The Psychological Foundations of Undersaving

1
The Psychological Foundations of Undersaving

• David Laibson
• Harvard University, Department of Economics
• and National Bureau of Economic Research
• August 4, 2006
• CFP Annual Meeting
• Los Angeles, CA

2
Psychological Foundations A Thought Experiment

• Would you like to have
• 15 minute massage now
• or
• B) 20 minute massage in an hour
• Would you like to have
• C) 15 minute massage in a week
• or
• D) 20 minute massage in a week and an hour

3
Choosing fruit vs. chocolateRead and van Leeuwen
(1998)
Choosing Today
Eating Next Week
Time
If you were deciding today, would you choose f
ruit or chocolate
for next week?
4
Patient choices for the future
Choosing Today
Eating Next Week
Time
Today, subjects typically choose fruit for next
week.
74 choose fruit
5
Impatient choices for today
Choosing and Eating Simultaneously
Time
If you were deciding today, would you choose f
ruit or chocolate
for today?
6
Time Inconsistent Preferences
Choosing and Eating Simultaneously
Time
70 choose chocolate
7
The desire for instant gratificationRead,
Loewenstein Kalyanaraman (1999)

• Choose among 24 movie videos
• Some are low brow Four Weddings and a Funeral
• Some are high brow Schindlers List
• Picking for tonight 66 of subjects choose low
  brow.
  
• Picking for next Thursday 37 choose low brow.
• Picking for second Thursday 29 choose low brow.
  
  
• Tonight I want sugar-coated entertainment
  next week I want things that are good for
  me.

8
Outline

• Modeling impulsivity and procrastination
• Self-defeating behaviors and retirement savings
• Neuroeconomics

9
Behavioral Model

• Quasi-hyperbolic discounting (Laibson, 1997)
• Discounted utility function
• Ut ut ½ ut1 ut2 ut3 ...
• Discounted utility from the perspective of time
  t1.
  
• Ut1 ut1 ½ ut2
  ut3 ...
  
• Discount function reflects dynamic inconsistency
  preferences held at date t do not agree with
  preferences held at date t1.
  

10
ProcrastinationAkerlof 1991

• Suppose you can exercise (effort cost 6) to gain
  delayed benefits (health value 8).
  
• When will you exercise?
• Exercise Today -6 ½ 8 -2
• Exercise Tomorrow 0 ½ -6 8 1
• Happy to make plans today to exercise tomorrow.
• But likely to fail to follow through.

11
Self-defeating behaviors

• Patient activities many of us plan to do
  tomorrow
  
• Quit smoking.
• Floss.
• Clean the attic.
• Comply with prescriptions.
• Cut back credit card spending.
• Join retirement savings plan.

12
Joining a GymDella Vigna and Malmendier (2004)

• Average cost of gym membership 75 per month
• Average number of visits 4
• Average cost per vist 19
• Cost of pay per visit 10

13
Saving for retirementLaibson, Repetto, and
Tobacman (2004)

• Need impulsivity to explain lifecycle consumption
  facts
  
• Substantial illiquid retirement wealth W/Y
  3.9.
  
• But, extensive credit card borrowing
• 68 didnt pay their credit card in full last
  month
  
• Average credit card interest rate is 14
• Credit card debt averages 13 of annual income
• Why do we see both saving and borrowing?!
• Patient long-run view leads us to set up
  automatic savings institutions (home mortgage,
  pensions)
  
• Impatient short-run view leads us to postpone
  sacrifices, so we spend on credit cards today

14
Procrastination in retirement savingsChoi,
Laibson, Madrian, Metrick (2002)

• Survey
• Mailed to 590 employees (random sample)
• 195 usable responses
• Matched to administrative data on actual savings
  behavior
  
• Consider a population of 100 employees
• 68 report saving too little
• 24 of 68 plan to raise 401(k) contribution in
  next 2 months
  
• Only 3 of 24 actually do so in the next 4 months

15
The power of deadlines Active decisions Choi,
Laibson, Madrian, Metrick (2004)

• Active decision mechanisms require employees to
  make an active choice about 401(k) participation.
  
  
• Welcome to the company
• You are required to submit this form within 30
  days of hire, regardless of your 401(k)
  participation choice
  
• If you dont want to participate, indicate that
  decision
  
• If you want to participate, indicate your
  contribution rate and asset allocation
  
• Being passive is not an option

16
401(k) participation increases under active
decisions
17
Active decisions conclusions

• Active decision raises 401(k) participation.
• Active decision raises average savings rate by 50
  percent.
  
• Active decision doesnt induce choice
  clustering.
  
• Under active decision, employees choose savings
  rates that they otherwise would have taken three
  years to achieve. (Average level as well as the
  entire multivariate covariance structure.)

