Are American Policymakers Using Behavioral Economics Against Us?

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Are American Policymakers Using Behavioral Economics Against Us?

Whether you know it or not, you and your clients encounter decision architecture based on behavioral economics in almost every financial decision.

By Justin Reckers and Robert Simon

Originally published by MorningstarAdvisor.com on November 17th 2011

Businessweek recently ran an article in its Opening Remarks section titled “Nudge Not.” The title is a play on Richard Thaler and Cass Sunstein’s book Nudge and offers a perfect segue into our next few articles. We are beginning to look into some amazing everyday applications of behavioral finance and economics. Some are obvious. Some are not. All are used to affect our decisions to buy, sell, borrow, and even cheat and steal.
We want to understand how the observations from behavioral economics are used against us so that we can make better decisions for ourselves and our clients. We say “against us” because whether the policymaker or marketer who is wielding these tools is doing so for positive or negative reasons, they are in fact trying to change the way we make financial decisions and, by extension, working against our natural human tendencies.
The “Nudge Not” article looks at the effect, positive or negative, of the Obama administration’s use of behavioral economic theory in the Making Work Pay tax credit. We are not privy to the underlying thought process that went into creating the tax policy, but the author submits that the Obama Administration structured the tax credit as a payment over time, rather than a lump sum as previous economic stimulus payments have been. They did so in the hope that this would encourage Americans to spend the money, and this would result in a bolstering of our economic circumstances.

The structure of this tax credit was meant to take advantage of our human tendency to do mental accounting. Policymakers hoped that a small incremental increase in monthly take-home pay would be accounted as current income and spent, rather than accounted as current assets and saved. It turns out we do have this tendency to make financial decisions differently based on whether we account for money as part of income or part of assets. The structure of the Making Work Pay credit is simply a clever way to combat the paradox of thrift using observations from behavioral economics.

We tip our hats to the Obama Administration for trying their hand at a Nudge. The jury is out on whether it worked.

One of us recently saw Dan Ariely, author of Predictably Irrational and The Upside of Irrationality, speak at the annual convention of the International Academy of Collaborative Professionals. The room was full of divorce lawyers, mediators, mental health experts, financial advisors, and other professionals interested in resolving disputes outside of court through a model known as “collaborative practice.” This is a growing avocation in the world of divorce and family law, and they were all very interested to hear Ariely’s insights into how we make financial decisions. One of the main takeaways from Ariely’s presentation was the value of default options or opt-out programs. Here is an example from American policymakers:

During the Bush Administration, concern over the health of the American Social Security retirement system and discussions about how to fix what ails the programs reached fervor. Policymakers asked how the average American might be encouraged to save for retirement on their own so they would not be forced to rely on the Social Security system alone. It turns out Americans aren’t very good at saving for themselves, so Congress took matters into their own hands and created the Pension Protection Act. Among other things, the Pension Protection Act creates incentives for employers to build opt outprovisions into 401(k) plans. Such plans automatically enroll employees into deferring a minimum amount of their pay into a 401(k) savings plan. They can only stop this automatic enrollment if they opt out of the plan. At the time of enactment, the Employee Benefit Research Institute projected that this change could double the number of American workers participating in 401(k) savings plans.

More saving means more economic security for Americans, so it seems like a great idea for the masses. But what it really tells us is that we, Americans at least, are not to be trusted with decisions about our own economic future. Why are we not to be trusted? Inertia is the key dilemma the Pension Protection Act attempts to employ and use against our human nature.

How much should I contribute? Should it be a fixed dollar amount or a percentage of my earnings? Can I afford to put food on the table if I take $150 per month out of my paycheck? Won’t Social Security take care of me? How should I invest? What is the difference between growth stocks, value stocks, bonds, mutual funds, and money market? Maybe I should just invest in the stock of my company. What happens to the money if something happens to me? When can I get the money back?

That sure is a lot of questions for an employee to answer at once. In the face of such complicated and difficult decision-making, many will procrastinate or simply make a conscious decision not to engage in the decision-making process at all. This is inertia. Because of this inertia, American policymakers believe they will make a better, more informed, well calculated decision about saving for your retirement than you will. Most importantly, they believe that removing the barrier caused by inertia in human cognitive functioning will lead to better financial decision-making by ultimately not requiring a decision to be made at all.

We find this realization of just how policymakers think of us to be sobering and also comforting. It is sobering to realize that they think most of us will not make good financial decisions for ourselves and that they think they can make better decisions for us. It is also a comforting thought to realize they do care about the welfare of the average American who is overwhelmed with complicated financial decisions. Or maybe they just care about the political fallout of a failed Social Security program and are doing an end-run to make it hurt less when we get the news that the Social Security Administration expects to be able to pay only about 70% of the benefit we have earned based on what has been paid in. It certainly does hurt less when I am told I won’t get something I wasn’t expecting anyway. I have no pride of ownership in what I have created, so I won’t feel a sense of loss when it is taken away.

We will talk more about the pride of ownership next month–its use in marketing and how advisors should use it in creating the architecture for financial decision-making with clients.

Justin A. Reckers, CFP®, CDFA™, AIF® is Director of Financial Planning at Pacific Wealth Management® and Managing Director of Pacific Divorce Management, LLC based in San Diego, Calif. www.pacwealth.com, www.pacdivorce.com

Robert A. Simon, Ph.D. is a forensic psychologist, trial consultant, expert witness and alternative dispute resolution specialist based in Del Mar, Calif. http://www.dr-simon.com

The Benefits of a Financial Nudge

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The Benefits of a Financial Nudge

Reconciling the concepts of libertarian paternalism and self-determination.

by Justin A. Reckers and Robert A. Simon

Originally published by MorningstarAdvisor.com on June 16th 2011.

