The influential book Nudge by behavioral economists Richard Thaler and Cass Sunstein came out over eight years ago. Since then, nudges have become a widely used means to influence American consumers, especially in their financial decisions.
The idea behind a nudge is to provide consumers with a set of options that are carefully designed and presented to push them into making a certain choice. Behavioral economists call these manipulations as “choice architecture.” The key to a successful nudge lies in providing a strategically chosen default option so that when consumers don’t choose actively (as often happens), the default choice is made for them. To give one example, in countries like France where the default is to donate organs after death (you have to actively opt out if you don’t want to donate), organ donations are 16.3% higher than in countries like Germany where non-donation is the default.
Why have nudges become so popular? Behavioral economists would like to believe it is because nudging steers people towards choices that are good for them. Without it, many of them would have chosen something worse, and suffered.
There is some truth in these beliefs. Consider the issue of saving money for retirement. Among personal finance experts, the consensus is that Americans haven’t been saving enough money for retirement. The problem has become more serious as fewer and fewer employers offer guaranteed pensions, replacing them with defined contribution plans, and shifting the responsibility of regularly saving money on to consumers.
When people are not saving anything, getting them to start saving regularly is a crucial first step. Nudges accomplish this task effectively by automatically enrolling new employees in a 401(K) savings plan when they start working. (The employers has to offer 401(K) plans to its employees, of course). Many studies show that automatic enrollment works. In one study, when a large company started automatically enrolling new employees, retirement savings plan participation shot up from 60% to 95%. But are there any downsides?
As I have written before, nudges also have potential downsides, and can have harmful effects on consumers. In the case of retirement savings, nudges have two potentially harmful consequences:
Vanguard is one of the largest and most reputed American financial investment companies. It manages over $800 billion in assets comprising retirement savings of 4.1 million consumers. Each year, it publishes a comprehensive report describing the retirement savings behaviors of its customers in detail. This year’s report titled “How America Saves 2016” was released recently.
A number of data-points in the Vanguard report reinforced my concerns about financial nudges and raised red flags. They had to do with three issues: 1) the retirement savings rate, 2) automatic enrollment, and 3) use of the default investment vehicle.
This is what the report had to say (Note that the “deferral rate” below refers to how much of their before-tax income Vanguard customers saved for retirement):
“The average deferral rate and the median was essentially unchanged at 5.9%. However, average deferral rates have declined slightly from their peak of 7.3% in 2007. The decline in average contribution rates is attributable to increased adoption of automatic enrollment. While automatic enrollment increases participation rates, it also leads to lower contribution rates when default deferral rates are set at low levels, such as 3% or lower.” [emphasis added]
For context, experts recommend saving at least 15% of one's income for retirement purposes. The report indicates that Vanguard’s customers are saving less than half as much. (Granted some of them could be saving at other institutions concurrently). This comment from Vanguard echoes my concern that automatic enrollment may lead to a lower-than-acceptable retirement saving rate for many Americans. Scarier still, Vanguard found that in 2015, almost half, or 48% of retirement plans had a default savings rate of 3%, and another 27% had rates of 4-5%. Just 16% of plans had a default savings rate of 6% or more. They didn't tell us how many plans came close to 15%, but based on these numbers, it can't be a lot.
Answering this question, the report stated: “At year-end 2015, 41% of Vanguard plans had adopted automatic enrollment, up five percentage points from 2014…Slightly more than 60% of all contributing participants in 2015 were in plans with automatic enrollment" (p. 4).
As automatic enrollment and the default saving rate go together, we can conclude that more than half of the Americans saving money for retirement at Vanguard have been nudged into saving at the default rate that their employer chose for them (even when it is too low in a vast majority of cases).
For successful retirement, how the saved money is invested is just as important as how much money is put away. Target-date funds are popular savings vehicles. They are usually mutual or exchange-traded funds that are “age-based” and become more conservative in asset allocation as the target retirement date approaches and passes. These funds are offered as default investments so commonly that economists have argued that they are “a form of implicit employer-provided lifecycle investment advice.” Vanguard described the adoption of target-date funds by its customers this way:
“Four in 10 Vanguard participants are wholly invested in a single target-date fund, either by voluntary choice or by default” (p.3)… Almost all plans with automatic enrollment―99%― default participants into a balanced investment strategy, with 97% choosing a target-date fund as a default.” (p.4).
While target-date funds are certainly better (even if riskier) investments than putting retirement savings in savings accounts or fixed-deposits, they do have significant issues. One study reported that a 50/50 stock/ bond portfolio outperformed target-date funds. Others have argued that target-date funds are not appropriate for everyone because they do not account for individual risk preferences, financial habits, or goals; nor do they factor other financial assets the person may have, leading to ineffective diversification.
Based on their findings, Vanguard concluded that “Participant deferral behavior is increasingly influenced by employers’ automatic enrollment and automatic escalation default designations” (p.10). It is clear to me that for those who don’t save anything at all, financial nudges such as automatic enrollment and default investing in a target-date fund are good starting points. But neither of these nudges is going to take consumers all the way to a comfortable retirement. Not even close. People need to do much more on their own initiative. They need to gather knowledge about their own financial situation and how personal finances work in general. And even more importantly, they need motivation to spend money prudently, save enough money consistently, and invest it wisely. Financial nudges cannot do these things.