SAVE MORE TOMORROW

In 2005 the personal savings rate for Americans was negative for the first time since 1932 and 1933—the Great Depression years. On average, American households spent more than they earned and borrowed more than they saved. Increased borrowing rates were fueled by substantial growth in home equity loans and in credit card debt. For many Americans, savings rates, especially retirement savings, are woefully low, if not zero. Consider, for example, the case of Tony Snow, the former White House press secretary, who resigned at age fifty-two in 2007 to return to
the private sector. He said his motivation for leaving was financial. “I ran out of money,” he told reporters. “We took out a loan when I came to the White House, and that loan is now gone. So I’m going to have to pay the
bills.” Before serving as press secretary, Snow worked a much more lucrative gig as a Fox News Channel anchor. But he arrived at the White House not having learned Retirement 101 lessons. “Snow conceded: ‘As a matter of fact, I was even too dopey to get in on a 401(k).’”

 

 The fact that many people are not saving for retirement exacerbates the looming problems facing the Social Security system. As all politicians know but few are willing to say, we will eventually have to bite the bullet in order to make Social Security solvent, through some combination of tax increases or benefit cuts. Americans would be better able to deal with this problem if they were saving more on their own. And indeed, the government has often passed laws designed to encourage personal savings, typically by creating tax-favored savings accounts such as iras and 401(k)s.

 

Such programs are well intended, but many Americans who are eligible for such plans do not take full advantage of them.

What can be done to help? We will be offering two central suggestions. The first is automatic enrollment in savings plans; the second is the Save More Tomorrow program. To understand why these nudges would work, and why they are not part of the usual economics repertoire, we need to step back a bit.


The standard economic theory of saving for retirement is both elegant and simple. People are assumed to calculate how much they are going to earn over the rest of their lifetime, figure out how much they will need when they retire, and then save up just enough to enjoy a comfortable retirement without sacrificing too much while they are still working.


As a guideline for how to think sensibly about saving, this theory is excellent, but as an approach to how people actually behave, the theory runs into two serious problems. First, it assumes that people are capable of solving a complicated mathematical problem in order to figure out how much to save. Without good computer software, even a trained economist would find this problem daunting. The truth is that we know few economists (and no lawyers) who have made a serious attempt at doing it (even with software).*


The second problem with the theory is that it assumes that people have enough willpower to implement the relevant plan. Under the standard theory, flashy sports cars or nice vacations never distract people from their project of saving up for a condo in Florida. In short, the standard theory is about Econs, not Humans.


For most of their time on earth, Humans did not have to worry much about saving for retirement, because most people did not live long enough to have much of a retirement period. In most societies, those who did
make it to old age were cared for by their children. In the twentieth century, the combination of rising life expectancies and geographical dispersion of families made it necessary for people to think about providing for
their own retirement income rather than depending on their children to do it. Both employers and governments began to take steps to help with this problem, with Bismarck’s early social security program in Germany leading the way in 1889.

 

Early pension plans tended to be defined-benefit plans. In such plans, participants are entitled to a benefit that depends on a specific formula, typically based on the participant’s salary and the number of years the participant was a member of the plan. In a typical private plan, a worker is entitled to receive a benefit that is a proportion of the salary paid over the last few years of work, the proportion depending on years of service.


Most public social security systems, including that of the United States, are also defined-benefit plans. Your Social Security check depends on the amount you have paid in taxes and the number of years you have worked.
The payouts are even adjusted for inflation, so you know exactly what you will be paid (unless Congress changes its mind, as it is entitled to do; the Constitution does not protect your right to Social Security benefits).

 


From the perspective of choice architecture, defined-benefit plans have one large virtue: they are forgiving to even the most mindless of Humans. With Social Security, the only decision a worker has to make is when to
start receiving benefits. The only form to fill out is the one where you write down your Social Security number, and you have to fill it out if you want to get paid! In the private sector, defined-benefit plans are also easy and
forgiving, as long as the worker keeps working for the same employer, and the employer stays in business. The decision about when to retire is not so easy, but it
is only one decision; the same is true for the decision about
when to start claiming Social Security benefits. We discuss that decision, and how the government might offer some useful nudges.


