Executive Summary
The President's Economic Recovery Advisory Board (PERAB) recently released its recommendations on how to simplify the tax code and improve the implementation of tax policy. Embedded within the report are numerous recommendations that would impact our so-called "retirement crisis" in the U.S., and a few of the report's solutions highlight a surprisingly simple yet important reality: we're not always very rational about the decisions we make regarding retirement.
According to a Marketwatch.com article last month, the retirement industry at large is generally giving a good review to the PERAB recommendations as they impact retirement planning. But I was struck in particular by a few of the solutions that the PERAB put forth - expanding automatic enrollment into retirement plans, and also establishing a process for automatic rollovers (to another employer retirement plan or an IRA) when an employee leaves a job.
From a theoretical perspective, if investors are rational, approaches like automatic enrollment shouldn't matter. After all, if we can afford to save for retirement, we would be expected to make the same retirement decision regardless of whether enrollment is automatic or not. Similarly, if we can afford when leaving a job to keep our retirement funds in a retirement account, then presumably we could and "should" complete the same rollover when changing employers, regardless of whether the rollover occurs automatically.
Unfortunately, as we see in the real world - and as the PERAB report implicitly acknowledges as well - we do not always make the rational decision. Instead, what research is increasingly showing is that the way decisions are presented to us - and the defaults that will apply if we do nothing - actually matter. A lot. When our default is to not contribute to a retirement plan unless we sign a form and volunteer to contribute, large numbers of people choose not to participate. When our default is to contribute unless we opt out, again we tend to choose the default - but now end out participating; the opposite result, simply because the default was presented in the opposite manner.
As I noted in a blog post a few weeks ago, Professor Dan Ariely has written about this extensively in his book "Predictably Irrational", making the point that not only are our decisions often irrational, but that we are often unaware of it, even after the fact; we make up explanations to justify the choices we made, when in reality our decision was impacted more by the way the choice was offered than our conscious thoughts about the decision itself! Accordingly, the concept of "choice architecture" - that the way choices are presented affects what decision we make - is gaining popularity.
I suspect that many financial planners who have experience working with clients would be quick to acknowledge that as human beings, we regularly make all sorts of decisions about our finances that are, to say the least, not an expression of pure rationality. But to me, it's another matter altogether when the idea that we are not always rational makes it into a series of recommendations on public policy, one of the last great bastions of the "humans are rational economic agents" assumption.
If economists and public policy makers are willing to start acknowledging that we are not all rational (or at least, not all the time), we could be in for a very different kind of tax and regulatory policies in the coming years - an alternative to the current approach, which I would summarize as: "Assume everyone makes rational financial and economic decisions, and provide good financial literacy and education to ensure those decisions are informed decisions."
What do you think? Should public policy embrace the irrationality in all of us? Is this a positive step in the progression towards helping everyone be more financially successful? Or are our efforts better focused on better delivery of financial literacy and education than worrying about irrational decisions and choice architecture?
Frankly, I’m stunned (in a good way) at the acknowledgement of irrationality and the importance of Choice Architecture (specifically opt-in provisions) displayed by the PERAB.
In a short period in history, we have moved from a society where people has short life expectancies after retirement to long life expectancies. We moved from a defined benefit society to a defined contribution.
It’s easy for us to sit back and view the retirement planning landscape, and say that individuals and families need to do X, Y or Z. But it’s difficult to change an entire country’s philosophy about retirement in one generation.