Mind on My Money

Will You Save More Tomorrow?

John Nofsinger, Ph.D. — Tue, 01 Sep 2009 20:42:25 +0000

If you plan to live a life of comfort in retirement, most of your retirement income will need to come from your savings. Social Security won't provide much and defined benefit retirement plans are becoming extinct. So how do we get people to contribute to their own defined contribution plan (i.e., 401k plan)?

Richard Thaler and Shlomo Benartzi proposed a four-step approach that they call Save More Tomorrow (SMarT) that overcomes several psychological biases. They suggest that employees who are not contributing to their 401(k) plan can begin to do so by agreeing to the following plan:

(1) The employee is asked to agree to the plan well in advance; that is, the decision does not have any immediate ramifications.
(2) The plan starts by having the employee agree to begin contributing at his/her next pay raise with a small contribution rate, such as 2 percent. By combining a pay raise with the contribution, the employee still sees a small increase in pay but also begins the contribution.
(3) The employee agrees to increase the contribution rate at each pay raise until a preset maximum level is reached.
(4) The employee can opt out of the plan at any time. Although the hope is that employees will not opt out, the ability to do so makes them more comfortable about joining the plan.
(5) The SMarT plan requires the employees to make decisions far in advance, and then the status quo bias works to their advantage because they do not take the option of opting out of the plan.

This plan was tested at a midsize manufacturing company whose savings participation rate was low. The 315 employees had an average savings rate of 4.4% of their earnings. They were asked to increase their contribution by 5%. Those employees who claimed they could not contribute the 5% were offered the SMarT program. The program was made available to 207 employees, and 162 employees agreed to join. These employees had a low savings rate of 3.5%, on average. The 153 employees who did not join the SMarT plan either did nothing or made a one-time increase in their savings rate. On average, the people who did not adopt the SMarT plan had a savings rate of 5.3%. The effect of joining the plan was dramatic. After three pay raises, those who had joined the SMarT plan had increased their savings rate from 3.5 to 11.6%. Those who did not join the SMarT plan increased their savings rate from 5.3% to only 7.5%. The dramatic increase in the savings rate associated with the SMarT plan was beneficial to those employees because they began saving more for their retirement.

For other programs that use psychology to help people make better decisions, see my post.

Reference: Richard Thaler and Shlomo Benartzi, "Save More Tomorrow: Using Behavioral Economics to Increase Employee Savings," Journal of Political Economy 112(2004): S164-S187.

Opt-in and Opt-out Pension Design

John Nofsinger, Ph.D. — Mon, 31 Aug 2009 04:03:28 +0000

The way in which a question is asked has a strong impact on the answer given or decision made. Consider the case of opting-in versus opting-out. To consent to be an organ donor in the U.S., you must sign a paper when getting your driver's license. This is an opt-in decision chosen by only about a quarter of the drivers. The levels are even lower for countries like Germany and the U.K. On the other hand, the program can be designed in which every driver is automatically defaulted to be a donor. People not wishing to be an organ donor sign a paper opting-out. The participation rate of organ donor consent in opt-out countries (like, Austria, France, and Sweden) is typically in the high ninety percent range. The simple decision frame of having people opt-out instead of opt-in dramatically raises the participation rate.

Should contributions to defined contribution pension plans be defaulted for new employees as opt-in or op-out? They have traditionally been opt-in and this has resulted in only about one third of employees contributing.

The status quo bias causes employees to procrastinate in making their retirement plan decisions. Indeed, many procrastinate so long that they never participate in the plan. Instead of requiring the new employee to take action to enroll, enroll the employee automatically and require the person to take action to disenroll. Instead of exerting an effort to start the participation, employees participate automatically. An automatic enrollment policy in a 401(k) savings plan results in substantially more employees participating in the pension plan-a jump from one-third to nearly 90%. Although, most just stay at the default level of contribution and asset allocation. One problem with this approach is that some of the employees would have participated without the automatic enrollment. In addition, they would have contributed a higher amount and chosen a more aggressive asset allocation than the default money market fund, but they do not change the default allocation because of the status quo bias. Therefore, this automatic enrollment of employees helps many but might harm some. To overcome some of this problem, plans are now allowed to automatically enroll new employees into Life Cycle or Target Date type funds.

