Executive Summary
A common challenge in financial planning is getting clients to actually implement the recommendations they've been given to help themselves progress towards their financial planning goals. While in theory, rational human beings should easily be able to take the necessary steps to improve their situation - especially once an expert has provided a list of recommendations and required action items to do so - the reality is that we're far less rational in practice. External influences that "shouldn't" be relevant can often impact our decisions and actions anyway, and in turn this means it's possible to influence decisions, or "nudge" people in certain directions, by paying attention to how the choices are presented.
This concept of "choice architecture" - acknowledging that the way choices are presented can influence their outcomes - is relevant not only for those making public policy decisions, but also anyone who is trying to help people make positive behavior changes... such as financial planners. Whether it's helping clients to change their own behaviors, to implement your financial planning recommendations, or even to help them determine whether to hire you in the first place, it may be time to pay a lot more attention to how those decisions are delivered to clients in the first place.
Choice Architecture In The World At Large
So what does choice architecture look like in the real world? Thaler and Sunstein, in their book "Nudge: Improving Decisions About Health, Wealth, and Happiness" provide several compelling examples. For instance, in one scenario it was observed that in a cafeteria, the order and manner in which items are presented impacts how often they are chosen; students tended to purchase more of items that were listed first, or also more items that happened to be close to eye level on the large menu behind the counter. As a result, choosing which items were presented first or at eye level could impact their outcome; if you want students to eat healthier, put the carrot sticks at eye level instead of french fries, and list the salads at the top of the list and the desserts near the end.
Notably, choice architecture can impact our decisions, even when we think we have engaged in a careful, rational thought process to come to the decision. For instance, one study tested how people decide whether or not to be organ donors, and discovered that when the default is not to be an organ donor unless the person chooses to be, 42% become organ donors; on the other hand, if the default is to be an organ donor unless the person opts out, 82% end out choosing to be an organ donor. Although the study was in a controlled environment, similar results have been found in the real world; in Germany, only 12% of people have opted in to be organ donors, while in Austria the default is to be an organ donor and as a result the organ donor rate is a whopping 99%. Notably, in none of these scenarios do those who choose to be organ donors or not ever attribute their decision to whether the default was to opt-in or to opt-out; they all believe they engaged in a thoughtful decision-making process, unaware that the default choice had in fact been as influential as the results clearly demonstrate they were.
Choice Architecture In Financial Services
So how might choice architecture apply in the context of the financial services industry? It turns out that we already provide numerous "nudges" in financial services world - albeit not always towards what we intend - while in other circumstances, we fail to provide nudges that would likely have a material positive impact.
Recent changes in the qualified plan space demonstrate some ways that nudges can be put to use in a positive way. For instance, employers can now by default automatically enroll employees into a 401(k) plan, for which they must opt out if they choose not to participate; as a result, 401(k) participation rates are boosted above what they otherwise would have been, where the default is to receive the money in a paycheck to be spent unless the worker opts out of spending and chooses to save (which, surprisingly, many people don't end out doing). Similarly, default investment options - both for the automatically enrolled plan participant, and even those who voluntarily enroll but must choose what to invest in - also shape subsequent investment decisions; when the default for 401(k) contributions was cash, people often accumulated large cash balances, while in today's world the default is often a balanced fund with stocks and bonds (often in the form of a target date fund); while there are some valid criticisms of the details of target date funds, the fact remains that with a balanced fund as a default instead of cash, far more people are putting their retirement savings to productive investment use.
Another example of giving people a nudge is by using their behavioral tendencies to get them to create their own defaults in the future, which then become set and difficult to change later. For instance, the Save More Tomorrow program pioneered by Thaler and fellow researcher Shlomo Benartzi encourages people to save by getting them to commit to saving more down the road, tying it to their future raises. As a result, the savings increases happen automatically, and the worker never experiences a decline in take-home pay, just a smaller increase when a raise occurs. Thus far, the program has been extremely successful; one study cited by the book looked at results for a particular employer and found that the Save More Tomorrow plan had helped some of the worst savers to boost their retirement savings from about 3.5% to 13.6% in just four years of pay (and savings) raises. A TED video discussing the Save More Tomorrow program is shown below.
At the same time, the Nudge book also provides some examples of how choice architecture can be done poorly. A prime example was the rollout of Medicare Part D, which entailed some highly complex choices, an incredibly wide range of potential options, and very limited guidance to consumers about how to properly choose the right plan (or effective tools to help them make a decision). As a result, many people delay and procrastinate, and while ultimately most people eventually got into some Medicare Part D program, ongoing research suggests that many may be in sub-optimal plans. Arguably, much of the history of 401(k) investment decisions has actually been similar; when presented with a high-stakes complex choice, many workers simply choose at best to take the default, or at worst to do nothing and not participate at all, rather than struggle with an incredibly complex decision with insufficient guidance about how to make the right choice.
Choice Architecture For Financial Planners
So how might the concepts of Nudges and choice architecture be applied by financial planners? There are many opportunities.
