Financial advisors can gain a lot of insight from behavioural economics.
In the past 40 years there has been an abundance of research dedicated to understanding human decision making. The findings that have emerged from this extensive body of knowledge is that we humans are not all that rational when it comes to making decisions that are in our best long-term interest.
Take for example new year’s resolutions. We declare this year to be the year we will lose weight, eat healthfully, routinely exercise, quit smoking and save more money. Yet, despite the best of intentions and a true desire to better our circumstances, 80 percent of us fail to accomplish our goals, and most of us quit by mid-February.
If you are amongst the 80 percent blame it on your biased brain! It turns out that the brain has very predictable ways of processing information that favours present day circumstance, over future well- being.
While we can’t change our mental circuitry, we can alter the environments in which we make decisions so that our choices result in more optimal outcomes – in other words, we can become better choice architects.
A choice architect, is a term coined by Richard Thaler, and Cass Sunstein, in their book Nudge. The choice architect is a person who can influence the environmental circumstances of others in a manner that gently nudges them to make short-term decisions that are aligned with their long-term future goals.
When used ethically, nudges have proved quite promising. In fact, Nudges have been very effective in helping people financially prepare for retirement. Decades of research indicate that people don’t sufficiently financially plan for their future.
One way employers can help employees increase their savings rate is to implement a default policy in which they are automatically enrolled in a retirement savings plans. Should employees wish to opt-out they can certainly do so. However, that requires that they fill out a form and indicate they want to be exempted.
In 2006 the US government enacted the savings default policy into law. This landmark change has resulted in a significant increase in the number of eligible workers participating in the plan.
Why does the plan work as well as it does?
The program works because people are naturally inclined to resort to default options because it’s so much easier than having to think and make decisions.
Have you changed the original ringtone on your mobile phone?
Defaults are especially attractive when contemplating future retirement savings that require the forecasting of several of life’s uncertainties, such as future earnings, retirement needs, age of death, age at retirement, inflation, medical needs, and economic growth.
This is not a task most of us want to entertain even if we somehow could manage to do it!
The issue is further complicated by the minimal costs associated with delaying such a laborious chore. The real problem occurs once retirement is upon us and we finally realize that building a nest egg requires years for investments to appreciate.
One way financial advisors can help clients make better financial decisions is by becoming retirement architects.
How can financial advisors leverage this research?
Financial advisors can suggest to a client a savings plan that ties future earnings to future contributions. This plan was developed by Thaler and Shlomo Benartzi and is called the Save More Tomorrow program. It automatically increases an employee’s savings rate every time she gets a raise.
For example, if you ask me to save more today, the typical retirement savings advice, I will likely decline because it means I have to decrease my present-day consumption and that just feels bad – even when it is in my best long-term interest.
But, if you ask me to increase my savings rate when I receive my NEXT raise, then I’m more likely to agree because I don’t need to give up anything in the present, and the increase in my future contributions doesn’t hurt because I’m not committing all future raises to my savings – only a percentage. So, I get to enjoy my bonus while simultaneously increasing my retirement savings rate over time.
This program has been widely successful.
At the time of this writing, Benartzi estimates that the Save More Tomorrow program has helped over 15 million Americans increase their savings rate.
Quite the accomplishment!
Nudging people to make decisions that are in their best long-term interest has a great many payoffs for themselves, businesses and society at large.
Financial advisors – want to learn more about how to become a retirement architect? Join the webinar September 19th at 12:00 pm where I will discuss tips on how to use the latest social science research to help you help your clients make retirement planning easier!
To your success!
Dr. Gill
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