Tuesday, June 07, 2011

Correcting Faulty Defaults to Improve Society?

California recently cut $170 million from the amount the state must pay toward 2012’s retirement benefits, according to an article in the Mercury News. With the uncertainty regarding the future of pension plans and social security, private retirement savings are more important than ever. Despite this need, many people have difficulty making consumption sacrifices today to provide for their future selves.

Recent changes to many private firms’ retirement savings programs seem to reflect this need for personal savings. In the past, employees had to actively opt-in to company savings plans by changing their monthly contribution amount from the default of $0 to some positive amount. Traditional economic models of savings assume that people are perfectly rational and will choose the level of saving that maximizes their utility over the entire course of their lives, therefore people’s decisions of how much to save should not be affected by something as small as the effort required to “opt-in” to a plan. Companies have found, however, that merely changing the default option from “no savings” to “X% of paycheck automatically saved” causes a significant increase in employee savings. One firm found that after switching from standard to automatic enrollment in retirement savings plans, the participation rate for new hires was 35 percentage points higher after three months on the job (as compared to those hired before the automatic enrollment). The participation rate remained 25 points higher after two years.

Why would something as seemingly trivial as changing the default setting have such a large impact on the decision of how much to save? The field of behavioral economics acknowledges that people do not always act according to the model of perfect rationality, which requires weighing all costs and benefits (present and future) and accounting for all available information. Deciding how much to save for retirement is an important life decision, yet the “easy” choice of accepting the default option often prevails against the rational action of giving it more serious consideration. Traditional economic models do not explain the widespread tendency to stick with defaults regardless of their suitability, but behavioral economists can replicate this behavior in controlled research environments.

Applying this understanding of behavioral economics to the savings plan structure is an example of “libertarian paternalism,” a school of thought that strives to maintain freedoms (libertarian) while still guiding people towards the choice that society deems best (paternal). The new default setting does not interfere with employees’ rights to do what they please because employees can easily “opt-out” by making a short phone call and signing a form. At the same time, it benefits society by encouraging more people to save, since those who do not sufficiently save for their future needs pose a problem not only to their older selves (who may have to work past their desired retirement age), but also for the government (and thus taxpayers) who may then have to help provide for them as well.

Discussion Questions:

1) Do you think that a company changing the default behavior for a retirement program infringes on employee's rights?

2) How do you make decisions about long-term financial planning? Do you research and model your finances, base your decisions on suggestions (from an employer, family, or friends), or ignore it entirely?

3) Are you surprised that changing a default value has an effect on what people select?

4) Imagine you are a freshman in college choosing a meal plan. You don’t know what the other food options on campus will be like, nor what your schedule will be. What advantages does a “default” option provide in this situation?


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