Retirement insights from a Colorado PERA perspective

Issues & Perspectives

Nobel Prize puts spotlight on behavioral economics, retirement plan policy

behavioral economics

The news is full of stories about Americans failing to adequately save for retirement. (MarketWatch, Fortune, and CNBC offer a few recent examples.) And national research has confirmed that Americans are uneasy about their retirement security. Why is it so hard to save enough to feel confident about retirement? A recent Nobel Prize winner offers important insight for those interested in protecting Americans from poverty in their retirement years.

In October of this year, the Royal Swedish Academy of Sciences awarded its Nobel Prize in Economic Sciences to Richard Thaler, a professor in behavioral science and economics at the University of Chicago Booth School of Business. In awarding the prize to Thaler “for his contributions to behavioural economics,” the Royal Swedish Academy of Sciences noted that he incorporated psychologically realistic assumptions into economic decision-making.

“People are complicated beings,” the Academy wrote. Thaler’s research has considered three psychological traits that systematically influence how people make economic decisions – limited rationality, perceptions about fairness, and lack of self-control. Thaler has shown how these “human traits” affect individual decisions as well as outcomes of financial markets and his work has had critical impacts on how workplace retirement savings programs are designed.

“In his applied work, Thaler demonstrated how nudging – a term he coined – may help people exercise better self-control when saving for a pension, as well in other contexts,” the Academy continued.

Along with Cass Sunstein, a law professor at the University of Chicago, Thaler has argued that both public and private institutions should try to nudge individuals in the right direction to avoid the temptation of irrational decisions. Simple changes such as how a default option is defined can make it more likely for people to save for retirement, participate in organ donation, or even eat more vegetables. When employees are automatically enrolled in a retirement savings plan, or drivers are asked to participate in organ donation any time a license is up for renewal, even the worst procrastinators can prepare for retirement or help save a life.

The PERA defined benefit (DB) plan is the retirement savings default option for public employees in Colorado. Public employees are automatically enrolled and contribute a set percentage of pay each pay period to fund a retirement account, thus alleviating the need to determine individual risk tolerance and the inertia associated with selecting how assets will be invested.

PERA members are also encouraged to save in addition to the PERA DB plan by participating in the voluntary PERAPlus 401(k) and 457 Plans. These plans use white label funds where the need to choose an investment allocation from a lengthy menu of brand-name investment products is simplified. Participants in the PERAPlus plans may also elect to participate in a target retirement date fund with premixed portfolios based on a future retirement date. Both the white label and target retirement date fund options use features that eliminate the pitfalls Thaler sees as hurdles to achieving investment success.

More and more retirement plans are using “auto-enrollment” and “auto-escalation” options to encourage participation, which should lead to successful retirement outcomes. The theory behind these features addresses the problem of investment inertia that many Americans have in their approaches to retirement saving.

Back in 2003, Thaler and Sunstein wrote a review of Michael Lewis’ Moneyball for The New Republic. Lewis’ book (which then became a movie) was about the low-budget success of the Oakland Athletics and their general manager, Billy Beane.

Thaler and Sunstein pose a question: Why did it take Billy Beane, a first-round baseball draft pick out of high school who abruptly quit the game after 301 at-bats and a disappointing .219 batting average, to change how baseball teams were managed?

“The problem is not that baseball professionals are stupid,” Thaler and Sunstein wrote. “It is that they are human.”

“Most people, including experts…tend to rely on simple rules of thumb, on traditions, on habits, on what other experts seem to believe,” they continued. “Even when the stakes are high, rational behavior does not always emerge.”

More recently, Lewis (of Moneyball fame) wrote a book called The Undoing Project about Amos Tversky – who is Richard Thaler’s mentor. In The Undoing Project, Lewis chronicles the work of Tversky and Daniel Kahneman and their collaboration in the field of behavioral finance and economics.

The stakes may not get much higher than saving enough for retirement. Hopefully the attention that Thaler’s work has received as a result of the Nobel Prize will continue to inspire baseball executives, policy makers, and retirement workers to avoid their own poor instincts and implement systems that make good decisions the easy decisions.

Read more about the work of Richard Thaler in “Easy money or a golden pension? Integrating economics and psychology,” a Popular Science background from The Royal Swedish Academy of Sciences.

Read more from PERA on the Issues on the topic of behavioral finance here, here and here.

Defined benefitAlso known as a pension, this is a type of pooled retirement plan in which the plan promises to pay a lifetime benefit to the employee at retirement. The plan manages investments on behalf of members, and the retirement benefit is based on factors such as age at retirement, years of employment and salary history.

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