The psychology of saving
‘There is one dramatic success for behavioural economics — the way it has shaped pensions’
“THERE ARE IDIOTS. Look around.” So began a famous economics paper by Larry Summers — a lauded academic before he became US Treasury secretary. It is perhaps the most concise expression of behavioural economics, the branch of economics that tries to take psychology seriously.
Behavioural economics is appealing not only because it is realistic but also because it is vastly more charming than the traditional variety. Championed by economists such as Richard Thaler (co-author of Nudge and author of a new book, Misbehaving ) and psychologists such as Nobel laureate Daniel Kahneman (author of Thinking, Fast and Slow), it has triumphed in the “smart thinking” section of the bookshop and exerted increasing influence in academia.
It can be hard to turn psychological insights into rigorous academic models, and even harder to turn them into good policy. But there is at least one dramatic success for behavioural economics — the way that it has shaped pensions. At a recent Financial Times event, Professor Thaler rightly celebrated this as the field’s greatest triumph.
Other than Thaler’s own evangelism, the reason for this success is twofold. First, when it comes to pensions there is a large gap between what we do and what we should do. Second, bridging that gap is fairly simple: we need to encourage people to save more, and in most cases those savings should flow into simple, low-cost equity tracker funds. The only comparable example that springs to mind is smoking: many smokers are making themselves unhappy and would be better off if they could find a way to stop. And as a classic research paper in behavioural economics concludes, taxes on cigarettes seem to make smokers and potential smokers happier by prompting them to quit, or never start.
Given the problem — people need to be nudged into saving more — the biggest pension policy breakthrough has been automatic enrolment, a cornerstone of modern UK pension policy and widely used in the US too. A typical defined contribution pension invites people to pay money into a pension pot, often enjoying tax advantages and matching contributions from an employer. Yet people procrastinate: money seems tight, retirement is a long way off, and who wants to fill in forms? Automatic enrolment reverses the default, deducting pension contributions from our payslips unless we take active steps to opt out. The process respects our autonomy — you can opt out if you wish — but makes it easy to do what we probably should be doing anyway.
A clever supplement to this approach is “Save More Tomorrow”, a scheme in the US whereby people make an advance commitment to redirect part of their pay rises into the pension. At a 50/50 ratio, for example, a 2 per cent pay rise becomes a 1 per cent pay rise and a 1 percentage point increase in pension contributions. It doesn’t take long for a 3 per cent contribution (which is inadequate but typical in the US) to become something more sensible, such as 10 or 15 per cent. Thaler has been a driving force behind both ideas.
Of course, these tactics do not work for everyone. I once spoke at a book festival in Australia and found that a slice of my modest fee had been automatically invested in an Australian pension for me. This benefited nobody except some administrators and the postman who delivered the letters from Australia, detailing the evaporation of my tiny pension pot.
A more serious difficulty is choosing the right level of default contribution. A default that is too aggressive — automatically deducting 25 per cent of salary — jolts most people into opting out. A default that is too low, such as 3 per cent of salary, could conceivably be worse than the old opt-in default of zero. Many people who might have taken an active choice to save 6 or 7 per cent rather than nothing end up settling instead for the default. As mentioned, 3 per cent is a common level for automatic enrolment in the US, for no good reason other than historical accident. Yet it is dangerously low.
There is also a painful conflict of interest at the heart of any corporate pension plan. From the perspective of classical economics, companies will offer generous pensions if they want to attract capable staff. It is expensive to subsidise a pension but staff value the subsidy, making it worthwhile.
From the more realistic perspective of behavioural economics, a tension emerges. A benevolent planner, armed with behavioural insights, would nudge people into a passive pension investment with almost no conscious thought. But a corporate human resources director would want to remind employees how generously their pensions are being subsidised. That means frequent reminders and ample opportunity to admire the pension pot — even if such admiration leads to anxiety about uncertain returns, or expensively trading shares within the pension.
There are approaches that might keep both the behavioural economist and the HR director happy. For example, a pension pot that is expressed in terms of daily or weekly income in retirement, adorned with photographs of cruise ships, seems more appealing than an abstract and rather meaningless lump sum.
We cannot blame behavioural economics for this tension but it is real. As automatic enrolment becomes the norm, it will be important to keep an eye on how corporations respond.
Written for and first published at ft.com.