For other programs that use psychology to help people make better decisions, see my post.

Reference: Eric J. Johnson, and Daniel Goldstein, "Do Defaults Save Lives?" Science (2003): 1338-1339, and Brigitte Madrian and Dennis Shea, "The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior," Quarterly Journal of Economics 116(2001): 1149-1187.

Combining Gambling and Saving

John Nofsinger, Ph.D. — Sat, 29 Aug 2009 17:27:02 +0000

This program is designed to help lower income households save more. Low-income families in the United States play lotteries and they believe that they are more likely to become rich from lotteries than from saving. Thus, to encourage more savers and savings, consider a saving's product that has a lottery prize drawing. These lottery-linked deposit accounts use each savings deposit (or bond purchased) as a "buy-in" to win lottery prizes selected frequently. The excitement of gambling draws people to start saving. The savers earn a slightly lower interest rate than they could obtain elsewhere. The difference between what they could obtain and what they actually get is the money used for the lottery prizes periodically awarded. This structure appeals to loss-adverse investors. They have the safety of the savings account and the excitement of the potential to win a lottery.

These programs have existed for centuries internationally. The longest running program may be the Premium Bond in Britain, started in 1956. The bonds require a £100 minimum purchase and make the purchaser eligible for monthly prize drawings. The excitement of gambling is maintained as more than 1 million prizes are given at each drawing. Prizes range from two £1 million prizes to more than a million £50 prizes. Over £30 billion of savings are held in Premium Bonds by one quarter of British households. Programs in Central and South America give away cars and equivalent prizes daily with larger lotteries drawn monthly. The Million-a-Month-Account program was started by First National Bank in South Africa in 2005.

Recently, a program called "Save to Win" was started by in Michigan and implemented through several credit unions. It is designed by the D2D Fund. Each $25 deposit into a savings account gives a chance to win (up to 10 chances) monthly cash prizes (cash, gift cards, laptops, etc.) and cumulates for chances to win the annual $100,000 grand prize. Time will tell how successful this program will be in promoting saving. $90 billion is spent on gambling in the United States each year, if only a small fraction of that is done through lottery-linked savings accounts, those individuals would be much better off!

For other programs that use psychology to help people make better decisions, see this post.

Reference: See Peter Tufano, "Saving whilst Gambling: An Empirical Analysis of UK Premium Bonds," American Economic Review 98(2008): 321-326; Mauro Guillen and Adrian Tschoegl, "Banking on Gambling: Banks and Lottery-Linked Deposit Accounts," Journal of Financial Services Research 21(2002): 219-231; and Peter Tufano and Daniel Schneider, "Using Financial Innovation to Support Savers: From Coercion to Excitement," in Access, Assets and Poverty, ed. Rebecca Blank and Michael Barr, Russell Sage, forthcoming.

Designing Choices with Helping Biases

John Nofsinger, Ph.D. — Sat, 29 Aug 2009 17:24:45 +0000

Decades of psychology research illustrates that people often don't know their own preferences for what they want. In other words, you can frame questions in different ways to elicit different responses. If people really understood what they wanted, they would not be fooled by framing effects. Decisions are influenced by cognitive errors, framing effects, mental shortcuts, social influences, and other psychological biases. When people are given the freedom of choice in financial decisions, they often choose badly. Should the government, corporations, and other institutions choose for them?

This is a question of ideology. Libertarians advocate the maximization of individual liberty, thus they value the freedom of choice. On the other hand, paternalism is the attitude that an authoritative figurehead should make decisions on behalf of others for their own good. Thus, Richard Thaler and Cass Sunstein's promotion of libertarian paternalism seems like an oxymoron. In their book, Nudge, they argue that private and public institutions should attempt to guide people's decisions and behavior in a direction that will improve their own welfare. That is, peoples' choices should be deliberately framed in a manner that steers them to making choices that will make them better off. Yet in the end, each person is free to choose. For example, health care options can be framed in a manner that leads to healthier lifestyles.

I am planning to post thoughtful choice architecture examples of programs designed to exploit behavioral biases for the good of the decision-maker. This post will act as a Table of Contents for those examples.

