Behavioral Economics of the Save More Tomorrow - Case Study Example

Behavioral Economics of the Save More Tomorrow Behavioural economics is concerned with the emotional, cognitive, social and psychological factors on economic decisions. From this perspective, the Save More Tomorrow schemes adopted in the US and the UK were informed by the knowledge that people were not saving adequately for retirement even though they wanted to (Thaler & Benartzi 2004, p. 164). Essentially, the programme aims at having employees commit to allocate a portion of their salary increments in advance towards retirement savings. Consequently, there has been considerable change whereby employers have shifted towards defined contribution plans rather than defined benefit plans, essentially meaning the responsibility of saving for retirement is now largely upon employees. This is critically important given that supporting the growing population of pensioners without reform will burden those still of working age financially (Yogo 2008, p. 133). On the other hand, albeit on the basis of traditional economic theory, it is imperative that employees are given control and made aware that they have a choice. However, according to behavioural economists, humans are not always economically rational and will often conduct themselves in economically suboptimal ways. To this end, psychological and behavioral issues such as choice architecture and emotions will greatly affect the savings behaviour of individuals. This paper will critically evaluate the concept of choice architecture and the Save More Tomorrow schemes adopted in the US and the UK. Occupational pension schemes typically promise retirees an income basing on a formula that entails the amount of pay a person earns at the time of retirement. It could also be on the basis of the average pay a person has been receiving during their period of membership to the scheme. This arrangement defines the defined benefit (DB) scheme. On the other hand, the defined contribution (DC) is a scheme of pension founded on the contributions an employee invests and the returns they receive on such investment, less any incurred charges. The key differentiating factor between the two schemed is the bearer of the risk as concerns the savings level or expected income during retirement (Thaler & Benartzi 2004, p. 169). The employer bears the risk in DB while the employee bears the risk. However, behavioural economists have shown different trends when it comes to employees voluntarily participating in DC (McClure, Laibson & Cohen 2008, p. 506). Viewed from the perspective of traditional economic theory, decisions are arrived upon by maximising utility functions in which all the relevant preferences and constraints are appropriately included and weighed (Lee, O'Brien & Sivaramakrishnan 2008, p. 180). This is an assumption that the full information is availed to rational decision makers who are able to process it and that, further, their preferences will remain constant and clearly defined over a period of time. In contrast, when approached from the perspective of behavioural economics, this assumption becomes highly questionable. The significance of taking individual financial responsibility has been emphasised by the realisation of the fact that retirement income will not be provided in its entirety by social security programmes. Therefore, individual employees are being required to have greater roles in the planning for their financial health in future and especially after retirement. The problem, however, is the decision-making barrier that employees face. A key reason as to why households do not save enough is because they are unable to figure out how much they need to save (Köszegi & Rabin 2009, p. 1139). The life cycle theory of saving opines that decisions on the consumption level by households will lead to either borrowing or saving to attain the decided amount. It is further opined by the theory that individuals will borrow while still young in their careers but later save in their prime career years for retirement. It is generally assumed by economic theory that important problems are solves in the same way as economists would, of which the life cycle saving theory provides an appropriate example (Barber & Odean 2008, p. 790). Through the example, it is assumed that households would want to even out consumption over the life cycle. It is further expected that households will solve relevant optimisation issues in all periods prior to deciding how much will be consumed and how much will be saved. On the contrary, actual household behaviour will differ from this assumption mainly because of lack of self-control targeting to minimise current consumption rather than enable future consumption (Knoll 2010, p. 116). The critical role of self-control is emphasised by the fact that typical households accumulate retirement-targeting wealth mainly through home equity, pensions and social security programmes. However, looking at these sources of retirement wealth, it is evident that none requires the willpower or significant effort of employees. According to behavioural economics and studies conducted in judgment and decision making, the savings behaviour of employees are affected by factors that may be categorised as informational issues, intertemporal choice, the decision context and biases and heuristics (Rick & Loewenstein 2008, p. 69). Informational issues may be exemplified by anecdotal evidence and ambiguity aversion; intertemporal choice by procrastination and self-control; decision context by choice architecture, framing effects, choice bracketing and reference dependence; and biases and heuristics by default effects, rules of thumb and status quo bias. Looking at informational issues, employees will exhibit a predisposition to avoid making decisions in cases where part of the relevant information to do so is either unavailable or unclear, as defined by ambiguity aversion (Barber & Odean 2008, p. 792). However, behavioural economics suggests that even if the employees had relevantly accurate and complete information, they would still not make optimal decisions about savings due to factors related to biases and heuristics. There are anomalies that models of traditional economics do not account for but they influence savings decision-making among employees. From