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Thursday 22 October 2009

Save More ... Tomorrow

Stop Lecturing, Start Helping

The investment maze we need to navigate gets ever more difficult. We’ve seen that investment advisors are unconsciously biased against us (Disclosure Won't Stop A Conflicted Advisor) and that financial training isn't much help (Financial Education Doesn't Work). We’ve been told that long term passive investing in stocks is a bad idea (40 Years Of Bonds Beating Equities) and worst of all we can’t even trust ourselves, because we’re likely to goof off rather than spend time managing our investments (Retirees, Procrastinate At Your Peril).

All told, it’s not a happy situation for the majority of people who’d like a comfortable financial future. Given that behavioural biases are inadvertently responsible for many of the problems that beset us it would be nice if the psychologists stopped telling us what’s going wrong and came up with some useful suggestions. As it turns out they’re already on the case, the only problem being that we don’t, such is the law of unintended consequences, have a clue what the result of this intervention will be.

Positive and Negative Freedom

Mostly free market democracies like to offer free market democratic solutions to problems. The invisible hand of the market is presumed, all other things being equal, to find the best possible solution in a world of difficult trade-offs. The least good solution is usually regulation that seeks to make people behave in their own best interests.

This “least good” option isn’t simply rhetoric. The philosopher Isaiah Berlin elaborated the concepts of Positive and Negative Freedom in his lecture Two Concepts of Liberty. Positive Freedom is the freedom to do whatever we want as long as it doesn’t harm anyone else. Negative Freedom is the freedom that comes from being compelled to act in our own best interests – think fluoride in drinking water, DNA databases to catch future perps or forced retirement savings.

Unfortunately if you give a legislator an opportunity they’ll start doing what they think they do best – introducing more and more laws to protect us. Here in the UK we’re wilting under a plethora of Health and Safety regulations and Anti-Terrorism laws that are intended to save us from nasty things and horrible people. In consequence these regulations are simultaneously depriving us of many of our traditional freedoms and rights: this may be inevitable, but the creep of Negative Freedom is not without its dangers.

Berlin was one of the twentieth century’s more passionate advocates for Positive Freedom. As he pointed out, the century’s more despicable dictators rose to power on a wave of regulations which ended in coercion and dictatorship. Loosely fettered capitalism is a heady bulwark against such trends but the actions of financial engineers over the past decade have placed these freedoms in doubt.

Forcing Retirement Saving

In such an environment it’s unsurprising that the idea of coercing people into saving for their own retirements has become popular. If people won’t voluntarily do what’s in their best interests then we should make them is, in essence, the argument. The difficulty is, of course, that coercing people into effectively taking a salary cut isn’t a universally popular idea so governments have tended to put off the decision in favour of more enjoyable activities like spending the next generation’s tax revenues to ensure that bankers get paid their bonuses in the US or making sure politicians can afford homes for their ducks in the UK. Never let it be said that Britain’s global ambitions have waned since the end of Empire.

Fortunately behavioural psychology has come to the rescue of our conflicted leaders with useful evidence showing that turkeys can be made to vote for Christmas or Thanksgiving just as long as you make sure that their attendance at the ceremonial dinner is the default option. Government advisors are all over this idea, as you can probably imagine.

Default Options Work

Leaving aside the questionable issues of freedom and coercion for the time being, the idea of making people elect out of things they might otherwise choose not to do is a trick commercial companies have been using for years, as the heap of pseudo-junk marketing mail that arrives by snail mail and email each week is testament to. In terms of retirement savings, however, the idea of making the default option something to be automatically opted in to has been shown to have a positive effect on scheme enrolment.

The problem is that this is a one-off intervention. Simply agreeing to invest a fixed value or even a fixed percentage of your salary each month may not be sufficient, especially if the starting amount is small. The ideas of Richard Thaler and Cass Sunstein are at the heart of many of the new initiatives, sparked by their popular book Nudge, which explains how people’s behavioural biases can be used to persuade them to act in their own best interests.