See Posts:

Combining Gambling and Saving

Opt-in and Opt-out Pension Design

Save More Tomorrow

Reference: See Cass Sunstein and Richard Thaler, "Libertarian Paternalism Is Not an Oxymoron," The University of Chicago Law Review 70(2003): 1159-1202.

The Treasury Bubble

John Nofsinger, Ph.D. — Sat, 04 Jul 2009 02:38:24 +0000

Remember the tech stock bubble? Then came the real estate bubble which is still deflating. Now we see the top of the U.S. Treasury bond bubble.

First, let's recall some characteristics of the bubble in tech stocks. Tech stock prices inflated to amazing heights when everyone was buying them. I recall shows on PBS describing people buying stocks who didn't even know the name of the firms they traded. Others quit jobs to day trade stocks. The demand for these stocks was unprecedented. This demand fostered a massive new supply of tech stock IPOs. The realization that prices were overvalued combined with the new supply of stocks (many were low quality companies) eventually led to the panic selling and price deflation. Within nine months, the Nasdaq index had lost half its value.

Now let's look at the real estate boom. At some point, the demand for houses increased more than usual. People who normally couldn't afford a home were given the chance to buy one. TV shows came out showing people owning many homes and ‘flipping' them. People who had a bad experience with stocks were putting their investments into real estate. Again, when prices and demand go up, so too will supply--eventually. Construction companies started building new neighborhoods and condo buildings. Again, this became unstable. The deflation of the real estate bubble will take much longer than that of the tech stock bubble. This is because transacting in the real estate market take much longer than transacting in the stock market.

During this difficult time, Treasury bonds have experienced a price bubble. Prices are historically very high, which means that interest rates are historically low. The demand for Treasuries from everyday folk has skyrocketed. Out of fear, many investors have run to Treasury securities. Some of those investors may not even know they have done so. They simply have taken what is left of their stock portfolio money and transferred it into money market funds and accounts. The short-term rates are less than 0.5% annualized, the 10-year note is at 3.5%, and the 30-year bond is at 4.3%. We have the demand that has driven prices high (and yields low). Do we have the characteristics for a pop in the bubble?

From the tech bubble and real estate bubble examples, it is clear that for the bubble to burst, we need both the Treasuries to be overvalued and a large new supply. First, let's look at the overvalued issue. I believe that the price has been driven artificially high from the high demand. I also believe that ‘quantitative easing' going on, which amounts to printing money, devalues US dollar securities. These two things together suggest an overvalued Treasury market. What about new supply? That one is easy. The rapidly increase budget deficit combined with the more funding needed for the stimulus bill means more supply. Additional spending programs (like health care) will just add more supply. In the longer-term Social Security and Medicare needs will greatly increase supply.

When will this occur? I don't know. Bubbles often last for quite awhile. But I think that when this one bursts, it will behave more like the tech bubble rather than the real estate bubble. This is because Treasuries are so easily traded. If foreign investors (like China) decide to sell, or even stop buying, prices will move quickly.

What are the ramifications of a price burst in the Treasury market? First, it would mean that interest rates skyrocket. This would harm the real estate market again because few would be able to afford the higher cost of a mortgage. Since much of the US government debt is borrowed short-term, it will quickly find it has to pay much higher interest. This will make the budget deficit even greater, so more bonds will have to be issued. This could be an ugly feedback loop.

The Next Wave of Layoffs: Public Employees

John Nofsinger, Ph.D. — Sun, 14 Jun 2009 02:21:10 +0000

The May unemployment numbers set the economists into a tizzy. Nonfarm payroll employment fell by 345,000 and the unemployment rate rose to 9.4%. Since the drop was much less then the 500,000+ drop in the previous months, the figure was heralded as a turning point for the economy. Not so fast...

The millions of people unemployment have largely come from the private sector, not public employees. For example, the change in government employment for May was only -7,000. This came on the heels of the surprising 92,000 increase in April, which is attributed to hiring for the upcoming Census. Yet, the news is full of budget crises in states across the country. Why haven't we seen this impact in the employment numbers? The answer is that states operate on annual or biannual budgets. The typical fiscal year begins on July 1. Thus, the new budget realities for most states will be realized next month. Although many states have started the layoff process by informing those impacted, the actual unemployment repercussion will most likely be seen in July and August.

