Shlomo Benartzi

March 21, 2012

The Simple Question that Will Encourage Saving

The Save More Tomorrow Program uses behavioral finance to increase retirement savings

By Shlomo Benartzi, Professor of Accounting
This appeared in the Financial Times on March 18, 2012.

As a major pension reform sweeps the UK this year, pension providers should consider one more change. Making it would mean a million or more Britons would save for retirement, and it is as simple as choosing chocolates or bananas.

The change - more of a tweak, really - is another nudge to save. With automatic enrollment, a modest slice of an employee's pay is automatically deducted for savings unless the employee chooses to opt out of the plan. The feature was mandated by parliament in 2008 as part of the pension reform.

The benefit of automatic enrollment varies by country, but it is always dramatic. One study showed that the number of retirement savers in a US plan jumped from 49 per cent to 86 percent with the addition of automatic enrollment. In the UK, a Department for Work and Pensions study showed 65 percent of Britons would join a plan if automatically enrolled. Automatic enrollment works so well because of human inertia. When faced with the option to save, many of us dither indefinitely over the simple choice to enroll. When enrollment is automatic, that same inertia turns many inveterate procrastinators into savers.

Unfortunately, automatic enrollment does not work for everyone. But tapping another basic human trait can convert many who opt out of a plan into savers in the near future. This brings us to chocolates and bananas, and an experiment of choice. The experiment's subjects were told they were going to meet in a week and that a snack would be provided. For the snack they could choose among unhealthy options, such as chocolates, and healthy ones, such as bananas. Most subjects chose bananas. But when the week was up, experimenters told the
subjects they had enough chocolates and bananas for everyone. When immediate gratification was an option, the subjects - even the virtuous ones who initially picked bananas - chose chocolates overwhelmingly.

The same psychology works in finance. When faced with a future choice, we generally select a smarter option, such as savings, while an immediate choice triggers the pleasure of spending. The science is clear. Brain scans show that the emotional and logical areas of our brains wrestle over immediate decisions, but our logical bits rule when considering our future well-being.

Based on this knowledge of human nature, a "future enrollment" tweak to pension plans will swell the ranks of savers. When workers opt out of a plan, they should be asked: "when you would like to start saving?" Doing so kicks the decision over to Logic Central in the brain. Employees should be offered options. One powerful option is to start saving when they get a pay rise. A US study showed that eight out of ten workers would be willing to save the amount of that raise in a retirement plan. This option does not trigger the pain of loss, because take-home pay does not drop. The idea has a proven record in the Save More Tomorrow program developed by myself and Richard Thaler, of the University of Chicago. In the program, employees commit to increase their savings automatically whenever they get a pay rise.

Not surprisingly, retirement plan providers must overcome their own inertia to add the future enrollment option. Of course, the government could mandate the change, just as it did with automatic enrollment. But mandate or not, future enrollment may follow Save More Tomorrow's path. Everyone we introduced the idea to thought it would work, but nobody wanted to be the first to use it. When one big mutual fund group looked past short-term qualms to long-term benefits and finally adopted it, others rushed to do the same. The National Employment Savings Trust (Nest), the new defined contribution plan, could lead future enrollment in the UK.

Consider the maths: about 10m employees will be eligible just for the Nest retirement plan. If the DWP's 65 percent estimate is correct, that is still 3.5m who will opt out of that plan. One simple future enrollment question could easily cut that number by 80 percent. And, even if I am overconfident and the actual number of future savers ends up being half or a third, it is still 1m Britons.

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