Save More Tomorrow

Thaler’s already shown that these ideas can be put into effective practice through his Save More Tomorrow(tm) scheme. In this he and Schlomo Benartzi have neatly used a number of biases to persuade people to behave better. The design of the scheme is simple: when people enrol they agree that as and when they receive salary rises the amount subscribed to their retirement savings is automatically incremented, by an amount that grows in percentage terms.

This may not sound like much but the impact is remarkable. In the initial study there were two groups – one group that agreed to contribute a higher percentage earnings to start with and who needed to make further decisions to invest more and a second group with lower initial investments but which had agreed - by failing to opt out of the option - to contribute a rising percentage of their future salary rises. Three years and four rises later the Save More Tomorrow(tm) group was contributing significantly more than their counterparts.

What the scheme is doing is taking advantage of a number of behavioural traits that normally militate against long-term savings. Firstly there’s inertia – the tendency to let the status quo continue. So once opted in most people can’t be bothered to opt out. Secondly this overcomes the effects of lack of self control and procrastination - the tendency to prefer short-term immediate rewards over longer-term, uncertain ones. Thirdly there's loss aversion - people don't like seeing a cut in their take home pay. The scheme overcomes this because when a salary rise occurs people still see more money in their wage packet so they don’t suffer the disappointment of ‘losing’ money by opting to save it.

Nudge, Nudge

These concepts have got government advisors everywhere busily figuring out how they can ‘nudge’ people in the direction of current policy. There’s plenty of evidence that default options work – as noted in this fascinating recent Undercover Economist article the organ donor base varies by nearly 80% between the culturally similar Austria and Germany: Austria requires citizens to opt out, Germany to opt in.

As the same article points out, however, there is a problem in using these methods. We know that they work but we don’t know exactly why. And therein lies an issue, because when we nudge people in one direction we’re likely to find that although we may get the desired outcome, we may also cause them to do other things we don’t expect: consumers who save more for retirement in automatic schemes will be consuming less and buying fewer financial products, for instance.

Be Careful What You Wish For

We may think these are generally desirable outcomes but we don't know what the effect will be of governments globally nudging their citizens in any particular way. We need to be careful what we wish for. This isn't a new idea - Thaler and Sunstein have addressed the issue in Libertarian Paternalism is Not an Oxymoron. Here they argue that guiding people to better decisions by using their behavioural weaknesses against them is morally justified.

Isaiah Berlin would probably have disagreed, seeing any form of coercion as the thin end of a long wedge. If we could keep the areas of application of these ideas limited - to retirement savings opt-ins and healthy food choices, for instance - then maybe this would be OK. Unfortunately, the chances of governments limiting their interference to such straightforwardly uncontroversial areas is minimal. Look out for automatic opt-in clauses with everything - after all, it's all in our best possible interests.

Related Articles: The End of The Age of Retirement, Investors, Embrace Your Feminine Side, O Investor Why Art Thou Rational?

1 comment:

  1. We know that they work but we don’t know exactly why.

    They work (to the extent they do) because the focus is on the human actor in the drama rather than on some theoretical idea someone cooked up in a classroom. Everything that derives from the Rational Man school of economics is theoretical. It all sounds plausible if you buy into the assumption that humans are creatures engaged in the rational pursuit of their own self-interest.

    If Madison Avenue believed in Rational Man, our economy would collapse. The people who market goods and services know that, if there is anything that humans are not, it is rational. So they go with what works -- appeals to emotion.

    What we need to see are Advertisements for Saving. If you were trying to persuade people not to save, you would do what we do today -- tell them that the purpose of saving is to provide for the day when they are old and grey. If we were to get serious about encouraging saving, we would tell people about all the wonderful things that saving can do to enhance the enjoyment of life in one's 20s and 30s and 40s and 50s.

    Everyone knows as a matter of logic that they should save. We need to get people to care. We need to impress on people how saving effectively can help you to retire early or to stay home with your kids when they are young or to start your own business or your own non-profit or whatever. We need to hit people's emotional hot buttons. We need to stop with the logic chains and make an effort to connect.