California's budget is still being negotiated, but the governor has warned of a loss of 20,000 state jobs (social workers, correctional officers, etc.) in closing their $24 billion budget gap. In California schools, over 40,000 teachers, bus drivers, janitors, secretaries, and administrators have already been notified they are likely to be laid off at the end of the year. California is not alone. Arizona handed out 5,500 pink slip warnings. Washington education groups estimate 5,000 job losses in its schools and 1,000 at the universities. These budget cuts come in spite of the billions allocated to education and states in the federal stimulus bill. The stimulus funds are temporary, so if the tax revenue problems continue, there will likely be more layoffs in future years.

Many city and county budgets are experiencing similar fiscal crises. Los Angeles is facing a $7 billion budget shortfall and will cut 1,200 workers. The New York City Mayor has announced nearly 4,000 city worker layoffs. Detroit plans to cut 900 employees in their school district. Hundreds of teachers and other public employees will be cut in places like Grand Rapids, Charlotte, New York City, Orlando, and Wisconsin to name but a few. Your local libraries, city services, museums, prisons, state parks, and social welfare systems will all be impacted.

Will the private sector finally be hiring again and offset these public employee job losses? It is possible, but unlikely. This new round of job losses could set back any progress made in the real estate markets and consumer spending. I don't think we are out of the woods yet.

Inflation or Deflation?

John Nofsinger, Ph.D. — Thu, 11 Jun 2009 04:36:02 +0000

The news is full of economists concerned about either upcoming inflation or the current deflation. So which is right?

The inflationary argument is that the Fed is pumping money into the economy as fast as they can. The printing press always leads to high rates of inflation. The impact is being realized already in the increased price of commodities (like gold, oil, copper, etc.).

The deflationary argument is that prices are falling because consumers are spending less. This is because of both the trend to save more and the restricted credit markets. The evidence of deflation is seen in continuing declines in real estate prices and retail sales pricing.

Both arguments are logical and have supporting evidence. So are we experiencing inflation or deflation?

I believe that at this time, the answer is ‘yes.' Here is how I see it. We are seeing what I call ‘domestic deflation' and ‘international inflation.' The products that are priced domestically, like real estate and what we buy in the grocery and department stores, are experiencing deflation from a lack of demand and credit. The products that are priced in US dollars internationally are showing inflation because the money printing press is weakening the US dollar. For example, the price of a barrel of oil may stay the same if priced in Euros. But if the dollar is weakening against the euro, then the price of oil will increase in dollars even when it is unchanged as priced in euros. This is why we see local products falling in price and global products (like gas) increasing in price.

Eventually, the international inflation will more and more overwhelm the domestic products. This is because much of our retail products are made overseas. Thus, the weakness of the US dollar will eventually take its toll.

My prediction, for what it is worth, is that we will continue to see domestic deflation and international inflation for awhile and then inflation will rule. Time will tell.

Tax the Rich

John Nofsinger, Ph.D. — Sun, 24 May 2009 23:40:27 +0000

It is a common political tactic to promise benefits to one group and claim that the rich will pay for it. Don't worry about the cost of these goodies, we'll just tax the rich to pay for it.

This attitude was prevalent in President's Obama's campaign and continues with his budget proposals. The general mantra has been that 95% of the population will not experience a tax increase and may get a tax reduction. Taxes are to increase on the upper 5%. Some talking heads on TV supporting the Obama administration have even claimed that the top 2% of income earners will pay for much of the health care and other social programs being proposed.

I set out to determine if taxing the rich to pay for everything is even possible.

I went to the IRS website and found data for 2006. This is the most recent data posted. 2006 was a year with a good economy and people were making money. I also obtained the Congressional Budget Office's estimates for the government's revenue and outlays under the President's budget proposals.

The CBO estimates massive budget deficits for 2009 and 2010. Much of this is due to the economic stimulus spending. So to be fair, I focused on estimates for 2011 and afterwards. The predicted budget deficits for 2011 to 2014 are between $650 billion and $970 billion. Note that this assumes a strong economy in those years. If the economy is weak, the deficits will be much greater.

In 2006, the top 1% in income paid a total $409 billion in income taxes. The top 5% paid $616 billion. Note that if these people paid double their tax payment, they would not be able to pay for the increased spending. I am aware of no one even talking about doubling the tax rates on the rich. Most are talking about increasing the top rate from 35% to 39%. That might increase revenue by $50 billion or so, which is nowhere near the $600 billion to $1 trillion needed.

