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The Psychology Behind Saving for Retirement

For over thirty years, the retirement savings landscape has shifted from company-financed pension plans to employee-financed retirement plans. The unintended consequence of transferring responsibility to employees is that Americans are now woefully unprepared for retirement. More than one in three Americans don’t have any retirement savings.

For women, two-thirds report they have either no savings or less than $10,000.

Why has this happened? Some explanations come from the field of behavioral finance, which uses psychology principles to understand people’s economic decisions.

While economic theory contends that people act rationally and will save more as their incomes grow, this is not how we act in reality. We are prone to present bias—preferring something now as opposed to in the future. Then, there is our tendency toward procrastination and its partner-in-crime, inertia. Lastly, we are innately loss averse, which means we feel losses much more acutely than gains. Instinctively, we view saving as a loss because it eats into how much money we can spend.

Our brains are wired to make the greatest use of what we have, which is why we seek immediate rewards over greater rewards in the future. The allure of “now” is powerful, and it intensifies as the gap widens between an instant and a delayed reward, no matter how much better the future reward is. Saving for retirement not only lacks an immediate reward, but the time interval is also overwhelming.

Many of us don’t save because we believe we can’t afford it. That belief is easier to accept than the reality that we can reduce our spending. Our cognitive biases are more likely the culprit behind a lack of savings—rather than actual financial hardship.

Fortunately, we can overcome these biases. In their 2008 book, Nudge: Improving Decisions about Health, Wealth, and Happiness, economist Richard Thaler of the University of Chicago and Harvard Law professor Cass Sunstein introduce the concept of “choice architecture,” or the way we present choices to others. The goal with choice architecture is to frame decisions in a way that is appealing and non-threatening. Whenever we offer choices, the behavior we desire should be the default choice. In this case of saving for retirement, the default is automatic enrollment in a retirement plan.

Additionally, along with UCLA professor Shlomo Benartzi, Thaler developed a plan called Save More Tomorrow™ (SMT) using the theories of behavioral finance. This plan allows employees to make savings choices that kick in when they get a raise. This controls for our preference for immediate reward, because there is a lag between agreeing to the savings plan and its implementation. It also accounts for loss aversion, because there isn’t a decrease in take-home pay.

Another default choice in the plan is to increase the percentage rate of the contribution each time the employee gets a raise, up to a predetermined level. This default solves for inertia because the employee doesn’t have to make any decisions or take any action, which means they will likely stay in the plan.

The results have been impressive. Thaler and Benartzi documented the outcome after four years from the first three companies that implemented the SMT plan. They saw 78% participation as well as contribution rates that went from 3.5% to 13.6% during the period. Also, about 80% of the original participants were still in the plan after four years.

What does this mean for you? If you haven’t started saving, or feel like an increase in your savings rate is too much, commit to making a change when you receive your next raise. The SMT results prove that it is easier to commit to an investment plan when it involves money you haven’t received yet as opposed to cutting into current spending.

If you’d like to learn how you can get yourself on stronger financial footing, the advisors at Jemma Financial are here to help.

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