While a defined-benefit world can be an easy one for someone who stays in one job her entire life, employees who change jobs frequently can end up with virtually no retirement benefits, because there is often a minimum
employment period (such as five years) before any benefits are vested (that is, owned by the employee). Defined-benefit plans are also expensive for employers to administer. Many old firms are switching over to definedcontribution plans, and nearly all new firms offer only defined-contribution plans. Under a defined contribution plan, employees, and sometimes employers, make specific contributions to a tax-sheltered account in the employee’s name. The benefits received by employees in retirement depend on the decisions they make about how much to save and how to invest.


Defined-contribution plans, such as 401(k) plans in the United States, have many desirable features for modern workers. The plans are completely portable, so a worker is free to move from one job to another. The plans are also flexible, giving employees the opportunity to adjust their savings and investment decisions to reflect their own financial situation and tastes. However, defined-contribution plans are not very forgiving. Employees have to get around to joining, to figuring out how much to save, to managing their portfolio over a period of years, and then to deciding what to do with the proceeds when they finally retire. People can find the whole process frightening, and many seem to be making a mess of the task. 

 

Are People Saving Enough?

Of course, a key question is whether people are saving enough. Are they? This turns out to be a complex and controversial question. For one thing, economists do not agree about how much saving is appropriate,
because they do not agree on the right level of post-retirement income. Some economists argue that people should aim to have retirement income that is at least as high as the income enjoyed when working, because retirement years offer the opportunity for such time-intensive expensive activities as travel. Retired people also have to worry about growing health care costs. Others claim that retirees can use their greater time to live a more economical lifestyle: saving the money once spent on business clothes, taking the time to shop carefully and prepare meals at home, and
taking advantage of senior discounts.

We do not take a strong position on this debate, but consider a few points. It seems clear that the costs of saving too little are greater than the costs of saving too much. There are many ways to cope with having saved too much—from retiring earlier than expected, to taking up golf, to traveling to Europe, to spoiling the grandchildren. Coping in the opposite direction is less pleasant. Second, we can say for sure that some people in our society are definitely saving too little—namely, those employees who are not participating at all in their retirement plan, or are saving a low percentage of their income after having reached their forties (or older). These folks could clearly use a nudge. 

 

For what it is worth, many employees say that they “should” be saving more. In one study, 68 percent of 401(k) participants said that their savings rate is “too low,” 31 percent said that their savings rate is “about right,” and only 1 percent said their savings rate is “too high.” Economists tend to belittle such statements, and partly for good reason. It is easy to say that you “should” be doing many good things—dieting, exercising, spending more time with your children—and people’s actions may tell us more than their words. After all, few of the participants who say they
should be saving more make any changes in their behavior. But such statements are not meaningless or random. Many people announce an intention to eat less and exercise more next year, but few say they hope to smoke
more next year or watch more sitcom reruns. We interpret the statement “I should be saving (or dieting, or exercising) more” to imply that people would be open to strategies that would help them achieve these goals. In
other words, they are open to a nudge. They might even be grateful for one.

Enrollment Decisions: Nudging People to Join

The first step in participating in a defined contribution plan, such as a 401(k), is to enroll. Most workers should find joining the plan very attractive. Contributions are tax deductible, accumulations are tax deferred, and in many plans the employer matches at least part of the contributions of the employee. For example, a common plan feature is that the employer will match 50 percent of the employee’s contributions up to some threshold, such as 6 percent of salary. This match is virtually free money. Taking full advantage of the match should be a no-brainer for all but the most impatient or cash-strapped households. Nevertheless, enrollment rates in such plans are far from 100 percent. Roughly 30 percent of employees eligible to join a 401(k) plan fail to enroll.3 Typically, younger, less-educated, and lower-income employees are less likely to join, but even high-paid workers sometimes fail to sign up, as the Tony Snow example illustrates.

To be sure, there are situations, say for young workers with other pressing financial needs, in which it could be sensible not to join even with an employer match. But in many cases, the failure to join is simply a blunder.
One extreme example comes from the United Kingdom, where some defined-benefit plans do not require any employee contributions and are fully paid for by the employer. They do require employees to take action to
join the plan. Data on twenty-five such plans reveal that scarcely half of the eligible employees (51 percent) signed up!
4 This is equivalent to not bothering to cash your paycheck.


