When it comes to savings, people seem to often deviate from the general laws of Life – Cycle theory which argue that households (or individuals) tend to maintain a stable level of consumption along time (Browning and Crossley, 2001).
During the early years of life, when no fixed income is earned, an individual would have to borrow for fulfilling needs such as financing their studies. After entering working life, a stable level of income is received, offering the option to meet needs and desires plus save an amount of money (either to repay older loans or to get prepared for retirement). Lastly, during retirement age, a lower level of income is usually earned which is simply not enough to cover extra expenses (eg. increased health related costs). Again, in order to achieve a good standard of living, someone would need to dissave.
Behavioral Economics support that the above mentioned model is built upon axiomatic regularities like people’s rational thinking and utility maximization which are not empirically confirmed. According to the research of Lusardi et al. (2009), some of the key barriers in terms of low saving rates are insufficient information on how to save and the reluctance of low-paid employees to plan for retirement (Lusardi et al., 2009). They also claim that age plays a vital role since youngers usually do not know where to start when it comes to saving for retirement (Lusardi et al., 2009). Moreover, individuals significantly differ in their planning abilities and choices in terms of loss aversion, framing effects, cognitive inertia, procrastination etc. (Mitchell and Utkus, n.d.). All the above heuristics, underline the fact that not all people share a common profile when it comes to economic behavior.
As a matter of fact, it seems to be important to raise their awareness over monetary planning and allocation because a relaxed retirement age seems to be no longer guaranteed. This newly established reality gave birth to «Save More Tomorrow theory» (SMarT). Thaler and Benartzi (2004) introduced a new compensation plan design that helps employees increase their savings over time, while overcoming basic behavioral elements that hold them back from doing so.
The plan proposes that firms will provide their employees with small raises of 4-5% on their salaries every 6 months. The employees will be aware of the exact amount of the raises as well as the fixed timetable of the implementation of the policy. They have been asked beforehand to commit to save some amount every 6 months and they are free to opt out anytime. The key in SMarT is that employees pre-commit themselves to automatically increase their savings each time they get a raise (Benartzi, 2013).
The SMarT plan was originally implemented in 3 different companies in terms of size and its effect was impressive. During these initial experiments, saving rates quadrupled from 3.5% to 13.6% over 3.5 years (Benartzi, 2013).
But why SMarT is a smart nudging technique?
Imagine the two following scenarios and think which one of the two seems more attractive:
- In addition to whatever you own, you have been given 100€. You are asked to deposit 20€ in your bank account (or piggy bank).
- You are asked to deposit 20€ in your bank account (or piggy bank).
Which one would you prefer?
Both of the above scenarios describe the same raise plan that Save More Tomorrow initiates. The only difference is timing. In A, it is the time when you receive the raise, thus your income is increased and you consider yourself above your prior financial reference point. In B, some time has already passed and you no more consider the 100€ as extra. You have it earned, it is your established financial reference point.
The SMarT plan offered an interesting insight back in 2004 and since then it is gradually becoming more and more popular. “The Profit Council of America reports that as of 2007, 39% of large employers in the US have adopted some type of automatic escalation plan” (Thaler and Sustein, 2008). Moreover, the program was part of the Pension Protection Act in 2006 in the US (Benartzi, 2013).
Procrastination, Mental Accounting and Loss-aversion all together form the notion that “Saving in the future is more attractive compared to saving now”. Thaler and Benartzi overcome this issue with the strategy of continuously increasing salaries in order to encourage people to save more in short-time. In other words, they proposed a “Ulysses strategy” (Benartzi, 2011) where companies, under the desire of their employees, need to clog ears to the Sirens/biases in order to achieve sustainable financing of their needs during their lifetime journey.
- Browning, M. and Crossley, T. (2001). The Life-Cycle Model of Consumption and Saving. Journal of Economic Perspectives, 15(3), pp.3-22.
- Lusardi A., Keller P. A., Keller A. M. (2009). New Ways to Make People Save: A Social Marketing Approach. NBER Working Paper No. 14715
- Benartzi S. (2011), Behavioral Finance in Action, Allianz global investors, Center of Behavioral Finance
- Benartzi S. (2013) Behavioral Finance and Post-Retirement Crisis, Allianz global investors
- Mitchell, O. and Utkus, S. (n.d.). Lessons from Behavioral Finance for Retirement Plan Design. SSRN Journal.
- Thaler, R. and Benartzi, S. (2004). Save More Tomorrow™: Using Behavioral Economics to Increase Employee Saving. Journal of Political Economy, 112(S1), pp.S164-S187.
- Thaler, R. and Sunstein, C. (2008). . New Haven, Conn.: Yale University Press.