One approach would be to use something like the Save More Tomorrow program, helping to get clients to commit not to saving more now - which entails giving up spending they might enjoy - but instead to commit to simply raising their spending by less than the amount their income increases. By helping people to simply maintain their current lifestyle, income growth over time can be redirected to savings, which over the long run can actually result in even more retirement wealth than just saving a percentage of income every year!
Similarly, ways that you can structure your client recommendations or how you help clients implement them, to take advantage of our tendency towards choosing defaults or leaning towards choices that are presented prominently, can help. An easy step to this is to help clients automate key steps that set up positive results; automatically debiting bank accounts for important insurance premiums or other bills, as well as savings contributions, increases the likelihood they will persist. The more guidance you can provide clients not just about the trade-offs of their financial decisions, the more you can help them make effective comparisons to ensure a good decision. If you want clients to implement recommendations, help to prioritize the list to reduce it down to simple, key points that clients can act upon and make a decision; the comprehensiveness of your long list of financial planning recommendations, just like a long list of 401(k) investment choices or Part D Medicare drug prescription plans, may not help and can actually lead to inaction because of the overwhelming way the choices are being presented.
In addition to impacting how clients select and implement planning recommendations, it's notable that choice architecture can also implement how and whether clients choose to hire you in the first place. For instance, providing financial planning services as part of a single consolidated fee means clients by default have access to all services, which encourages clients to utilize them; on the other hand, when financial planning fees are charged separately from other services, it means clients by default will not receive financial planning, and consequently may lead them to engaging in financial planning less. The bottom line: be cognizant of what services your clients are being defaulted in to, or out of, in your own financial planning practice!
A Choice Architecture Word Of Caution
Notwithstanding all the benefits of effective choice architecture, a word of caution is appropriate - as with many behavioral finance techniques, it's important to help clients use their irrationality for good, and not for evil! For instance, a default can help clients to stick with a good savings and investment program, but can also be used to get clients stuck in undesirable, high-priced alternatives. Be certain that when presenting choices in a manner that influences the outcome, the strategies are used in a manner that achieves the most good for the client, not the company's profit margin.
At the same time, that doesn't mean a level of hyper-objectivity is necessarily better. The authors of Nudge point out a notable example with Medicare Part D, where a program wanted to give people a default for enrollment, but didn't want to show favoritism to a particular private business; while noble in concept, the end result was that instead of matching people to the prescription drug plan that best matched their actual needs, they were assigned a default drug plan entirely at random, virtually ensuring that many people would end out with sub-optimal solutions. Yes, the person could always make a change and enroll in another plan later... but as the nudge research itself has made clear, it's very likely that a lot of the sub-optimal plans are going to remain in place once consumers have been nudged into them.
In addition, it's important to realize that there can be a slippery slope between just giving people nudges, and dictating or forcing particular solutions upon them. Thaler and Sunstein refer to their Nudge approach as "libertarian paternalism" - where choices are not restricted or eliminated in a paternalistic fashion, and the libertarian freedom of choice remains, but a subtle form of paternalism applies in trying to "nudge" people towards a particular decision in the absence of their strong preference to go another direction (while still always preserving the option for them to do so). On the other hand, recent research has shown that nudges alone aren't always enough... so in reality, there may ultimately still be some times where restricted choices to force people towards certain outcomes may be preferable to just nudging them in that direction.
Nonetheless, the fact remains that "choice architecture" and a focus on not just what the decisions are that clients face, but how those decisions are presented to them, really does matter in many cases and can often influence client outcomes. So next time you're working through some financial planning recommendations with a client, or inviting them to hire you for financial planning services, make sure you think about how those choices are being delivered!
Having read “Nudge” by Cass Sunstein and having researched his background, the author of this article on Nudge misses the point of Sunstein’s book. What he is promoting is that instead of the government commanding the public to do things, that the government should use its powers to nudge people into making the right choices as the government (actually the elite followers of the Saul Alinsky philosophy) determines. I think the author has a good idea about making clients aware of options and alternatives, but the bias of the CPA should not come into play to nudge the client into making what the CPA chooses is the right choice for the client.
Denis,
Certainly, much of the context that Sunstein and Thaler give “Nudge” is about how it should be applied in government settings, and they take pains to delineating their “libertarian paternalism” approach from a more over governmental paternalistic approach.
Nonetheless, the same principle applies for planners, and similarly is subject to many of the same issues. No, a planner shouldn’t use nudge techniques to drive a client towards the planner’s personal views – nor should government. But just as there are government nudges that can help to support healthy eating choices, exercise choices, or saving and investing choices, so too can planners be cognizant of how they structure recommendations, implement them, and otherwise guide clients.
As I’ve noted in the past on this blog, there certainly is a risk when applying behavioral finance techniques to use them wrong or improperly. But that doesn’t mean it’s wrong to use them or that they shouldn’t be applied; it simply means they should be applied with thoughtful caution towards appropriate client outcomes.
Respectfully,
– Michael