A recent survey of consumer finances conducted by the Federal Reserve showed families are saving less towards their retirement. While most people recognize they bear the responsibility for their retirement savings, over the past decade the number of families participating in a retirement plan dropped from 48.2% in 2007 to just 40.2 % in 2013. The average balance in the plans was $147,300, but for lower income families the balance was just $39,100. Since these assets are one of the most significant components of a family’s retirement security, it is obvious that something needs to be done to help families save more for tomorrow.
A plan to increase retirement savings
Researchers in the field of Behavioral Economics at the University of Chicago and University of California, Los Angeles studied why workers did not take greater advantage of pension savings plans. Using the principles of psychology and behavioral economics, the researchers developed a savings plan that would overcome saver’s lack of willpower and act on their desire to save. By turning negatives into positives, the savings plan overcomes common roadblocks and opens a pathway to save more tomorrow.
Behavioral economists have documented our natural desire to have more money in our paychecks today and how we can find ways to save that few extra dollars out of some future paycheck. The tendency to procrastinate is always prevalent in retirement savings plans. The value of a dollar saved for some far off retirement is always outweighed by some current need in our spending plans.
This natural tendency towards procrastination is combined with a status quo bias in savings plans. Once a person is enrolled at a set contribution level in a retirement plan, the person rarely changes their commitment to automatic savings. By taking advantage of these two natural tendencies, savings plan procrastination can be reduced.
Whenever you change jobs or have the opportunity to enter a workplace savings plan, take advantage of the enrollment. Many employers now offer automatic enrollment to help employees overcome the procrastination problem. By starting contributions to the savings plan, the worker is well on his way to success. The research study showed that of those enrolled in their savings program, 98% remained in the program.
Saving more tomorrow
The second roadblock to successful savings that the researchers documented is loss aversion. People tend to weigh losses significantly more heavily than gains. Empirical tests showed that losses typically hurt twice as much as gains. Here’s how this effects savings decisions: Once a person gets used to a level of disposable income, a constant figure on their paycheck, then any reduction is viewed as a loss. Thus nobody wants to increase their contributions to their saving plan as any increase would reduce their take home pay. This seems pretty logical.
Now combine this loss aversion with a desire to save more for retirement at some future time. Most workers know that they will get an annual review and most likely receive an annual salary increment at some point during the year. Everyone looks forward to receiving the first paycheck after the annual increment to see what their new take home pay comes out to. Here is the time to make that increase in your saving plan contribution rate.
Remember that losses are twice as bad as gains? If you increase your contribution by one third of your annual increase, you will be giving up one dollar for every three of your raise and taking home two. You will feel as though the two extra dollars you take home are equal to the extra dollar you lose off your check as a retirement savings contribution. Turn a negative into a positive by utilizing what we’ve learned from behavioral economics -- trade one dollar loss for a two dollars gain and you will still feel like you got a fair trade.
How does this build over time?
If you continue to use this strategy every time you receive a raise, your savings plan contribution rate will gradually raise over time. By starting low and saving more out of tomorrow’s paychecks you will ratchet up your savings rate over time. An initial 1% contribution easily grows to 2% next year and continues. Stay at your current job for 10 years and you will have a very comfortable savings plan. You will have achieved an admirable goal with the least amount of anxiety because you utilized the neat little trick on how we perceive losses.
The path to success
The two biggest hurdles to overcome in establishing your retirement savings plan are procrastination and loss avoidance. Utilizing the research into behavioral economics, you can overcome both of these. Enrolling in your company’s savings plan when you are first hired or at your first opportunity allows you to join the status quo and remain in the plan. Splitting your annual raise between your plan and yourself gives you a painless route to maximizing your contribution rate.
This post was written by Christopher Dunmall, CFA Senior Fixed Income Portfolio Manager at Colorado PERA. Would you like to contribute a guest post to The Dime? Email us at firstname.lastname@example.org