Early behavioral finance studied the way people arrive at financial decisions and then tended to smile. The good news is that behavioral finance has moved well beyond amusement, and is now turning our behavioral challenges into behavioral solutions.
By Shlomo Benartzi
This relatively young field is moving into an important new phase. We can call the first phase Behavioral Finance 1.0, which was an effort to understand why people tend to make the money mistakes they so often do. For example, inertia is often a behavioural challenge or an obstacle that prevents employees from saving for their future.
The goal of the new phase, Behavioral Finance 2.0, is to use this knowledge to help people avoid mistakes. Behavioral Finance 2.0 is about designing behavioral solutions. Behavioral Finance 2.0 is about turning inertia into a behavioral opportunity.
Making inertia work
For instance, one could make good use of inertia by changing the default so that employees are automatically enrolled in the retirement saving plan, unless they actively opt-out. With automatic enrollment, taking no action results in saving for retirement, which is what the majority of people say they want.
Inertia is now an ally – not an enemy.
This seemingly minor change dramatically affects plan participation. The first study of this issue found that plan participation of new employees jumped immediately to close to 90 percent, compared with 64 percent for employees who had been on the plan for between three and five years (Madrian and Shea, 2001).
By now more than a dozen such studies have been reported, and all show a similar boost. Automatic enrollment not only works, it is also extremely powerful.
The [United States] Pension Protection Act of 2006 encouraged plan sponsors to adopt automatic enrollment, and its popularity is growing. In 2010, 34.4 percent of plans had automatic enrollment for new hires and a further 7.4 percent offered it to existing, non-participating employees (PSCA, 2011). (Participation varies according to plan size; it is highest in large plans.)
Automatic enrollment is by far the most effective tool identified to date to increase plan participation. However, its strength is also a potential weakness, compounded by other psychological factors.
Progressive plan sponsors who adopted automatic enrollment early on typically set the savings rate at 3 percent. Some feared a higher rate might provoke more participants to opt out. However, research shows that this is ungrounded (Beshears et al., 2009). A low initial deferral remains common today. In 2010, 61.8 percent of plans with automatic enrollment had an initial deferral rate of 3 percent (PSCA, 2011).
Of course, saving just 3 percent will not provide anyone with a comfortable retirement. The expectation was that plan participants would gradually raise their saving rate to a more adequate figure – 10 to 15 percent, for example. My colleague Richard Thaler and I predicted, however, that because of inertia most participants would stick with that initial low saving rate and fail to increase it.
Indeed, an article in the 7 July 2011 issue of the Wall Street Journal reported that 40 percent of new hires who were automatically enrolled in their company’s 401(k) plan are now saving less than if they had actively opted into their plans (Tergesen, 2011).
We therefore designed a behavioral solution to help employees save more – tomorrow.
Just like deciding to exercise more and eat less tomorrow (rather than today), “saving more tomorrow” is perceived as less painful
Save More Tomorrow
The first ingredient of the Save More Tomorrow (SMarT) solution is to invite employees to save more: not now, but in the future. This feature assumes the same human tendency I will exhibit as I head out to the Toscana Restaurant with my wife, Lesli, as soon as I finish writing this article, praying that they still have plenty of my favorite profiteroles and naively believing that tomorrow, I will exercise more and eat healthily.
This self-delusion is based on the psychological principle of “present-bias,” where we heavily discount the future. So, tough tasks like dieting and saving seem easier to face – if we locate them in the future. Most people are master procrastinators, convincing ourselves that we will do the right thing tomorrow.
Thaler and I therefore guessed that inviting plan participants to start saving more tomorrow, rather than today, would be perceived as more attractive. It was.
The second ingredient is to time the saving increases with pay raises, so employees save more when they make more money, ensuring that their take-home pay never goes down. This avoids loss aversion, which is hyper-sensitivity to losses or reductions in our spending.
And the third ingredient is to put the program on auto-pilot, so employees automatically increase their saving rate every time they get a pay raise, up to a set target. On this auto-pilot program plan participants are spared the task of taking action and their saving rate climbs all by itself.
In our first case study of SMarT in 1998, we faced a rather challenging environment: a company with rather low savings rates, especially among the lower-paid employees. The employer brought in a financial advisor and offered free consultation to all employees.
Ten percent declined the invitation, preferring to make their own decisions. The average saving rate of this group was 6.6 percent. Almost a quarter followed the advisor’s advice to have a one-time boost in savings rate of five percentage points. The remainder, mostly the lower-paid blue-collar employees, said they could not afford to save more at that time. Their average saving rate was just 3.5 percent.
We can call them “timid savers.” Yet, 78 percent of this group who could not save more at the time were happy to sign up to automatically save more in the future, every time they began to make more money.
After three-and-a-half years and four pay raises, the average saving rate of timid savers had almost quadrupled to 13.6 percent. This was double the saving rate of employees who had elected to make their own saving decisions (Thaler and Benartzi, 2004).
SMarT had empowered timid savers to become bold savers by transforming behavioural challenges into behavioral solutions.
As of 2010, more than half of the large employers in the United States have incorporated automatic saving increases in their 401(k) plans, and similar programs are being implemented in the United Kingdom, New Zealand and Australia.
The SMarT program turned the behavioral challenges of present-bias, limited self-control, loss aversion and inertia into a behavioral solution that is likely to have already helped millions of people boost their savings. The key lesson here is that Behavioral Finance 2.0 not only works, it is also extremely effective at improving outcomes (Benartzi and Lewin, 2012).
While Behavioral Finance 2.0 has helped millions boost their retirement savings, there are many more opportunities to help people make better financial decisions. I am passionate about extending behavioral finance to the “decumulation phase” of retirement planning; that is, how people manage their finances after they retire.
How do they manage the risk of outliving their money? Stay tuned as the Allianz Center for Behavioral Finance applies behavioral finance lessons to the monetary challenges that retirees face.
This article was first published in Project M.
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