18
Automatic enrollment

• Welcome to the company
• If you dont do anything
• You are automatically enrolled in the 401(k)
• You save 2 of your pay
• Your contributions go into a money market fund
• Call this phone number to opt out of enrollment
  or change your investment allocations

19
Madrian and Shea (2001)Choi, Laibson, Madrian,
Metrick (2004)
20
Employees enrolled under automatic enrollment
cluster at the default contribution rate.
Default contribution rate under automatic enroll
ment
21
Participants stay at the automatic enrollment
defaults for a long time.
22
Automatic enrollment

• Participants hired under automatic enrollment
  tend to stay at the automatic enrollment defaults
  (about 75)
  
• Default saving rates
• Default asset allocation
• Automatic enrollment results suggest that
  employees are passive

23
Automatic enrollment Conclusions

• Automatic enrollment dramatically increases
  401(k) participation
  
• Participants hired under automatic enrollment
  tend to stay at the automatic enrollment
  defaults
  
• Similar default effects are observed for
• cash distributions at separation
• company stock asset allocations
• saving rates at match thresholds

24
Unsuccessful solutions to savings problems

• Paying employees to save
• matches dont work
• Educating employees
• financial education (alone) doesnt work

25
100 bills on the sidewalkChoi, Laibson, Madrian
(2004)

• Employer match is an instantaneous, riskless
  return on investment
  
• Particularly appealing if you are over 59½ years
  old
  
• Have the most experience, so should be savy
• Retirement is close, so should be thinking about
  saving
  
• Can withdraw money from 401(k) without penalty
• We study seven companies and find that on
  average, half of employees over 59½ years old are
  not fully exploiting their employer match
  
• Average loss is 1.6 of salary per year
• Educational intervention has no effect

26
Financial education Choi, Laibson, Madrian,
Metrick (2004)

• Seminars presented by professional financial
  advisors
  
• Curriculum Setting savings goals, asset
  allocation, managing credit and debt, insurance
  against financial risks
  
• Seminars offered throughout 2000
• Linked data on individual employees seminar
  attendance to administrative data on actual
  savings behavior before and after seminar

27
Effect of education is positive but small
28

• Financial education effects are small
• Seminar attendees have good intentions to change
  their 401(k) savings behavior, but most do not
  follow through
  
• Financial education alone will not dramatically
  improve the quality of 401(k) savings outcomes
  
• We have also studied the effect of the
  Enron/Worldcom/Global Crossing scandals on
  employer stock holdings
  
• No net sales of employer stock in reaction to
  these news stories

29
NeuroeconomicsShiv and Fedorikhin (1999)

• Cognitive burden/load is manipulated by having
  subjects keep a 2-digit or 7-digit number in mind
  as they walk from one room to another
  
• On the way, subjects are given a choice between a
  piece of cake or a fruit-salad

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Emotional system (dopaminergic targets)
vs. Fronto-Parietal System
Frontal cortex
Parietal cortex
Dopaminergic Targets
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Hypothesis
Emotional system discounts reward at a higher
rate than does the prefrontal cortex.
Discounted value of delayed reward
32
McClure, Laibson, Loewenstein, and Cohen Science
(2004)

• Do agents think differently about immediate
  rewards and delayed rewards?
  
• Does immediacy have a special emotional
  drive/reward component?
  
• Does emotional brain discount delayed rewards
  more rapidly than the analytic (fronto-parietal
  cortex) brain?
  

33
Two kinds of choices (d vs. d)
Time

• delay d0
  d
  
• Reward R
  R
  
• Hypothesis fronto-parietal cortex.
• delay d0 d
• Reward R R
  
  
• Hypothesis fronto-parietal cortex and
  emotional.
  

Time
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Methods
Subjects given a series of choices between
(R at d) and (R' at d') where Rd
35
Emotional brain only shows elevated activation
when a subject considers an immediate reward.
ventral striatum
medial PFC
hippocampus
7
T13
ventral striatum
0
x -4mm
posterior cingulate cortex
medial OFC
medial OFC
36
Emotional system responds only to immediate
rewards
BOLD Signal
Seconds
37
Analytic brain responds equally to all rewards
38
Brain Activity in the Frontal System and
Emotional System Predict Behavior(Data for
choices with an immediate option.)
Frontalsystem
0.05
Brain Activity
0.0
Emotional System
-0.05
Choose Immediate Reward
Choose Delayed Reward
39
Conclusions of fMRI study

• Time discounting results from the combined
  influence of two neural systems
  
• Emotional structures are impatient
• Fronto-parietal systems (analytic systems) are
  patient.
  
• The emotional brain, does not respond to delayed
  rewards
  
• The emotional brain creates a drive for instant
  gratification

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Summary

• The drive for instant gratification
• Self-defeating behaviors and retirement savings
• Neuroeconomic foundations of behavior
• The battle between emotional and analytic
  decision-making.
  
• Practical solutions that overcome passivity or
  exploit it.