Some older American workers are also turning down “free money.” To have this free money option, a worker must meet three qualifications: he  needs to be more than 59
1/2 years old, so that he faces no tax penalty when
he withdraws funds from his retirement account; his firm has to offer a matching contribution (meaning that the firm contributes something if the employee does); and his employer has to allow employees to withdraw funds from their retirement accounts while still working. For such employees, joining the plan is a sure profit opportunity because they can join, then immediately withdraw their contributions without any penalty, yet keep the employer match. Nonetheless, a study finds that up to 40 percent of eligible workers either do not join the plan at all or do not save enough to get the full match.


These extreme examples are just the clearest cases in which people’s failure to join a plan is foolish beyond a doubt. In many other cases, workers take months or years to join the plan, and it is a reasonable assumption that most of these workers are just spacing out or procrastinating rather than making a reasoned decision that they have a better use for their money. How can we nudge these people to join more quickly?*

 

Making Savings Automatic

An obvious answer is to change the default rule. As things now stand, the default is nonenrollment; you have to do a little work to get into a retirement plan. When workers are first eligible to join (sometimes immediately upon employment), they usually receive a form to fill out. Employees who want to join must decide how much to put aside, and how to allocate their investments among the funds offered in the plan. Forms can be a headache, and many employees just put them aside. An alternative is to adopt automatic enrollment. Here’s how it works.


When an employee first becomes eligible, she receives a form indicating that she will be enrolled in the plan (at a specified savings rate and asset allocation), unless she actively fills out a form asking to opt out. Automatic enrollment has proven to be an extremely effective way to increase enrollment in U.S. defined-contribution plans.6
In one plan studied in an early paper by Brigitte Madrian and Dennis Shea (2001), participation rates under the opt-in approach were barely 20 percent after three months of employment, gradually increasing to 65 percent after thirty-six months. But when automatic enrollment was adopted, enrollment of new employees jumped to 90 percent immediately and increased to more than 98 percent within thirty-six months. Automatic enrollment thus has two effects: participants join sooner, and more participants join eventually.


Does automatic enrollment merely overcome workers’ inertia, helping them make the choice they would actually prefer? Or does automatic enrollment somehow seduce workers into saving when they would prefer to be spending? One telling bit of evidence is that under automatic enrollment, very few employees drop out of the plan once enrolled. In a study of four companies that adopted automatic enrollment, the fraction of 401(k) participants who dropped out of the plan in the first year was only 0.3 to 0.6 percentage points higher than it had been before automatic enrollment was introduced.7 Although the low dropout rate is, of course, partly due to inertia, the fact that so few people drop out does suggest that workers are not suddenly discovering, to their dismay, that they are saving more than they had wanted.

 

Forced Choosing and More Simplicity

 

An alternative to automatic enrollment is simply to require every employee to make an active decision about whether to join the plan. If a worker is eligible when he is first hired, he might be required to check a “yes” or a “no” box for participation in order to get paid. With required choosing in place, employees have to state their preferences, and there is no default option. As compared with the usual opt-in approach (you are not enrolled unless you decide to fill out the forms), required choosing should increase participation rates. One company switched from an opt-in
regime to active decisions and found that participation rates increased by about 25 percentage points.8 A related strategy is to simplify the enrollment process. One study tested this idea by analyzing a simplified enrollment form.9 New employees were handed enrollment cards during orientation with a “yes” box for joining the plan at a 2 percent savings rate and a preselected asset allocation. Employees did not have to spend time choosing a savings rate and asset allocation; they could just check the “yes” box for participation. As a result, participation rates during the first four months of employment jumped from 9 percent to 34 percent.

While automatic enrollment or “quick” enrollment makes the process of joining a retirement plan less daunting, expanding the number of funds available to participants can have the opposite effect. One study finds that
the more options in the plan, the lower the participation rates.10 This finding should not be surprising. With more options, the process becomes more confusing and difficult, and some people will refuse to choose at all. 

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