Neuroeconomics and Savings

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Neuroeconomics and Savings

• David Laibson
• Harvard University, Department of Economics
• and National Bureau of Economic Research
• April 1, 2006
• NIA Conference, Stanford University

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
Read and van Leeuwen (1998)
Choosing Today
Eating Next Week
Time
If you were deciding today, would you
choose fruit 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
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Impatient choices for today
Choosing and Eating Simultaneously
Time
If you were deciding today, would you
choose fruit or chocolate for today?
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Time Inconsistent Preferences
Choosing and Eating Simultaneously
Time
70 choose chocolate
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Instant Gratification and Movie DemandRead,
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.

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Outline

• Modeling impulsivity
• Self-defeating behaviors
• Neuroimaging evidence and neuroeconomics

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Behavioral Model

• Quasi-hyperbolic discounting
• Phelps and Pollak (1968), 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.

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Procrastination Akerlof 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.

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Self-defeating behaviors

• Patient activities many of us plan to do
  tomorrow
• Watch less TV.
• Improve diet.
• Quit smoking.
• Floss.
• Comply with prescriptions.
• Exercise.
• Cut back credit card spending.
• Join retirement savings plan.

12
Della 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

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Laibson, 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, DB
  and DC pensions)
• Impatient short-run view leads us to postpone
  sacrifices to tomorrow, so we live hand to mouth,
  borrow on credit cards, and procrastinate

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Survey Evidence on ProcrastinationChoi, 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

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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

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401(k) participation increases under active
decisions
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Active decisions

• Active decision raises 401(k) participation.
• Active decision raises savings rates by 50.
• Active decision doesnt induce choice clustering.
• Under active decision, employees choose
  participation level and savings rates that they
  otherwise would have taken three years to achieve.

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Automatic enrollmentfirst studied by Madrian
and Shea (2001)

• 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

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Choi, Laibson, Madrian, Metrick (2004)
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Employees enrolled under automatic enrollment
cluster at the default contribution rate.
Default contribution rate under
automatic enrollment
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Participants stay at the automatic enrollment
defaults for a long time.
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Unsuccessful solutions to savings problems

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

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100 Bills on the TableChoi, 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 savvy
• 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

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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

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Treatment effect is positive but small
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• 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

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What is the underlying mechanism?

• Why are our preferences inconsistent?
• Is it adaptive?
• How should it be modeled?
• Does it arise from a single time preference
  mechanism (e.g., Herrnsteins reward per unit
  time)?
• Or is it the resulting of multiple systems
  interacting (Shefrin and Thaler 1981, Bernheim
  and Rangel 2004, ODonoghue and Loewenstein 2004,
  Fudenberg and Levine 2004)?

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Shiv and Fedorikhin (1999)
"Heart and Mind in Conflict Interplay of Affect
and Cognition in Consumer Decision Making,"
Journal of Consumer Research, Vol. 26 (December
1999), 278-282.

• Cognitive/deliberative mental processing
  resources manipulated by having people keep a
  2-digit or 7-digit number in mind as they
  walk from one room to another
• On the way, subjects face choice between piece of
  cake or fruit-salad

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Limbic system vs. Fronto-Parietal System
Frontal cortex
Parietal cortex
Limbic system
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McClure, Laibson, Loewenstein, and Cohen (2004)

• Do agents think differently about immediate
  rewards and delayed rewards?
• Does immediacy have a special emotional
  drive/reward component?
• Does emotional (limbic) brain value delayed
  rewards differently than the analytic
  (fronto-parietal cortex) brain?
• Specifically, does the limbic system discount the
  future at a greater rate than the fronto-parietal
  cortex?

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Subject choices (delay d vs. delay d)
Time

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

Time
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Methods
Subjects given a series of choices between
(R at d) and (R' at d') where Rd
d d'-d (R'-R)/R
? Today, 2 weeks, 1 month ? 2 weeks, 1
month ? 1, 3, 5, 10, 15, 25, 35, 50
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Q Which regions only show elevated activation
when a subject considers an immediate reward? A
Limbic systems and para-limbic cortex.
ventral striatum
medial PFC
hippocampus
7
T13
ventral striatum
0
x -4mm
posterior cingulate cortex
medial OFC
medial OFC
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Emotional brain
36
Analytic brain
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Brain Activity in the Frontal System and Limbic
System Predict Behavior(Data for choices with an
immediate option.)
Frontalsystem
0.05
Brain Activity
0.0
Limbic System
-0.05
Choose Immediate Reward
Choose Delayed Reward
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Conclusions of fMRI study

• Time discounting results from the combined
  influence of two neural systems
• Limbic structures are impatient
• Fronto-parietal systems are patient.
• These two systems are separately implicated in
  emotional and analytic brain processes.
• The limbic (emotional) brain, does not value
  delayed rewards
• The limbic brain creates a drive for instant
  gratification
• Results have now been replicated with juice
  rewards

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Summary

• A model of impulsivity
• Self-defeating behaviors
• Neuroimaging and neuroeconomics
• Future research Age variation
• Limbic drives
• Cortical control
• Learning and Memory
• Analytic cognition

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How quickly do different age groups learn how to
exploit a complicated teaser rate offer?
Naives Slow learners
Sophisticates Immediate learners
Age of credit card holder
45-64
65
25-34
35-44
18-24
Source Agarwal, Driscoll, Gabaix, and Laibson
(2006)