Tuesday, December 12, 2017

A Nobel Prize for retirement savers.

Steve Utkus, Principal and director of the Vanguard Center for Investor Research

Professor Richard Thaler, who won the 2017 Nobel Prize in economics last month, is known for his many contributions to the field of behavioral economics.

But his most enduring and far-reaching impact will be felt in the field of retirement savings. More than anyone else, Thaler—along with his frequent collaborator, Professor Shlomo Benartzi of UCLA—has caused us to rethink our most fundamental assumptions about how to help individuals save for the future.

It was more than a decade ago when I came across the Benartzi and Thaler “Save more tomorrow” plan for retirement savings. “SMarT” was their short-hand for what is now called an autoescalation feature—an automatic increase, usually once a year, in how much a participant is contributing to a defined contribution retirement plan.

But their innovation wasn’t simply the idea of making savings increases automatic. In fact, SMarT was not about workers saving another 1% of pay today. Instead, it was that workers would agree today to save 1% more tomorrow—to agree to save more a year from now.

The program was based on behavioral ideas such as present bias and inertia. If workers are present-biased, they would worry about saving more today, as it would reduce their take-home pay directly. But workers who are present-biased don’t worry much about decisions in the future, so it’s easy to commit to save more a year from today, just as it is easy today to commit to go on a diet or start exercising in a year. And when a year passes, and it’s time for the increase in savings, workers, through inattention and inertia, tend not to notice the drop in take-home pay (especially if offset by a regular salary increase). As a result, they’d end up saving more—automatically—over time.

When it first surfaced in an academic working paper, the SMarT program was largely untested. A small Texas company had experimented with it and generated impressive results. But part of its success was due to the firm’s owner, who was a strong advocate of higher retirement savings in the workplace. Would the idea work at scale in a larger firm?

We worked with Thaler and Benartzi and a large Vanguard client to test the idea in 2002. That test yielded equally impressive results.¹

And so the feature went on to become a standard element of retirement program design, both at Vanguard and across the industry. Today, automatic enrollment and automatic escalation features are par for the course in recommended strategies for improving retirement saving. In the U.S., they’ve been enshrined in policy in the Pension Protection Act of 2006.

The adoption of automatic enrollment in Vanguard plans has grown by 300% since year-end 2007, according to How America Saves 2017. Plan sponsors have increasingly adopted autoescalation features, which raise plan contributions at regular intervals until a maximum level is reached or an employee opts out.

In the U.K., automatic features are now mandatory elements of the retirement saving system. The U.K. is just completing the process of autoenrolling all of its workers. Its first countrywide automatic increase is scheduled for next year.

In the end, perhaps the greatest contribution from Thaler and Benartzi is the change in mindset they engendered. Prior to their work (and the work of others in the field), retirement savings was thought to be a question of either incentives, such as employer matches or government tax incentives, or education and information. Yet we know today that incentives and education have positive, but limited, effects. For many of us, our decision to save for the future is also plagued by procrastination and inattention. And simple mechanisms like autoenrollment and autoescalation can help trump these behavioral biases.

So yes, the Nobel Prize goes to Professor Thaler, and it is well deserved for his many contributions in the field of economics. But in some ways it’s also a Nobel Prize for retirement savers—for the millions of ordinary individuals helped by his ideas and as a result on their way to a better financial future.

¹ Richard H. Thaler and Shlomo Benartzi, 2004.  Journal of Political Economy.  112(1): S164-S187.

About Steve Utkus

Mr. Utkus is principal and director of the Vanguard Center for Investor Research. The Center conducts and sponsors research on investor behavior and decision-making. It also works to apply behavioral insights to real-world settings. The Center’s scope includes individual investors (whether direct, advised, or in defined contribution plans), and institutional investors. The Center’s work will be of interest to investors, advisors, consultants, employers, media, the research community, and policymakers. Mr. Utkus’s personal research interests include retirement economics, behavioral finance, and the role of psychology in household financial decisions.  He earned a B.S. from the Massachusetts Institute of Technology and an M.B.A. from The Wharton School of the University of Pennsylvania. He is a member of the advisory board of the Wharton Pension Research Council, is currently a visiting scholar at Wharton, and is a member of the board of trustees of the Employee Benefit Research Institute in Washington, D.C.