The Retirement Plan Cooked up by Two Behavioral Scientists
How you can implement a similar approach to your retirement savings
The 401k perfectly encapsulates the brilliance and flaws of traditional economic models.
Contributions are tax-deductible
Investment gains grow on a tax-deferred basis
Employers typically match a certain percentage of contributions
If used correctly, it’s an incredibly powerful tool to help middle-income workers save for retirement.
There’s only one problem.
It was designed for a “perfectly rational” economic actor. As we know, humans are far from rational, and none of us approach a description of perfectly rational.
But what would happen if you had a workplace retirement savings plan designed by two experts in behavioral science?
People would save a lot more money.
Building a savings plan around your biases
In a 2001 paper, Richard Thaler and Shlomo Benartzi discuss the retirement savings plan they created called “The Save More Tomorrow (SMT) plan.” The plan works within the rules of real-life workplace retirement plans like 401ks—but with a few tweaks that increase the likelihood that employees participate in the plan and save more money.
Here’s how the plan works.
The whole idea is to get people to save more money—but the plan get’s people to increase their savings at a gradual pace. Employee contributions are increased when they get a pay raise.
One of the strongest biases humans suffer from is loss aversion. People don’t want to see their paychecks go down, so timing increased savings rates with the day their pay increases means their take-home pay does not have to change. This means they get the increased savings without feeling like they have less money to spend.
Timing increases in savings with increases in pay raises is something I have written about a lot in the past. I call it “reverse lifestyle inflation.” Once you are done reading today’s article, go back and read this one from the archives, where I walk you through how to “treat new money like it doesn’t exist.”
Thaler and Benartzi understand that people also suffer from present bias, which means they prefer immediate rewards over future gains—even if we know those decisions are not in our best interest in the long run.
To overcome the impacts of present bias, they get people to commit to the increase in their retirement savings contributions months in advance of their pay raise. That way, it’s not your present self that has to save more—it’s your future self. This is a brilliant feature that flips the usually negative impact of present bias and uses it to help people save more money.
Another key feature of the plan is that employee retirement contributions continue increasing every time they get a raise until it reaches the maximum amount that the employee agreed to when signing up for the plan.
This leverages status quo bias—which is our tendency to go along with whatever the current status quo is. Even if people don’t like saving more money each year, status quo bias means they aren’t likely to do anything about it. So they save more money, whether they like it or not. Again, they harness what are typically wealth-destroying cognitive biases and use them for good.
Most importantly, employees can opt out of this plan at any time—although not many do for the reasons we just discussed.