A Nobel Prize for retirement savers

05 December 2017 | Topical insights


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Steve Utkus

Commentary by Steve Utkus, PhD, principal and director of the Vanguard Center for Investor Research.

University of Chicago Professor Richard Thaler, who won the 2017 Nobel Prize in economics, is known for his many contributions to the field of behavioural economics.

But his most enduring and far-reaching impact will be felt in the field of retirement savings. More than anyone else, Thaler – along with his frequent collaborator, Professor Shlomo Benartzi of UCLA – has caused us to rethink our most fundamental assumptions about how to help individuals save for the future.

It was more than a decade ago that I came across the Benartzi-Thaler "Save More Tomorrow" plan for retirement saving. "SMarT" was their shorthand for what is now called an auto-escalation feature – an automatic increase, usually once a year, in how much a worker contributes to a defined contribution retirement plan.

But their innovation wasn't simply the idea of making savings increases automatic. In fact, SMarT was not about workers saving another 1% of pay today. Instead, it was that workers would agree today to save 1% more tomorrow – to agree to save more a year from now.

The programme was based on behavioural ideas such as present bias and inertia. If workers were present-biased, they would worry about saving more today, as it would reduce their take-home pay directly. But workers who are present-biased don't worry much about decisions in the future, so it's easy to commit to save more a year from today, just as it is easy today to commit to go on a diet or start exercising in a year. And when a year passes, and it's time for the increase in savings, workers, through inattention and inertia, tend not to notice the drop in take-home pay (especially if offset by a regular salary increase). As a result, they'd end up saving more – automatically – over time.

When it first surfaced in an academic working paper, the SMarT programme was largely untested. A small Texas company had experimented with it and generated impressive results. But part of its success was due to the firm's owner, who was a strong advocate of higher retirement savings in the workplace. Would the idea work at scale in a larger firm?

In 2002, Vanguard decided to test Thaler and Benartzi's SMarT theory and apply it to the retirement savings plan for a large Vanguard client. That test yielded equally impressive results.1 And so the feature went on to become a standard element of retirement programme design, both at Vanguard and across the industry. Today, automatic enrolment and auto-escalation features are par for the course in recommended strategies for improving retirement saving. In the United States, they've been enshrined in policy in the Pension Protection Act of 2006.

The adoption of automatic enrolment in US plans administered by Vanguard has grown by 300% since year-end 2007, according to How America Saves, 2017. Plan sponsors have increasingly adopted auto-escalation features, which raise plan contributions at regular intervals until a maximum level is reached or an employee opts out.

In the United Kingdom, auto features are now mandatory elements of the retirement saving system. The UK is just completing the process of auto-enrolling all of its workers. Its first countrywide automatic increase is scheduled for next year.

In the end, perhaps the greatest contribution from Thaler and Benartzi is the change in mindset they engendered. Prior to their work (and the work of others in the field), retirement savings was thought to be a question of either incentives, such as employer matches or government tax incentives, or education and information. Yet we know today that incentives and education have positive, but limited, effects. For many of us, our decision to save for the future is also plagued by procrastination and inattention. And simple mechanisms like auto-enrolment and auto-escalation can help trump these behavioural biases.

So yes, the Nobel Prize goes to Professor Thaler, and it is well deserved for his many contributions in the field of economics. But in some ways it's also a Nobel for retirement savers – for the millions of ordinary individuals helped by his ideas, who, as a result, are on their way to a better financial future.

1 Richard H. Thaler and Shlomo Benartzi, 2004. Journal of Political Economy. 112(1): S164-S187. 

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