this observation, it has been shown that employees tend to sanction status quo options disproportionately as well as the methodical persuasion of the default alternative on choice. Employees will also often make use of heuristics (rules of thumb) that, although generally beneficial, sometimes result in erroneous decisions (Lee, O'Brien & Sivaramakrishnan 2008, p. 173). Hyperbolic discounting, as observed under intertemporal choice, will mainly entail the change in preference by employees as their retirement draws closer and will be affected by emotions, procrastination and self-control. Under decision context, it has been shown that the manner in which choices are arranged, considered and presented will have considerable effects on the way employees make decisions about saving for retirement. After analysing these factors, there is an evident disconnect existing among employees between objective and behaviour. Further and more importantly, there exists a dissonance between doing what they need to do and what they want to do (Rick & Loewenstein 2008, p. 93). Hence, even when employees have sound intentions, they still end up making poor decisions about savings. Employees tend to view their present career selves differently from their future retired selves. According to Derek Parfit, a British philosopher, the lack of understanding of the future self is a manifestation of the failure of imagination and presence of false belief (McClure, Laibson & Cohen 2008, p. 504). As shown by brain scans, the same regions of the brain are active when people think about strangers as when they think of their future selves. This disconnection between the future and present self has been shown by behavioural economics to be well recognised and correlated with the reluctance to save. When people are made to imagine about their future selves in practical ways, it a considerable challenge because it is not a mental activity that they ordinarily engage in. For employees, imagining themselves at retirement age invokes multiple possibilities and diverse eventualities, for example, changing cities or losing hair. Placed under such predicaments, it becomes difficult for employees to perceive themselves in a single future focus, of which saving for retirement is part (McClure, Laibson & Cohen 2008, p. 506). The commonest heuristics seems to be the notion of saving the maximum the law allows or the necessary minimum to obtain the full match employers offer. The concepts of self-control and procrastination are increasingly interesting economists with modern models of behavioural economics using the hyperbolic discounting concept (Rick & Loewenstein 2008, p. 94). Intertemporal choices are only time consistent where agents discount exponentially and use rates that stay constant over time. However, employees will display behaviour that is not consistent over time. This is more so when they weigh near-term and current consumption. This can be demonstrated by the example that considers two rewards, big and small, at time t(Xt) and t(Yt+1) respectively. When this is analysed, it can be established that Yt+1 will be preferred in cases where t is far off (Park 2009, p. 214). This is because the difference in the value of the rewards is more than the supposed cost of waiting. On the other hand, as t tends towards zero, there is an increase in the discounted values ration, which leads to a switch of preferences. This is a present-biased preference and it may be captured by hyperbolic discounting in either the naïve or sophisticated varieties. In the case of the sophisticated variety, employees will acknowledge their hyperbolic preferences and act towards addressing their problem, while in the naïve variety, they will fail to acknowledge the problem or, in the least, its extent. Their actual behaviour will be characterised by an attribute that falls in-between the two (Stanovich & West 2009, p. 675). Hyperbolic agents will procrastinate because of their false belief that whatever they are doing presently is more significant than what they will be doing in the future. Therefore, as agents become more naïve, they also tend to procrastinate more and, in turn, procrastination will lead to a strong tendency towards status quo bias, or what behavioural economists have termed inertia. In conclusion, it can be stated that traditional economic theory does not account for some aspects of saving decisions. Policymakers will be able to understand better why employees make the savings decisions that they do if they depart from the premise that man is economically rational (Rick & Loewenstein 2008, p. 74). From that, they can design appropriate interventions that will help and encourage employees make optimal decisions and save adequately for retirement. It is from such interventions that schemes such as the Save More Tomorrow were designed and eventually saw employers shifting towards defined contribution plans rather than defined benefit plans. This has placed the responsibility of saving for retirement upon employees and it is important because it will relieve the burden of supporting the growing population of pensioners from those still of working age. References Barber, B & Odean, T 2008, ‘All that Glitters: the effect of attention and news on the buying behavior of individual and institutional investors’, The Review of Financial Studies, vol. 21, no. 2, pp. 785-818. Knoll, M 2010, ‘The role of behavioral economics and behavioral decision making in Americans’ retirement savings decisions’, Social Security Bulletin, vol. 70, no. 4, pp. 114-119. Köszegi, B & Rabin, M 2009, ‘A model of reference-dependent preferences’, Quarterly Journal of Economics, vol. 121, no. 4, pp. 1133-1165. Lee, B, O'Brien, J & Sivaramakrishnan, K 2008, ‘An analysis of financial analysts' optimism in long-term growth forecasts’, Journal of Behavioral Finance, vol. 9, no. 3, pp. 171-184. McClure, S, Laibson, D & Cohen, J 2008, ‘Separate neural systems value immediate and delayed monetary rewards’, Science vol. 306, no. 5695, pp. 503-507. Park, Y 2009, Investment behavior of target-date fund users having other funds in 401(k) plan accounts, Employee Benefit Research Institute, Washington. Rick, S & Loewenstein, G 2008, The role of emotion in economic behavior, The Guilford Press, New York. 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