June 07, 2008

Behavioral Economics: How People Make Economic Decisions

Mark Thoma highlights a very interesting piece from the FRBSF (Federal Reserve Board of San Francisco) that looks at the factors that change the way people save for retirement. One of the bigger changes in the past few years is how companies are moving from providing a pension where they manage their employees retirement fund to a defined contribution plan where they help employees set up 401(k) savings plans and then contribute a certain percentage to the employee's individual plans.

401(k)s have been around for a long time, but what is now apparent is that most people who have been eligible for them, have not been using them optimally. What behavioral economists have found is there are some specific patterns in the way people make decisions that have led to the poor track records for people saving enough for their retirements. And so the behavioral economists are offering suggestions on how to make sure people are nudged into making better economic decisions.

The theory of free market economics stresses that the people are rational and act in their own self interest. However, behavioral economists show that this basic tenet is wrong. When people have to manage their own retirement savings they often make mistakes due to the way they make decisions. Some of the barriers to using 401(k) saving plans effectively are:

  • Procrastination. Why make a decision today when you can put it off until tomorrow?
  • Choice overload. When one is faced with too many choices, people simplify the way they choose and sometimes even decide not to decide.
  • Perceived endorsement effect: Many people think the company's model is appropriate for their own situation which leads to poor investment choices.

As the article says:

The problems of procrastination, choice overload, and endorsement effects have led researchers to look for ways both to improve decisionmaking and to ensure superior fallback results if no decision is made, all while protecting freedom of choice. The solutions fall into a line of work in behavioral economics known as "asymmetric paternalism" (Camerer et al. 2003). Many of these solutions are now commonly used by employers and were formally endorsed in the Pension Protection Act of 2006.

One of the simple changes that employers have made that have increased the participation rate for employees is changing the default from "opt-in" to "opt-out". When someone is hired by the company, they are automatically enrolled in a 401(k) savings plan with 3% of their income going directly to the plan unless they explicitly opt-out. Then for the next three years, the percentage saved is increased by 1% each year until the employee is saving 6% per year in the plan -- again, unless they explicitly decide to change the default.

And it isn't just saving for retirement that runs up against our human tendencies as not quite so rational actors. As the piece says:

The lessons from applying decision theory and behavioral economics to 401(k) plans have broad implications for all types of decisionmaking. We already see the ideas about choice overload, for example, being considered in the delivery of health-care alternatives. And it may be possible to create the equivalent of the risk profiles for investment for individuals choosing health care, giving workers greater guidance on selecting health plans to fit their changing needs over time. Looking forward, it will be important to consider how the ideas of procrastination and choice overload affect the decision to convert 401(k) money into an annuity rather than to take it out in a lump sum or spend it unrestricted over time. With the baby boom generation entering retirement, these types of issues will be moving to the forefront of public discourse over retirement policy. In each of these situations, the ability of a little guidance to help individuals achieve better outcomes will be an important part of the discussion.

Definitely worth the read.

Posted by Mary at June 7, 2008 05:35 PM | Economy | Technorati links |

The company I used to work for gave 3 days of investment classes, as well as retirement investment intro lessons. I pretty well understood what I was doing, and I made about 6K on 20K in 2007. I pulled out of the market completely at the first of 2008. That was a lot better than the average, let me tell you.

Posted by: Scorpio at June 8, 2008 06:50 AM