By Paula Hayes
How many of us remember the Nike slogan, “Just Do It?” It was coined in 1998 by Dan Wieder, the founder of the ad agency, Wieden + Kennedy. The slogan makes an impact even to this day when we see it printed on sports apparel probably for the simple reason that those three little words emphasize “action.” On the flip side, is the “motto” that too many individuals may live by when it comes to making sensible 401(K) investments—“Just Do It Later!” Many people are too dismissive, treating 401(K) as an optional investment, underinvesting, or not investing at all. Besides a lack of full knowledge on 401(K) plans, I would venture to say the chief obstacle to rallying people to invest is procrastination. I will admit that I am one of those people who needs to pay closer attention to building a 401(K). With that said, it is not often I come across a book that completely transforms my financial perspective. Without any exaggeration, I can tell you that Shlomo Benartzi and Roger Lewin’s book, which is a Wall Street Journal Best Seller, Save More Tomorrow: Practical Behavioral Finance Solutions to Improve 401(K) Plans, truly has helped me think about 401(K) investments in a new light.
What is Behavioral Economics?
What is strikingly transformative about this book is that it shifts the focus of the discussion about 401(K) investments past the typical discussions on how to invest toward a fresh set of questions that focus upon the behavioral responses impacting whether one chooses to invest, how much one invests, and how one understands investment. Save More Tomorrow uses as its framework the theoretical field of behavioral finance, which is a sub-set of a larger spectrum of behavioral economics. In case you’re wondering, behavioral economics is the study of how psychological, social, and emotional traits impact a person’s economic choices. The Concise Encyclopedia of Economics points out the limitations that the traditional model of economics presents, observing that, “Economics traditionally conceptualizes a world populated by calculating, unemotional maximizers that have been dubbed Homo economicus. The standard economic framework ignores or rules out virtually all the behavior studied by cognitive and social psychologists” and that “The standard economic model of human behavior includes three unrealistic traits—unbounded rationality, unbounded willpower, and unbounded selfishness—all of which behavioral economics modifies.” This is where the field of behavioral economics picks up—it uses psychology and sociology to help determine the types of economic, and in this case retirement investment choices, that a person will make. Behavioral economics, when used correctly, can help individuals overcome a sense of apathy toward making 401(K) investments. Important as well is the role of the employer; companies can use behavioral economics in predictive ways to determine, for example, whether employees should be permitted to opt-in or opt-out of 401(K) plans.
Benartzi and Lewin address three pivotal areas, which they refer to as “behavioral challenges” to investment—“inertia, loss aversion, and myopia.” The book’s arrangement is comprised of three sections that build progressively from saving, to saving more, to eventually saving smarter. In a nutshell, section 1 deals with embarking upon the decision to enroll in a 401(K); section 2 looks at how to select a suitable rate of savings; and finally, section 3 studies investment decisions.
An Example of Applying Behavioral Economics Taken from Chapter 1
If we look briefly at a first selection, chapter 1, “The Power of the Default Option,” the authors explore two highly important concepts, “Auto-Grounded and Auto-Takeoff.” Benartzi and Lewin point out that traditional economic theory has been largely incorrect when it comes to explaining and predicting behavioral choices with regard to default options—“According to standard economic theory, defaults should have only a limited effect on people’s decisions: theory says that if a default is not aligned with people’s preferences, they will choose otherwise.” To illustrate the fallacy of this belief that people will “choose otherwise,” Benartzi and Lewin use an analogy of how defaults tend to work with regard to organ donations.
Citing a 1993 Gallup Poll, there was a huge discrepancy between how people felt about organ donations, whether they approved of it from a societal and ethical perspective versus whether they registered as an organ donor. The Gallup Poll showed “85 percent of Americans approve of organ donation, and yet only 28 percent actively take the steps to register as a donor.” How is the gap to be explained? Benartzi and Lewin conclude that the “choice architecture” has much to do with the behavior choices. Looking comparatively at organ donations internationally, using Germany and Austria as examples, the authors observe that if you give individuals the choice of opting in, even if they approve of organ donations, the statistics show that people do not opt in at very high rates; yet, if people are automatically enrolled in organ donation, and then given the choice to opt out, the vast majority stay enrolled and do not take the choice to opt out.
Using the known theories of behavioral choices with regard to default options, Benartzi and Lewin argue in favor of what they call “Auto-Grounded enrollment” in 401(K) plans as opposed to preferring “Auto-Takeoff enrollment.” The difference between the two types is simply this—Auto-Grounded enrollment means that companies automatically make provisions to enroll employees into 401(K) plans and employees are given the choice to opt out versus the idea of companies giving employees the choice of opting into enrollment. In other words, change the dynamics of behavioral architecture and companies will find that employee behavioral choices will follow suit. As the authors argue, “Automatic enrollment in a 401(K) plan (auto-takeoff) gives an immediate and substantial boost to participation.” The time it takes an employee to make the decision to enroll, which in some cases can be years, the employee has already lost opportunity for initial growth. Benartzi and Lewin note, “But the fact that participation occurs almost immediately after a new employee joins the company under Auto-Takeoff, rather than after a lag of three to five years, as often happens under the Auto-Grounded system, is important, too. Those ‘lost’ few years at the beginning of a thirty-five year investment program have a significant financial impact down the line, because of the power of compound growth.”
A major selling point is that in each chapter Benartzi and Lewis examine counterarguments letting readers make up their own minds about the effectiveness of applying behavioral economics to 401(K). When discussing the implementation of Auto-Takeoff, the authors note that arguments against a company enrolling employees into a 401(K) and then providing an opt out option include the company being perceived as too paternalistic; and furthermore, if a company has a high-turnover rate it might seem counterproductive. The authors do not stop with offering the counterarguments; they offer solutions to the counterarguments. For example, with regard to high employee turnover rates, they argue a comprised approach—“Offer an Auto-Grounded plan when new employees join, and put in place Auto-Takeoff on people’s first anniversary of joining the company.”
Virtual Reality is Reality for the Future
Additional parts of this book really dig into the meat of behavioral economics by exploring research studies on subjectivity, the “self,” from the enjoyable and exciting perspective of virtual reality. This might seem like pretty abstract material when thinking about how to increase investments, but as the authors argue the emotional level of conceiving of a “financial self” is a key factor in becoming a successful investor. An important term is “temporal myopia,” which is defined as the inability to project oneself into the future, or to visualize oneself operating and behaving in certain ways in the future. As Benartzi and Levin explain, younger individuals experience an “identity gap” and an “empathy gap”; the first is the inability to see how one will need to live in the future (such as making retirement investments at a young age), and the latter is the overvaluation of presently felt emotions and the devaluation of emotions that could be felt in the future. These fluctuations in self, in identity and emotions, impacts whether a person chooses to invest early on in life in a 401(K) or whether one habitually postpones making the investment. To help people move past these subjective distances between present and future, Benartzi and Levin recommend conceptualizing “two selves,” an immediate financial self and a future financial self; and, they reference some pretty amazing research studies that utilize virtual reality tools to accomplish this “twinning” of the financial self. To construct this balancing act between a present self that may not see the immediate need to invest and a future self that requires the security of investment, it requires some degree of imaginative reconstruction to have these two versions of self “meet” in virtual time. Yet, Benartzi and Levin note, “There is a difference between knowing on an intellectual level that one will be old at some point in the future and feeling it on an emotional level.”