By Andrew Zumwalt
This week I had the opportunity to attend a conference focused on retirement issues. Many topics were discussed, but one common theme among attendees was ‘saving money is hard’. Saving money seems simple, but research has shown that many people are living paycheck to paycheck, and that an individual’s retirement savings are often inadequate when she or he actually retires.
There are several reasons why people do not save for future expenses; one large reason is procrastination. Individuals say to themselves, “I’ll start saving money tomorrow.” When ‘tomorrow’ turns into ‘today’, the refrain is the same, “I’ll start saving money tomorrow.” This behavior is understandable since savings represents a reduction in your ability to consume today. You are choosing to defer gratification today and save some income for future consumption. Since many people have a hard time making the choice to save today, government, industries, and individuals are adopting strategies to help people save.
A close cousin to procrastination is inertia. If we can put something off to tomorrow, and there is no force spurring us to action, then we’re unlikely to take action. A simple example is the choice to save in a defined contribution plan that employers have setup to help employees save for retirement; these plans have the fun numbered names like 401(k), 403(b), and 457. About 40% of employees contribute something to their 401(k) after working one year at their job; these employees opt-in to savings. They actively make the choice. If employers offer pre-filled applications and allow the employee to just check a box to enroll, then about 50% of employees contribute something after being employed for one year. If employers require that you actively choose either to contribute to a 401(k) or not (there is no default option), then enrollment rises to 70% after one year. Finally, employers have the ultimate strategy to help employees save money for retirement: auto-enrollment. In auto-enrollment, individuals are automatically enrolled in the retirement plan and contribute a default percentage of their earnings. With auto-enrollment, after one year, 90% of employees are contributing to their retirement plans. Of course, employees can choose to opt out of saving. But what makes this strategy so powerful? The very force that was preventing people from saving, inertia, is actually being used to help people save. Instead of making a choice ‘to save’, employees are confronted with the choice ‘to not save’.
Automatic Re-enrollment and Escalation
For employees that are already employed and not contributing, employers can offer another savings tool: auto re-enrollment. Employees that are not contributing to the plan are annually re-enrolled in the plan. As with auto enrollment, an employee can opt out, but many choose to stay enrolled. Since employers tend to automatically-enroll or re-enroll employees at a low savings rate, employers can also implement automatic escalation. Annually, employee’s contributions are increased. So an employee who was auto-enrolled contributing 3% of income might contribute 4% after auto-escalation. These increases are small, and inertia works to help people save.
I will admit that these commitment strategies worried me at first. I believed that employees would resent these automatic enrollments, re-enrollments, and escalations! And some employees have inadequate or expensive investment options in their retirement plans, so opting out might be the financially prudent action. However, employees largely appreciate these tools; they understand their own weaknesses in making the choice to save and actively increase their savings rate. So these commitment strategies actually help strengthen their financial situation.
I will close with an interaction I had with someone several years ago. I was helping this person decide how much should be withheld from her paycheck by filling out a W4. After reviewing paystubs and other documents, I realized that she had enough taxes withheld for the year, and she could receive all of her earnings in her paycheck. After I informed her of this, she indicated that she wanted an additional amount saved. With great certainty, she stated that if she had access to the money, in either her checking or savings account, she would spend it. Years of financial planning education made me point out the weaknesses in this plan: the government doesn’t pay interest on excess withholding, the process to get excess withholding before filing a tax return is extremely difficult, tax refunds can be late, and a few other issues. However, she held firm and insisted that the extra money be withheld. I complied as I realized that this was her commitment strategy. She knew herself better than all of my financial planning textbooks combined. She had to let someone else (the government in this case) take possession of her money until it could be presented to her as a lump sum in her refund. Putting the money within her reach was too tempting and alluring of a target and could be easily raided. Now when I meet with someone, and they explain their unorthodox financial strategies, I take more time to consider their mindset, situation, and commitment strategies.
What commitment strategies do you use to save money? Send me an email at Zumwalta@Missouri.edu if you’re willing to share. Your ideas might be used in a future Financial Tip of the Week! Your name will not be used or changed to protect your identity.
Thank you for your time and attention!