Executive Summary
Over the past several decades, the national savings rate has plunged, even as the system for retirement preparedness has shifted increasingly towards defined contribution plans that rely on workers choosing to save in order to succeed. The end result is a generation of baby boomers that have found themselves woefully behind on retirement, notwithstanding all the "save more and spend less" advice that has been laid upon them for years.
Yet recent research suggests that perhaps the key to resolving this is to stop telling people to cut their spending now and save more, and instead to simply encourage them to save more tomorrow, instead. While this doesn't necessarily solve the challenge of the baby boomer who is already on the eve of retirement, the research suggests that for those in Generation X and Generation Y who still have years or decades until retirement, it may be a far more effective approach. The concept is rather straightforward - just commit to saving most of next year's raise, instead of cutting your spending now - yet the simple elegance is backed by a number of important behavioral finance concepts, including aversion to a loss of current lifestyle and taking advantage of our tendency towards hyperbolic discounting to make (future) saving less painful.
While there are some real world challenges to implementing a Save More Tomorrow approach - in part because planners lack some of the tools necessary to fully automate the process the way it's been done in the early research - it nonetheless raises the question of whether our "traditional" approaches to retirement advice, like "save more and spend less" or "save X% of your income every year" are due for a radical rethinking. By focusing on saving more tomorrow - and by not spending more tomorrow - perhaps we can actually find a better path to guide today's future retirees towards success.
Save More Tomorrow (SMarT) Program
The "Save More Tomorrow" program is the brainchild of behavioral finance researchers Shlomo Benartzi and Richard Thaler (the latter is the author of the book "Nudge" which has been previously reviewed on this blog). The basic idea is relatively straightforward: instead of asking people to save more now, ask them to save more in the future instead.
For instance, retirement plan participants were asked to commit to increasing their savings rate next year by 3% (assuming their annual raise would be at least a little more than 3%), and in their initial study Benartzi and Thaler found that while only 28% of employees accepted and implemented advice from an advisor to immediately increase their too-low savings amount, a whopping 78% of those who refused to increase their savings now were willing to increase their savings by 3% per year in the future. After making the commitment, only 2% of the participants dropped out after a year, and only about 20% dropped out after four years. Yet the end result was astonishing: after four years, those who accepted the recommendation to increase savings had managed to boost their rate from 4.4% to 8.8%, but those who participated in the SMarT program lifted from 3.5% (a lower base as they appear to have been less inclined towards saving in the first place) to a whopping 13.6% savings rate. In some subsequent scenarios with other firms, the researchers found that the effects were often even more dramatic for those who were not already saving at all (i.e., starting from a baseline of 0%) than they were for those who had been saving already but were trying to increase further.
Notably, these tests were done with real plan participants; thus, the SMarT program is not merely a theory, but has survived some real world environments. Although the programs were not implemented in a true experimental fashion - e.g., participants self-selected into the program and whether to save more now or later, rather than being randomly assigned - the authors take pains to share in their research why the results are probably quite robust and should sustain for many/most retirees.
Using Financial Irrationality For Good
The reason why the SMarT program seems to work so well is that it takes a lot of irrational behaviors we tend to have and frames them for good, instead of allowing them to inflict self-harm.
For instance, we all would prefer to have $1 in hand today than $1 in the future; we discount the value of things we don't receive until later (which is why we demand a rate of return for parting with our money). However, as behavioral finance research has found, we don't apply this very consistently; it turns out that we discount a lot for things we have to delay at all, and then only modestly discount further from there. For example, I might demand $2 next year to give up $1 today, but might give up that same $1 to get "just" $3 five years from now. Technically, that means the initial discount for waiting one year was far greater than the subsequent discount for later years (100% discount rate for 1 year, but only about a 10% discount rate for the subsequent 4 years); this phenomenon has been labeled as hyperbolic discounting in the research. While this behavioral "quirk" makes it difficult for us to commit to save now - because we so overweight the value of the present - it also makes it easier for us to make big commitments in the future (because we deeply discount their future value!).
Similarly, another big challenge to saving is the simple fact that we are loss averse; we don't like giving things up, and choosing to save more now inherently means we must give up - i.e., "lose" - something now from our spending to afford the saving. By contrast, when we commit to save more in the future, we never actually give up anything we currently enjoy. In fact, the SMarT research generally only committed people to saving some or most of their future raises, not all of them. Thus, over time, the individual's net income and therefore spending actually continues to rise over the years... it just rises by far less than the total amount of the raise!
