Retirement Savings Schemes: Savings Rates Pt.1

After assessing how to boost enrolment, we will now look at how much is actually saved. Now that we have people saving responsibly for their future, how do we get them to save as much as reasonably possible?

Another issue is choosing how much is contributed, as the individual will have to take into account a variety of complex factors. They need to consider when they will retire, as this determines both how long they will make contributions and how much they will have to save, as retiring earlier requires more savings, and these additional savings need to be made in a shorter time frame. They would also need to think about future pay raises as well as future costs, such as buying a home or raising children, as these incidents can cause drastic changes in how much one can afford to contribute. This is where the cognitive bias of computational weakness comes into play, as ordinary people would be unable to assess the multiple intricate factors accurately to calculate an estimate for this figure. When it comes to savings rates, myopic behaviour is also likely to occur. People prefer instant gratification over long-term benefits – put bluntly, they would rather spend now than save for later. This is justified by the mental notion ‘I’ll save more next year…’, which creates a vicious cycle of putting off saving more until it is too late. This problem is also known as present bias, as it suggests you are more likely to make irrational decisions in the present rather than the future. In addition, loss aversion is present yet again. This time, the individual interprets a higher savings rate as being able to spend less, and so they try to avoid this loss by opting to stay at the same lower rate. Although they are not losing anything by taking a higher savings rate but rather saving more for later, when they see a larger sum of money leave their earnings, they feel more miserable – this is where loss aversion takes root.

When taking this decision, there is a chance of saving too much or saving too little, but the latter is considerably worse, and so the aim of the choice architect trying to solve this problem is to encourage people to choose the higher savings rates. To solve this pressing issue, Richard Thaler and Schlomo Bernartzi devised their embarrassingly simple but shockingly powerful (common traits of nudging) ‘Save More Tomorrow’[1] programme. This gave workers the option to increase the percentage they saved each time they received a pay raise and qualifies as a nudge as it does not limit any options, nor is it difficult or expensive to avoid – they can just say no. This solved the various issues caused by cognitive biases. Firstly, the issue of loss aversion is circumvented, as the workers will not have to save more immediately and instead later in the future. A loss in the future does not hurt as much as a loss right now, and so participation is much more likely. The concern about spending less is also eliminated, as the savings rate rise would only occur at the same time as an increase in wages. Instead of spending less, this additional income will allow you to consume more, but with a portion of this extra income going to increased savings. This cancels out the impact of workers being ‘loss averse’.

Furthermore, myopic behaviour and present bias are eliminated as the employees are asked if they want to save more in the future, meaning they are much more likely to say yes. They are not going to feel the impacts immediately, and so it does not seem as substantial as having to save more at that instant. This takes advantage of the cognitive bias of myopic behaviour as the workers will not consider how they will feel when having to save more in the future, but in this case, it leads to the most rational outcome possible for them.

[1] Thaler, R.H. and Benartzi, S. (2004). Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving. Journal of Political Economy, 112(S1), pp.S164–S187. doi:10.1086/380085.

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