Do you ever wonder why lottery winners sometimes go bankrupt, even after winning big? Why some people keep balances on their credit cards and pay high interest rates when they have savings available to pay the bill?
And why it seems so hard for Americans to set aside regular savings for retirement, even though they know they should?
These paradoxes can all be traced back to one concept you may have noticed is gaining attention as of late: behavioral economics.
The idea of psychology as a driver of economic action dates back at least to Adam Smith's The Theory of Moral Sentiments (1759). Behavioural economics has, however, only in recent years been getting more popular.
In 2017, the Nobel Prize in Economics was awarded to Richard Thaler, professor of behavioral science and economics at the University of Chicago Booth School of Business. Dr. Thaler's research looked at why people often make irrational decisions with their money.
Instead of acting rationally and having self-control, we tend to get easily distracted from long-term goals by short-term rewards, we often make poor financial decisions when we know better, and we give in to impulses way more than we should.
The bad news is marketers have figured this out and they're constantly sending you small "nudges" telling you about special offers, limited-time sales, and never-before-seen deals encouraging you to spend your money now instead of saving it for tomorrow.
The good news is you can apply these same psychological strategies to boost your retirement savings.
In 2008, Dr. Thaler and Cass Sunstein, a legal scholar, wrote a book called Nudge: Improving Decisions about Health, Wealth, and Happiness. Dr. Thaler defined nudges as something that “alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives. To count as a mere nudge, the intervention must be easy and cheap to avoid.”
“Nudges are not mandates,” the authors write: “Putting fruit at eye level counts as a nudge. Banning junk food does not.”
This idea of nudging extends beyond health and personal finance. Several countries around the world, including Britain, Germany and Japan have started implementing "nudge units" within their governments to change citizen behavior.
But for today's discussion we'll focus on how you can use little nudges to save more, invest more, and meet your retirement savings goals faster.
Commitment devices are voluntary, binding arrangements that people make to reach goals that may otherwise be hard to achieve. Commitment devices are not a new concept.
From "Christmas club accounts" designed to help you save for holiday expenses, to CDs, financial providers have offered commitment savings products for decades now.
Commitment savings devices have helped a lot of people save more than they would have otherwise. Studies suggest that people would rather be nudged than shoved into commitment savings though.
Here's an example:
In Kenya, researchers found that simply providing people in pre-existing savings groups with a safe box (a metal box with a key they controlled), increased preventive health product investments by 75 percent in the following year.
However, a hard commitment device – where people put money for preventive health in a locked
box, and could not withdraw it for emergencies – had a much smaller impact over the same one-year period.
Automatic ("opt-out") enrollment is when you are automatically enrolled in a product or service unless you choose to opt out. Setting the default to "opt-out" instead of "opt-in" has been shown to significantly increase uptake of certain savings vehicles, especially in retirement planning.
Research around the world suggests that defaults affect savings at every step of the way, from the rate at which people participate in savings programs, to the amount people contribute, to the likelihood that people will increase their contributions over time.
Especially in the U.S., we've seen the dramatic effect defaults have on retirement savings plans. One study found that when companies began automatically enrolling new hires in a 401(k) plan, participation rates went from 59 to 95 percent.
When the employer changed the default contribution rate from 3 percent to 6 percent, it increased retirement savings amounts without reducing participation rates. The 6 percent default doubled the amount of people who contributed 6 percent of their pay, from 24 to 49 percent.
A lot of people struggle to build good savings habits because there are so many seemingly urgent needs today that it's hard to save for tomorrow, or they simply forget. Setting reminders is an easy, low-cost way to bring savings goals to the top of your mind.
Research from different countries around the world show that reminders are a useful tool in fighting procrastination and helping people follow-through on their goals.
For example, Canadian online robo-advisor firm Wealthsimple started using a system that provides personalized, frequent alerts (displayed when clients sign in to their accounts) to inform them about possible investment options, like unused RRSP or TFSA contribution room.
“The idea is to proactively educate clients about the opportunities available to them - such as contributing to a retirement account. As this is personalized and immediately useful information, our hope is that it will nudge them to make decisions that are aligned with their longer-term interests,” says Dave Nugent, Wealthsimple’s chief investment officer.
As you can see, gradual changes or "nudges" can make significant shifts in financial behavior. If you're ever feeling stuck, don't look to make big moves right away. Instead look for small nudges that can change your course.
To a richer life,
- Nilus Mattive
Editor, The Rich Life Roadmap