A political plan to help you save more
A new breed of economists say they know what you need to do to save more money, secure your retirement - and rescue the planet. The nation's politicians are starting to listen.
(Money Magazine) -- On April 15, 2018, Johnny Behave wakes up feeling pleased with himself. His tax return was filed weeks ago, thanks to the IRS' Insta-File service, which e-mailed him a completed form for his approval. One click and his taxes were done. He has no worries about having enough money for his kids' college or his own retirement because his employer's Save-a-Bundle plan automatically suctions money from his paycheck and hikes the withdrawal rate as his salary rises.
Once a year, Behave's cable company, cell-phone provider and credit-card issuer send him a summary of what he watched, whom he called and what he bought; for a modest fee, a service checks those reports to see if he's getting the best deal. To top it off, his gas is free. The government grants every American family a 30-gallon monthly allowance. But if the Behave family uses more, they pay $20 a gallon. They rarely have to pay.
If you were a lawmaker and wanted Americans to do what's good for them, you'd have two classic options. You could outlaw imprudent behavior. (If you think that always works, note how many drivers obey the speed limit next time you're on the highway.) Or you might dangle financial rewards for doing the right thing and hope the free market will do the rest.
Or you could turn to a third option (the one carried to a tongue-and-cheek extreme in the futuristic scenario above): Let people freely make their own decisions, but rig the system so they're more likely to make good moves in spite of themselves.
That third option is the intriguing brainchild of a coalition of economists, psychologists and policy wonks steeped in behavioral economics - a once upstart discipline that's now accepted wisdom among financial planners and investment managers.
If you're a longtime Money reader, you're already familiar with the field, which studies how psychology often gets in the way of wise financial decisions. You know that recognizing those blind spots can be the best way to avoid wrongheaded money moves in your own life.
Now that same research is seeping from personal finance into public policy. Right now, the movement's intellectual spearpoint is the book "Nudge: Improving Decisions About Health, Wealth, and Happiness" by Harvard law professor Cass Sunstein and University of Chicago economist Richard Thaler, whose research into savings behavior played a role in shaping the 2006 law that made automatic 401(k) enrollment possible.
But Thaler and Sunstein are not alone. Predictably Irrational by Dan Ariely, a behavioral economist at Duke and MIT, spent 11 weeks on the New York Times bestseller list this year. And experts at the Brookings Institution, the National Bureau of Economic Research, the Federal Trade Commission and the Federal Reserve Bank of Boston have joined the movement to use behavioral economics to get you to lower your energy bills, drive less and make your money last in retirement.
Even the presidential candidates' platforms show signs of the field's influence. "Both campaigns understand that markets work but don't fully get the job done," says Arthur Brooks, who teaches public policy at Syracuse University.
To be sure, behavioral economics is still in its political infancy. But get ready. You're going to be on the receiving end of it in the years ahead.
Thirty years ago, economists and psychologists began challenging one of the central tenets of traditional economics: that people are rational decision makers who always act in their own best interests.
They started with the inconvenient fact that people are only sporadically rational and often don't act in their best interests. They then set out to investigate the psyche's most puzzling tendencies.
We humans are, for example, irrationally averse to loss. In a classic behavioralist experiment, subjects are asked to choose between a certain $3,000 loss and an 80% chance of losing $4,000 and 20% chance of losing nothing. Most people pick the second option, even though it's not the mathematically sound choice. (An 80% chance of losing $4,000 works out to an average loss of $3,200; better to lose an even $3,000.) But the idea of accepting a loss when there's even a slight chance of avoiding it runs against our instincts.
Similarly, we tend to be inordinately wary of taking any action that might turn out to be wrong, a habit the behavioralists call "status quo bias" or what the rest of us call inertia. It's why some 30% of employees eligible for 401(k) plans never participate, and why the overwhelming majority of 401(k) participants never make a move to rebalance their portfolios.
The catalogue of psychological blind spots goes on: We place too much value on immediate rewards and too little on deferred rewards, one reason it's so hard to save for the future and so easy to over-spend on credit cards.
And when faced with a shortage of information, we have a peculiar habit of attaching significance to whatever data are handy ("anchoring"). That's why investors tell themselves they'll hang on to a losing stock until it gets back to even, and why homeowners still insist that the value of their home is what their neighbor's sold for in 2006.
While such tendencies may be unproductive, they're not unpredictable. Therein lies the entrée to public policy. To turn irrational human beings into financially astute citizens, policymakers simply have to frame a set of options so that people's wayward instincts guide them toward the socially desirable choice.
About 10 years ago, based on the work of Thaler and others, behavioralists began to theorize that this kind of economic jiujitsu could help solve the problem of low participation in 401(k) plans.
As you know, even a modestly generous 401(k) comes with tax breaks and free employer matches so attractive that any rational employee would enroll. Still, some 30% of eligible workers don't. The solution: Instead of trying to persuade employees to sign up, employers would simply enroll them without their permission and let them quit. In other words, make inertia work for employees, not against them.