The net result, as shown from some of the research above, is that after a few years of compounding the effect, spending may rise slightly but savings rises significantly. For instance, an individual who earns $50,000/year (spending all of it) and gets a raise of 4% per year - while also committing to increase savings by 3% per year or 75% of the raise - ends out after 5 years with a salary of $60,833, with spending of about $52,500 and saving of about $7,500/year. Thus, the client ends out with a whopping 12.5% savings rate, even while still spending more money every year - and following a path far easier than trying to figure out how to carve out 12.5% (or 10% or 5% or any amount of savings) to save from current income that's already being spent.
In other words, the client achieves a 12.5% savings rate by not giving up anything from his/her lifestyle... except a commitment to increase that lifestyle by less than the amount of each raise in the future! Or viewed another way, self-control around spending turns out to be a lot easier when we're redirecting future higher spending, rather than today's lifestyle spending.
Save More Tomorrow Strategies For Financial Planners
Notwithstanding the efficacy of a Save More Tomorrow approach from both the behavioral research theory, and the real world results, in practice it seems planners are often reluctant to implement plans that defer savings for the future. Typically, this seems to be built around the basic assumption that if a client is struggling to save now, it's unlikely that behavior will change in the future. Ironically, perhaps this means planners themselves are succumbing to hyperbolic discounting themselves, irrationally discounting the likelihood and relevance of saving in the future and overweighting the importance of saving immediately!
On the other hand, one unfortunate challenge of the approach from the planner's perspective is that, unlike the testing environment of Benartzi and Thaler, we cannot fully automate and "force" clients to save in the future to follow-thru on their commitment. By contrast, in the aforementioned research, the saving was truly automated once the participant committed; if/when/as the raise finally came, the savings contribution was immediately and automatically adjusted. The net result: with no further action necessary on the client's part, every raise just turned out to be more of a savings raise and only slightly a spending/paycheck raise. Given the systems available now to planners, it would be difficult to fully automate this in the same manner outside the qualified plan environment... and to the extent that implementation and follow-through requires additional steps later, there is an increased risk that clients really won't follow through when the time comes (although planners in an ongoing monitoring process could at least partially mitigate this problem by intervening quickly when raises occur to help ensure clients follow-through on their future-saving commitment).
Nonetheless, this still raises the question of whether a SMarT style approach wouldn't be a better baseline for teaching fiscal responsibility and encouraging saving. After all, another way to frame "save more tomorrow" is to simply say "don't spend [much] more tomorrow" - in other words, it's not even a commitment to cut spending and lifestyle, but simply a commitment to increase it by less than the amount of an individual's raises over time. Arguably, that's a much better way to help clients manage their spending and savings behaviors than simply insisting and repeating to spend less and save more, even as the falling savings rate for decades has made it clear that a huge number of people simply cannot implement that advice. At what point do we acknowledge that the in-the-present focused "spend less and save more" approach just isn't working very well; or alternatively, given how low the savings rate, how much is there to lose with a new and potentially better approach!?
Another benefit of a more focused approach on controlling spending over time - rather than just telling people to save more and spend less - is that it avoids the fundamental flaw of the "save-a-percentage-of-income" approach: that committing to saving 10% or 20% of your income each year also equates to permission to spend 80% to 90% of your raise every year and continuously raise lifestyle costs! Sustained over time, this leads many workers to lifestyles that require enormous sums of money to afford in retirement, and leads to a scenario where savings in the early years turn out to be woefully inadequate because spending and lifestyle rises to much later. Viewed from this perspective, the SMarT approach encourages people to save the majority of their future raises, while save-a-percentage-of-your-income encourages people to spend a majority of their future raises; compounded over a period of years or decades, this results in a drastic difference in both spending/lifestyle, savings rate, and accumulated savings, where those who merely save X% of their income lag further and further behind over time.
Unfortunately, the reality is that a save-more-tomorrow approach really only works when there are some tomorrows left for saving; in other words, this is less about solving the retirement crisis for baby boomers who are closer to retirement and have fewer tomorrows (years) available to save, and more about how to maximize the savings and success of today's Gen X and Gen Y workers. On the other hand, this also represents a significant opportunity, as most Gen X/Y workers have not yet reached their peak income/earning years, and therefore still have time to lock in their spending and lifestyle today and ensure it doesn't rise too fast in the future! So the next time you sit down with a younger client who asks about retirement advice, consider whether you're going to tell them they need to start saving more today for retirement success, or if it would be better to tell them to start saving tomorrow, instead?
In the meantime, for those who are interested in further information, see below for Shlomo Benartzi's TED talk about the "Save More Tomorrow" approach.
