Behavioural Economics (ECON30270)
Professor Liam Delaney
Behavioural Economics and the Effects on Retirement Planning Decision Making
Traditional economic theory suggests that people tend to make decisions by maximizing a utility function in which all of the relevant constraints and preferences are included and weighted appropriately (Levin, 2004). However, behavioural economists often are most interested in exploring how people make decisions in situations when they have incomplete information and decision biases (Levin, 2004). Previous research that has been conducted by Richard H. Thaler and Shlomo Benartzi supports the idea that in certain situations people tend to make decisions that are not economically rational, and in this report I will analyze how Thaler and Benartzi recognized that this was a major issue effecting employee retirement savings. This report will discuss the solution that they presented by specifically focusing on how the application of behavioural economic concepts shed light on how employee decision making tended to be economically irrational with regards to their retirement savings. This report focuses on how Thaler and Benartzi applied behavioural economic concepts when creating the Save More Tomorrow Program to help find a solution to issues faced with employee retirement savings.
Thaler and Benartzi designed the Save More Tomorrow program to help employees that were interested in saving more, but who were not committed enough to make those decisions on their own. This program consisted of four main parts, which each are highly influenced by behavioural economic concepts.
The first phase of the program consisted of employees being contacted regarding increasing the amount of their contribution rates (Thaler, 2004). In the designs of their program, Thaler and Benartzi stressed that during this initial phase, it was important for companies give employees ample notice of this opportunity before requiring a decision to be made (Thaler, 2004). The reasoning behind stressing this importance was due to hyperbolic discounting. Hyperbolic discounting relates to this stage of the program because it is the idea that people tend to favor immediate payoffs rather than later payoffs. However, this tendency is much stronger when payoffs are closer together in time. So, the strategy that Thaler and Benartzi created to emphasize that is it critical to approach employees as early as possible helped mitigate the hyperbolic discounting effect that employees would feel when deciding whether or not to take part in the program in the future (Thaler, 2004). So the idea of saving more tomorrow and in the future helped to weaken the hyperbolic discounting effect, ultimately leading them to preferring to join the program in the future as opposed to sticking with their current situation (Thaler, 2004). In contrast, if employees were not given much time to make the decision, they would most likely prefer their current situation as opposed to joining the program. So, with this strategy that was put in place, proved to be effective with regards to the number of employees who chose to participate in the initial program. People were more inclined to make this choice on their own, and it led to more employees deciding to take part in the program.
The second phase of this of this proposal was that after an employee joined the program, they would be required to increase there savings contribution after their first pay raise. This strategy was inspired by the understanding of behavioural economics. The behavioural economics concept that was applied when forming this strategy was to help the employee not feel strong loss aversion when more of their money starts getting contributed to their savings program. The idea behind this is that an employee will experience a decrease in future gains as opposed to a loss in pay, and because people tend to place more significant importance on loss of money, as opposed to future gains, this strategy proved to be effective (Thaler, 2004). This method led to employees having money taken away from their pay beginning when they first received their pay raise. So, they never got to feel what it was like to have their full pay as take-home money which helped mitigate the feeling of loss aversion because their never became accustomed to living on that increased available income (Bergman, 2009). If this policy had not been enforced, and say for example, employee contributions only started after the fifth raise, then the employee might be shocked and feel like more money is being taken away from them because they have already been getting accustomed to living on that increased take-home pay. This had been a previous issue, which was one reason leading to issues with employee retirement savings. So, with a strategy like this, employees may have felt that larger cuts to their pay as contributions to their savings program were more of a loss than a gain due to those contributions leading to less present take home pay. This feeling leads into the idea of an employee’s self-control. Self-control can play a role here because if employees have to cut spending and have more of their pay go to their savings, they may have to change their habits and lifestyle (Tversky, 1974). This can be a huge change in ones life and incredibly difficult to bring oneself to actually do. So, in order to dilute this feeling of loss aversion, Thaler and Benartzi realized that people were happier if they had money taken away from the beginning so they would not have to experience the feeling of loosing pay and giving up lifestyle habits that they have grown accustomed to (Thaler, 2004).
The third phase of the Save More Tomorrow program which I touched in in the previous paragraph, is that employee contributions start from the first pay raise, and continue to be increased after each future pay raise, until the maximum contribution rate is satisfied (Thaler, 2004). Thaler and Benartzi designed this strategy because it allowed this continuous contribution increase to become a seemingly default setting for employees participating in the program. The idea behind turning this into a default options was that it enforced the status quo bias and inertia effect. This basically meant that once this option became the employee’s default plan, they had the tendency to just stick with it and not attempt to do anything different. This also had the effect of encouraging people to stay enrolled in the plan. The reasoning behind this is that once an employee makes their decision, then as I previously mentioned, it becomes the default option, and they will likely be most satisfied by sticking with it. So, by understanding the concept of status quo bias, Thaler and Benartzi were able leverage their understanding of how to influence people in order to design this part of the program to really increase satisfaction among participants, while also continuing to help them save more.
The fourth phase of this program is to allow the employee to opt out at any time (Thaler, 2004). The goal is to still have employees decide on participating in the program, however the idea behind giving them the opt out option is that by allowing employees to freely exit the program whenever they want, it helps create a sense of security and comfort for an employee when deciding whether or not to participate.
In conclusion, Thaler and Benartzi successfully used the concepts of behavioural economics to launch the Save More Tomorrow program, which was very successful. By recognizing and understanding how employees often make decisions with regards to their retirement savings, Thaler and Benartzi, have been able to apply behavioural economic concepts to design programs that truly are able to help change the structure of the way employees participated in company savings plans. This model has continued to be implemented in a wide variety of settings, but is has drastically changed the way companies set up their employee retirement saving programs.
References:
Beggs, A. and Kathryn, G. (2009) 'Anchoring Effects: Evidence from Art Auctions'.
Bergman, O., Ellingsen, T., Johannesson, M. and Svensson, C. (2009) 'Anchoring and cognitive ability'.
Levin, J. and Milgrom, P. (2004) 'Introduction to Choice Theory'.
Thaler, H., Richard and Shlomo, B. (2004) 'Save More Tomorrow™: Using Behavioural Economics to Increase Employee Saving'.
Tversky, A. and Kahneman, D. (1974) 'Judgment under Uncertainty: Heuristics and Biases'.