The prediction was that far fewer people would opt out of the new plan than were failing to opt into the old one. Sure enough, a 2001 study of one 401(k) by Brigitte Madrian of Harvard and Dennis Shea of Penn State found that automatic enrollment lifted participation rates for new hires from 65% of employees after 36 months on the job to 98%.
Five years later, as part of the Pension Protection Act, Congress adopted this approach and allowed any company to automatically enroll workers in a 401(k) - and the notion that behavioral economics can actually help solve social problems suddenly had legs.
"Our ideas are gaining traction because they are based on common sense and a description of behavior that everyone, from voters to politicians can relate to," says Thaler. Democratic presidential nominee Barack Obama borrowed the automatic enrollment provision for his campaign's retirement savings program; under his proposal, companies without savings plans would be required to set up employees in a direct-deposit IRA. Workers could opt out, but few probably would.
And savings plans are just the beginning for behavioralists. "The problem is the market doesn't protect us from our own folly," says psychologist Daniel Kahneman, who won the Nobel Prize for his work on behavioral economics in 2002. "If what we want is to improve people's choices without eliminating their freedom, then I think behavioral economics is very helpful."
One problem with automatic enrollment is that once enrolled, workers tend to keep saving at the default level, typically 3% of pay. That's not enough for a healthy retirement.
A solution, already in place at hundreds of companies, is a system conceived by Thaler and UCLA's Shlomo Benartzi called Save More Tomorrow. Taking advantage of the fact that you find it easier to promise to tighten your belt in the future than to do it today, the program asks you to agree to boost your savings automatically with every future raise. In one 401(k) that Thaler studied, three years after Save More Tomorrow was introduced, the average savings rate had risen from 3.5% to 13.6%.
Another serious issue arises once you retire: Since you don't know how long you'll live, how can you make sure that your savings will last your lifetime? Immediate annuities - insurance contracts that promise to pay you a check a month for life - are the obvious answer. But annuities require a huge up-front investment, and policymakers have yet to figure out how to get retirees to buy them.
Enter the behavioralist solution, proposed by economists at the Brookings Institution. Companies should automatically direct a portion of retirees' 401(k) assets into an immediate annuity for the first two years of retirement with the option to cancel at that point. Once seniors got used to the security of a monthly check, the researchers believe, status quo bias would take over and few retirees would cancel.
One reason it's hard to reduce energy usage at home, say Thaler and Sunstein, is that we don't connect the immediate relief of turning up the air conditioning, say, to the pain of paying the utility bill four weeks later.
Their solution: instant feedback. Utilities should give every household an indicator light that would track electricity, gas and oil use. Start sucking up more energy than your target - say, the average of your neighbors - and you get a red warning light. Moderate the thermostat, and eventually the indicator blinks off. Just being able to track your energy burn makes you a more efficient user.
Experimenting with such a system last year, Southern California Edison found that homeowners cut their energy use during peak hours by 40% in just a few weeks. The program might be even more effective if the warning light were visible from the street; social pressure, Thaler and Sunstein maintain, is a powerful behavioral prod in its own right.
Behavioral incentives can work with high-profile polluters too. Both McCain and Obama endorse versions of a system called cap-and-trade, in which the government would limit overall greenhouse gas emissions and issue pollution permits to major emitters like utilities and manufacturers. Companies that exceeded their allotment would have to buy extra permits from energy misers who have more than they need.
Obama would auction off the permits. McCain would give them away - which may actually be more behaviorally astute. According to behavioral economist Ariely, people (and presumably companies) tend to quickly "anchor" on free as the "right" price. We perceive going from free to some price as harder than going from inexpensive to more expensive. "It turns out that it's incredibly painful to pay for something that was once free," says Ariely. Result: a nudge to pollute less.
While behavioral economics hasn't offered much in the way of solutions to the nation's dysfunctional health-care system, research suggests where possible solutions might come from.
For example, any self-respecting behavioralist could have predicted that when asked to choose a Medicare Part D drug plan, millions of seniors would fail to pick a plan and be shunted into the default. Recognizing that, more states would have followed Maine's lead in creating an intelligent default choice that addressed the Medicare participants' needs. In that state, all seniors who didn't select a plan were defaulted into plans that covered at least 90% of drug costs; in other states, such seniors were assigned randomly and ended up paying, on average, $700 more than needed.
In the end, of course, behavioral economics has its limitations. The chief one is that while every true behavioral program is voluntary, each is designed so that citizens default to the "right" course. But who decides what's right?
And Richard Pildes, a law professor at New York University, points out that behavioral economic techniques work only where there's consensus. "Everyone agrees that people should save more," he says. "But when discussion moves to thornier issues, we could end up debating the default forever."
From firsthand experience, Johnny Behave knows that this new world can be annoying. Between his daughter spending hours on Mynextspace and his son jumping around in front of Wii 3, the energy warning light in his house is always glowing red. And because he programmed his fridge last Sunday for healthy eating, he's stuck with fat-free yogurt this morning even though he really wanted bacon. When he heads off to work in his SUV, he must sport a PLEASE HONK. I POLLUTE bumper sticker. Still, as beeping horns follow him down the highway, Behave has to admit that the air is cleaner, his finances are sounder and his life is, yes, just a little more rational. 
