How behavioral economics is increasing retirement savings

(Phys.org) —A new study of retirement plans in the US has demonstrated how adopting behavioral economics is encouraging people to increase their savings for retirement.

Behavioral economics

is the study of how emotional, social and cognitive factors influence economic decision-making both at the individual and institution level, and the financial consequences of these decisions. In combining economic and psychological theories it seeks to correct for the traditional economic viewpoint that people always act rationally, always have unlimited willpower and are always self-interested, which are obviously untrue.

Saving for

retirement is a difficult cognitive and self-control problem and many low or middle-income earners have virtually no retirement savings because there is a stronger urge to spend now than to save for a period a long time in the future. Retirement savings are low in many countries, and in the US only about half have inadequate savings for retirment, but this is up from 31 percent only 30 years ago.

In the US, retirement funds are either IRAs (individual retirement arrangements) or 401(k) pension accounts, which both aim to overcome the self-control problem by providing incentives to save and penalties for withdrawing the savings early. One problem with these retirement funds is they are not compulsory and many people forgo the long-term advantages for short-term gains. They essentially delay joining the retirement funds because they want to spend the money now.

Researchers Shlomo Benartzi of the University of California Los Angeles and Rchard Thaler of the University of Chicago have suggested four steps, which they dub the "four A" steps: Availability, Auto-enrollment, Automatic investment choices, and Automatic escalation of savings.

The first step is to ensure retirement plans are available for every American worker regardless of the size of the company they work for. At present only around 50 percent of American workers have access to retirement savings plans in their workplace.

They suggested a simple way to lower the psychological barriers to joining a retirement plan is to use automatic enrollment, which makes opt-in the default . This works because less effort is then required to join the plan and forms need to be filled in to avoid joining. Many companies that have switched the default to opt-in have seen dramatic increases in participation rates.

The third A is automatic investment options, and Benartzi said this increases saving because when people choose their investment options themselves they tend to make poorer choices.

An automatic escalation process was proposed by Benartzi and Shlomo in their SMarT (Save More Tomorrow) program released in 2004. Under this plan employees' contributions to their 401(k) plan automatically rise each year at the same time as salary increases. This ensures that while employees' savings inclrease their take-home pay does not decrease, and so the psychological aversion to loss does not occur. In the first company to adopt the SMarT plan employees who participated increased their savings from 3.5 percent to 13.6 percent over four years.

This week, Benartzi and Thaler reported in the journal Science on their large-scale field study of the impacts of the suggested behavioral economics changes are having on retirement plans. They report that since 2005 companies providing an auto-enrollment retirement plan for their employees has risen from 19 to 56 percent. Over 50 percent of the retirement plans in the US now have automatic escalation, which is up from 9 percent, and this has resulted in an increase in annual retirement savings by $7.4 billion.

Inadequate savings for retirement is a problem common to many countries. In a recent report the retirement system in the Netherlands were rated best, Australia second, UK sixth and the US tenth of the sixteen nations surveyed.

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