution.  Now the strange thing about these annuities is that if you bought an annuity you would actually want your annuity company to be conservative because you don’t want them to take risks to price things too low and then in 20 years from now run out of money.  You don’t want them to take high risks because then they will go bankrupt and you would lose potentially everything. 

Another approach is to go back to the Napoleonic solution called tontine.  Tontine is an interesting approach.  Imagine ten people sitting around the table.  Everybody around the table is putting a big amount of money down, with the last person alive taking all the money. 

This approach had two problems.  The first one was that the last person alive doesn’t need all that money.  The second problem of course is that people killed each other to collect.  But I think that given the fact that we have the internet and anonymity, tontines could be revived.  And the kind of tontine that I would like to revive is one where money is distributed every year depending on how many people still survive. 

So, imagine that a thousand people join a tontine, and after a certain age — 65 or whatever — you take the number of people who passed away and you divide their share of the pie and distribute it among those who are left.  What would happen in this situation is that the amount of money people would get would be the mirror image of the mortality rate.  Not many people die at sixty-five, so not much money would be distributed.  But over time you would get more and more and more and more money. 

I like that approach because it changes who’s the bearer of the risk.  It’s not an insurance company because if one year fewer people die they’re just distributing less money, which means that they don’t know exactly what amounts that they will get every year or every month.  The good news about it is that the insurance company is not bearing any risk and is not taking any premium for that risk which makes the whole system much more efficient. 

5.  As you point out repeatedly, money is complex, it is hard for people to delay gratification and saving money is difficult. What is your best idea for helping people do a better job planning for retirement?

Money is difficult.  And money is difficult to deal with now.  Every time we deal with money — we buy a cup of coffee or a computer or car — we need to think about what we are giving up in the future for this pleasure.  We need to think about the opportunity cost. 

But it’s very hard to think about the opportunity cost because there are so many different things we could get with money.  So what exactly we giving up is very, very hard, very hard to think about. 

Often people don’t think about anything.  We went a few years ago to a car dealership and asked people what they would not be able to do if they bought a car today.  And people didn’t know what to say to us because they had never thought about it. 

When we pushed them and said, look something has to give, most people said that if they buy a Toyota then they can’t buy a Honda.  So they were making a substitution in the same timeframe and in the same category. 

 But what they should have been doing is making substitutions in a different time frame with different categories, such as saying that the car represents something like one week’s vacation for the next four years.  Or it’s seven hundred lattes and so on.  But people have a very hard time doing that.  So we often don’t.

Now with retirement it’s especially difficult because we not only don’t know exactly what we’re giving up, it’s also far away in the future.  That makes it very, very difficult to think about.  It’s called hyperbolic discounting — we just care less dramatically about the future so not only is it hard for us to understand what we are giving up, it’s also really, really delayed. 

I think there are basically a couple of different approaches we could take in this area.  One is to create rules.  This is something that people have a very hard time thinking about, so just create rules and tell people what the right thing to do is.  You need to save X dollars a month, right?  That’s it. 

If you’re behind you’re breaking the rule.  You’re not doing the right thing for you and your familyThis is what you need to do.  Parents need to tell their kids.  Companies need to tell their employees.  The government can tell citizens and so on. 

The second thing is to help people understand the negative consequences of not doing it.  Post lots of interviews with people who did not save enough to get people to realize what the costs are.  Imagine a five-minute interview with a retiree on television every week that basically showed how miserable their lives are and what bad trade-offs they made. 

Thus, the first solution is about creating personal and maybe even government regulations and rules.  The second one is about increasing the vividness and the imagination of the downside of not saving.  The third one is to portray for people exactly what they’re getting for their money.  So if you think about the opportunity cost of money — if I spend a thousand dollars now on a new bicycle I know what I’m getting.  If I put it into my retirement account I don’t really know what I’ll get in the future. 

How do we help people realize what they’re going to get in the future?  How do we mark the money that says this is money that would help you pay for X in the future?  I think if we did that, if we actually helped people understand what exactly they’re saving for, saying something like, You’re right now saving for your being able to live in your house.  And you’re right now saving to be able to have health care, and to be able to eat, and so on. I think that money would become more meaningful because more people would understand what’s at stake.

So it’s not an easy problem, I don’t think there’s going to be one solution.  But I think we need to try many, many solutions because it’s clearly a terrible problem.  I hope this was helpful.  Thank you.


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