Is Retirement Saving ‘Wasted’ on the Young?

 The academics are at it again.

In a paper provocatively titled “The Life-Cycle Model Implies that Most Young People Should Not Save for Retirement” no fewer than four of them take 48 pages to make that case. The “trade press” breathlessly intoned “Most Young People Should Not Save For Retirement in Their 401k,” “Many young people shouldn’t save for retirement, says research based on a Nobel Prize–winning theory,” “Under 35? Don’t Save For Retirement Yet, These Experts Say,” “Economists Say Enjoy Your Youth and Save Later.” At least one had the temerity to offer a contrasting viewpoint (see “A New Paper Says Young People Shouldn't Save for Retirement. Advisors Disagree”), while The Street at least called it out as “This May Be the Worst Financial Advice Ever Shared.”

Like most research, the conclusion is a premise based on assumptions. Here the most basic is that this thing called a “life-cycle model” is worth considering in the first place. Now, granted, it’s the “Nobel Prize-winning theory” noted above—so mere mortals might be inclined to give it some breathing room.  But the underlying premise behind it is that individuals prefer to smooth out their consumption over their lifetimes, or—as the authors of the paper put it, assuming that “rational individuals allocate resources over their lifetimes with the aim of avoiding sharp changes in their standard of living.” Now, I don’t know about you, but my aspirations—and I consider them rational—have always been a bit higher than that.   
 

As it turns out, the authors here do anticipate some growth in income over time—indeed, that’s a contributing factor in their logic about putting off saving for retirement. Buttressing this are three basic arguments; first that since high-income workers tend to experience “wage growth” over their careers (and thus, for them “maintaining as steady a standard of living as possible therefore requires spending all income while young and only starting to save for retirement during middle age”—that’s right, it REQUIRES spending). Second, that low-income workers “receive high Social Security replacement rates, making optimal saving rates very low”—which apparently means that if you’re at a low-income level now, you’d (only?) be looking to maintain that level into retirement (and certainly, if you’re spending.  The final point has to do with what was then an artificially low interest rate environment that they claim “make a front-loaded lifetime spending profile optimal”—basically, at least at that point in time, they argue you might as well spend the money because there’s no economic advantage in saving. But what about market gains, you say? Hang on, we’ll come back to that in a minute.

‘Star’ Bucks?

Now, if you find yourself scratching you head at all that gobbledygook, it seems to boil down to this—you’ll get more “value” out of spending all of a smaller income now than you will suffer by depriving yourself—so that you can spend later when you’ll have more money to spend. Or something like that.  But to put some numbers behind those assumptions, you have to do a little financial alchemy—create some sort of “value” for consumption—something beyond a mere price tag. How much DOES that cup of Starbucks that we’re always telling people to forego actually mean to them in terms of what academics call “utility”? Indeed, that’s another required assumption here—and it’s key in terms of assessing the perceived trade-offs. 

What’s also odd here is that they actually talk about the “welfare costs” of automatic enrollment—essentially treating an individual who has been defaulted into saving as the equivalent of being scammed by a Nigerian prince. 

And for those of you wondering what happened to the “magic” of compounding those savings, the authors have a direct, but quizzical response: “…there is no power of compound interest when real interest rates are zero. While individuals could invest in risky assets with higher expected returns (which we do not model), those higher returns are merely compensation for taking on the additional risk.” So, basically, in this magical theoretical world… it’s a “wash.” 

Oh—and leakage? Well, in this world, since participation in plans by younger workers (who are particularly vulnerable to things like mandatory cash outs), they comment that, “Viewed from this perspective, leakages from 401(k) balances for young workers might be interpreted as correcting a mistake rather than a major problem in need of further government policy.” That’s right—early cash outs are a good thing (doubtless the taxes and penalties are considered a well-deserved “punishment” for the mistake of saving). 

That said, the authors do offer some caveats—they admit that they’re focused on saving for retirement, and that there may, indeed be reasons for saving earlier for non-retirement purposes. But they also admit that their model “does not account for uncertainty about future wages, employment, or health.”   They acknowledge that “if the wage profile is uncertain, or if there is a risk of future unemployment, individuals may wish to begin saving for retirement earlier in life in case future earnings do not turn out as expected.”

Ya think?

- Nevin E. Adams, JD

Behavioral Finance – the Next Frontier

All too often the innovations honored with a Nobel Prize fly under the radar of “regular” Americans. But that wasn’t the case last week when the work of University of Chicago’s Richard Thaler was acknowledged.

Thaler was, of course, recognized by the Royal Swedish Academy of Sciences, who said that his focus on limited rationality, social preferences and lack of self-control has “built a bridge between the economic and psychological analyses of individual decision-making.” More plainly, to my reading, Thaler (finally) managed to prove to economists that human beings don’t (always) act rationally and/or in their own self-interest.

Now, anybody who has ever actually interacted with human beings knows this. Indeed, in some ways the most amazing thing about Thaler’s insights of this reality is that it is seen as being innovative by economists.¹ I still remember reading the report that Thaler and Schlomo Benartzi authored way back in 2004, “Save for Tomorrow: Using Behavioral Economics to Increase Employee Saving.” That’s where (among other things) I first learned about the concept of what we today call contribution acceleration, based on the premise that people are more likely to act (and act more aggressively) on their good (but painful) intentions in the future than if they had to do so today.

There’s no denying that Thaler’s work has had a big impact on retirement savings (about $29.6 billion worth, according to one estimate). And if Thaler and Benartzi did not exactly create the notion of automatic enrollment, they at least freed it from the “dark” connotations of “negative election,” as it was called at the time.

Today we may wonder at – but no longer question – the notions that human beings rely on heuristics (mental shortcuts) when making complex decisions, that they fear loss more than they value gain, that they tend to diversify across the number of options provided, without regard to what lies within those choices, and that they tend to treat “old” money differently than “new” money. For this, Prof. Thaler and his collaborators over the years deserve our thanks.

That said, it may be worth remembering that while we tend to assume that plan fiduciaries are rational in all their decisions, they too are human beings making complex decisions. Consider that:

• Many remain hesitant to “impose” automatic enrollment for concerns about negative response from workers, though multiple surveys suggest workers would appreciate the move.
• Many continue to auto-enroll new hires, but not current workers.
• Many extend auto-enrollment to eligible workers – once.
• Many choose to implement auto-enrollment – and then wait 3 to 4 years to start contribution acceleration.
• Long-standing (and probably ill-considered) fund choices are routinely mapped during a recordkeeping conversion. Perhaps through multiple conversions.
• Plan committees often seem more worried about the negative reaction to removing a poor-performing fund than the possibility of being sued later on for keeping it on the menu.

That doesn’t mean that there aren’t any number of positive, rational reasons for those decisions (see “Why the ‘Ideal’ Plan Isn’t”). Indeed, most of us are rightly hesitant to superimpose our imperfect judgments on “other people’s” money – even on those on whose behalf fiduciaries are admonished to act.

But as we commemorate – and celebrate – those behavioral finance “nudges” that have done so much to buoy individual retirement security, perhaps some of those fiduciary decisions are worth (re) considering as well.

- Nevin E. Adams, JD