So what is the lesson here? We are not going to be able to tax the rich to pay for our social benefits. We will either have to forgo the benefits or we will all experience significant increases in taxes---regardless of what the politicians and talking TV heads say.

Wrong Medicine for this Economic Illness

John Nofsinger, Ph.D. — Fri, 27 Mar 2009 22:12:46 +0000

It is a well researched and well known theory that economic/financial liberalization leads to economic growth. Very simply put, this liberalization reduces the size and control of government (public sector) relative to the private sector.

Reducing the public to private ratio spurs growth. Increasing this ratio retards growth.

Here are two extreme examples: Argentina and China. Argentina has a well educated population and many natural resources (like oil). In the early 1900s, it was the 10th richest nation (per capita) in the world. But over the last century its public sector has gradually taken over. Recently it seized all private pension assets and transferred them to its social security system. It is now the 82nd richest nation. On the other hand, China began its economic liberalization in 1978. Since that time, its economy has grown 70 times bigger.

Now let's turn to the United States. How much did the Federal Budget grow in the Clinton and Bush administrations? How was the economy?

Time Period           Annual Budget Growth   Economy Growth
2 Clinton terms               3.3%                        5.6%
2 Bush terms                  6.4%                        4.8%

It is not a coincident that the economy was good in the Clinton years. His budgets grew at a modest 3.3% rate. This allowed the public sector to shrink in relation to the private sector. It spurred growth. Although Bush was considered business friendly and fiscally conservative, it sure didn't turn out that way. His budgets grew almost twice the rate during the Clinton Administration. As a consequence, the public sector grew in relation to the private sector. Thus, his economy was bad. In fact, it was only propped up for a few years through massive household debt expansion (see blog post). In the end, the larger government spending has retarded economic growth.

We are now struggling with poor economic growth. What should we do? Reduce the size of the public sector relative to the private sector! Unfortunately we are doing the opposite. In fact, it appears that we have started a new era of government expansion. The Obama Administration has offered a budget that is nearly 25% larger. Now that may be unfair because he is throwing money at the recession. But that is one of my points-Government expansion retards growth! Still, his budget does include much new spending. But let's look at the budget growth out three years, that should get past his expectations on poor economic growth. The 2011 budget suggests a 7.6% annual growth rate!

At our current rate of the government taking over the private sector, we will have poor economic growth for the foreseeable future.

Research on liberalization:
Geert Bekaert, Campbell Harvey, and Christian Lundblad, 2005, "Does Financial Liberalization Spur Growth?" Journal of Financial Economics, 77(1), 3-55.

Psychology and Taxes on Capital

John Nofsinger, Ph.D. — Thu, 05 Mar 2009 22:35:10 +0000

President Obama's proposed budget includes an increase in taxes on capital. That won't be very useful in generating tax revenue in the short-run. But it will also make fixing the broken economy even harder.

Taxes on capital include taxes on interest income, dividend income, and capital gains. First, let's get real, people aren't receiving much interest and dividends these days. Interest rates are at historic lows and companies have slashed their dividend by half, 90%, even 100%. And with stocks and real estate falling so much, who has capital gains these days? You are not going to raise much revenue here for quite awhile.

Increasing taxes on capital now will discourage capital from coming into our markets at this critical time. As an illustration of this, consider the proposed energy cap and trade program. This program seeks to tax carbon emissions above a certain level (the cap). A business under the cap can sell those credits to other businesses (the trade) that are over the cap. The purpose of this program is to tax pollution in order to discourage it. They seek to encourage companies to invest in low emission technologies. Note that taxing the carbon emissions discourages producing carbon emissions.

The same principle applies to capital. We need capital to come into the marketplace. We need it for buying homes. We need it going into the stock market (so my 401k can recover!). We need it in our banks so that the government can stop providing it. We need new capital, so why are we discouraging it by increasing taxes on it?

Increasing taxes on capital right now has no benefits because it won't raise significant revenue. However, it has severe disadvantages because it signals those with capital to go somewhere else (for example, China has no taxes on capital gains). I encourage politicians to avoid their ideological stances and think clearly about what new policies actually achieve and what incentives they create.