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The Power of Suggestion: Making Savings Automatic

The Power of Suggestion: Making Savings Automatic. Microeconomics for Management and Policy PADM 5211 Presentation by: Eloisa Martinez and Isabelle Lachance. Format of the Presentation. 1. To provide the context for the topic of this presentation

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The Power of Suggestion: Making Savings Automatic

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  1. The Power of Suggestion: Making Savings Automatic Microeconomics for Management and Policy PADM 5211 Presentation by: Eloisa Martinez and Isabelle Lachance

  2. Format of the Presentation 1. To provide the context for the topic of this presentation 2. To explain the study by Madrian and Shea (2001) 3. To analyze the study’s main findings 4. To discuss some of the policy implications The Power of Suggestion: Making Savings Automatic

  3. Context • Nudge’s Chapter 6 titled “Save More Tomorrow” • Article by Brigitte C. Madrian and Dennis F. Shea titled “The power of suggestion: inertia in 401(k) participation and savings behaviour” (2001) • Key features of the U.S. 401(k) vs. Canada’s Registered Retirement Savings Plan (RRSP) • 401(k) is setup with the employer’s plan whereas an RRSP can be setup with any financial institution; 401(k) contributions can only be made through payroll deductions whereas RRSP contributions can also be done as cash contributions (after tax) which then generate a tax rebate. The Power of Suggestion: Making Savings Automatic

  4. The Study • Methodology • Unit of study: U.S. company which implemented a change in 401(k) enrolment (automatic; moved from opt-in to opt-out ) and eligibility (upon hire and not after one year of service) on April 1st, 1998. • Time frame and objective: to look at savings decisions of employees (participation rate, contribution rate, and investment allocation) from June 1997 to June 1999. • Default plan: 3% contribution rate entirely allocated to the money market fund The Power of Suggestion: Making Savings Automatic

  5. The Study • Methodology cont’d (Madrian & Shea p.1154 Employee Cohorts) • Note: for all cohorts the employer’s match was 1 year after hire The Power of Suggestion: Making Savings Automatic

  6. The Study • Results of automatic enrolment • Higher participation rate; there is indeed a “suggestion to participate” • In most cases employees stay with the default option. There is a perceived message “to invest as suggested’ (3% rate and money market fund) • After 2 years the majority of employees will remain with the default option (but declines with tenure) • Even if employees do not stick with the default option, they are still likely to invest in default settings (anchoring) The Power of Suggestion: Making Savings Automatic

  7. Analysis of Findings • Rational factors • Transaction costs (direct or indirect) involved in switching to another alternative • Increasing complexity of decision-making = procrastination. More options = refusal to choose • Behavioural factors • Problems with self-control: tendency to leave for tomorrow what we can do today • Status quo bias driven by the “endowment effect”: asymmetry between perception of losses and gains; we tend to be loss averse vis-à-vis what we have The Power of Suggestion: Making Savings Automatic

  8. Analysis of Findings • Behavioural factors cont’d... • Anchoring: initial starting value (the default option) is used as a reference point from which to make adjustments • Framing of participation decision: how choices are presented. Default is participation after automatic enrolment • Tend to see the default option as implicit advice from the company e.g. 3% rate is the ‘advice’ of the company. The Power of Suggestion: Making Savings Automatic

  9. Policy Implications • It is important to understand why we observe differences in savings behaviour so as to inform the discussion on how best to create savings incentives • E.g. 1: If procrastination is a result of complexity of choices: offer a menu of popular options • E.g. 2: If procrastination is a result of inadequate information: offer investment education • Pros of automatic enrolment: • Tends to increase participation rate among groups with lowest participation rate (Blacks & Hispanics, young, low-income, women) • Tends to equalize participation differences across various demographic groups The Power of Suggestion: Making Savings Automatic

  10. (Madrian & Shea, p.1154 Effect of Automatic Enrolment Only) The Power of Suggestion: Making Savings Automatic

  11. Policy Implications • Cons of automatic enrolment: • Participants’ inertia: tend to stick with the default option • “Default savings behaviour under an automatic enrolment may lead to lower individual total savings compared to traditional opt-in 401(k) plan that require an active savings decision” (Madrian & Shea, p.1185) • Ways to make automatic savings a win-win situation: • Participants’ education • Improve default options • Increase the contribution rate in small increments in the future Eg. use inertia to increase savings The Power of Suggestion: Making Savings Automatic

  12. Thank you! The Power of Suggestion: Making Savings Automatic

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