Richard Thaler is undeniably one of the godfathers of behavioral economics. Thaler is the professor of behavioral science and economics at the University of Chicago Booth School of Business and director of the Center for Decision Research. As an economist, he has collaborated with the founders of cognitive psychology and “prospect theory,” Amos Tversky and Daniel Kahneman.

Thaler’s publication credits are lengthy, his research important, and his ideas brilliant. He grasped the tenets of cognitive psychology early on in his career as an economist and has used those tenets to build an original model for effecting positive change in the world of economic policy and financial decision-making. He calls it the “Nudge.” Thaler penned a book along with Cass Sunstein by the same title in 2008.

In previous writings, Thaler and Sunstein detailed an economic strategy they call “libertarian paternalism.” The basic idea, in my words, proposes that private and public institutions might do well to nudge people (citizens) toward certain decisions the institution believes to be in the best interest of its constituents. The nudges should help people make decisions that improve their lives economically, while supporting each individual’s freedom of choice. The nudge represents paternalism and the freedom of choice represents libertarianism.

We wrote last month about the importance of self-determination in financial advisory practices and financial decision-making in general. This month we look, briefly, at whether Thaler and Sunstein’s nudge may be a successful way to effect positive change in daily financial decision-making and whether it meets with our goals of supporting self-determination and informed consent.

In the abstract of Thaler and Sunstein’s principal paper Libertarian Paternalism is Not an Oxymoron, it states “Often people’s preferences are unclear and ill-formed, and their choices will inevitably be influenced by default rules, framing effects, and starting points. … Equipped with an understanding of behavioral findings of bounded rationality and bounded self-control, libertarian paternalists should attempt to steer people’s choices in welfare-promoting directions without eliminating freedom of choice. It is also possible to show how a libertarian paternalist might select among the possible options and to assess how much choice to offer.”

Cognitive psychology studies how people perceive, remember, think, speak, and solve problems. The discoveries made since its founding in the 1970s have shaped how psychologists and economists perceive the science behind cognitive processes in financial decisions. We agree with Thaler and Sunstein that people’s preferences are often unclear or ill-informed when they are set in the midst of ambiguity and created by life experiences. We also agree that framing and other cognitive distortions will influence the decisions made to a greater extent in the midst of ambiguity and emotion. The part that deserves more attention, in our minds, is Thaler and Sunstein’s belief that “libertarian paternalists should attempt to steer people’s choices in welfare-promoting directions without eliminating freedom of choice.”

How is this done while supporting and maintaining true self-determination? We wrote in our last column that we believe self-determination to be the greatest motivation behind an advisor’s decision to incorporate behavioral finance into practice. Self-determination at its simplest is the power or ability to make a decision for oneself without influence from outside forces. Libertarian paternalism attempts to maintain the freedom of choice yet advocates for advisors and policymakers to “steer” the decision-making processes of those who would be helped in the direction of decisions the advisor or policymaker believes to be welfare promoting.

Can we really support self-determination while exerting our own influence as advisors and policymakers upon others? Doesn’t that fly in the face of the goal for self-determination if we believe that the absence of outside influence is necessary for true self-determination?

Thaler developed a great plan he calls Save More Tomorrow. This libertarian paternalism-inspired plan allows workers to sign up today to save more of their wages in the future. In this way workers are 1) encouraged to make the right choice and save more of their future earnings and 2) allowed to make their own choice and self-determine that they believe saving a greater percentage of their incomes over time is a prudent decision.

The difference between libertarian paternalism and true self-determination is slight but clear. In the instance of the Save More Tomorrow program, self-determination is encouraged, but the array of choices offered is predetermined by the advisor or policymaker. The only options are to Save More Tomorrow or not. Most people will realize the value of savings and choose this option, which the policymaker also believes to be in the individual’s best interest. When they are asked to part with future dollars not yet in their possession instead of current dollars they may have already allocated elsewhere, mental accounting will kick in and tell them to make the choice the policymaker suggests would be best, and they will choose to Save More Tomorrow. In this way it encourages people to make the right choice without imposing it upon them. This and many of Thaler’s other libertarian paternalism-inspired endeavors beg the question of where is the line between self-determination and choice architecture.

Each individual practitioner will ultimately make many choices over time as to how to encourage clients to choose the “best” avenue for their financial decision-making. If too much focus is given to the strategies, solutions, and implementation while ignoring the client needs, wants, and wishes, we risk the relevance of the advisory process and its ability to reflect the client’s unique circumstances.

We believe the choice architecture of financial decision-making must be built with self-determination as its main motivation. We also believe people can and should be encouraged to make better decisions with their money. Businesses have been using the nudge for years seeking to drive a wedge between people and their self-control in order to persuade them to purchase something or to spend on credit. So, without discussing the political ramifications of such policy intervention, we totally support the nudges behind libertarian paternalism and encourage the use of choice architecture in facilitating economically rational and informed financial decisions for clients. It does not destroy self-determination; it simply redefines the process.

We will continue our Applied Behavioral Finance series next month with a look at common professional biases such as confirmatory bias, attribution error, and availability, which can come into play when an advisor chooses to be the architect of a client’s financial decision-making.

Citation: Thaler, Richard H., and Cass R. Sunstein 2003. “Libertarian Paternalism .”American Economic Review, 93(2): 175-179.

Justin A. Reckers, CFP, CDFA, AIF is director of financial planning at Pacific Wealth Management www.pacwealth.com and managing director of Pacific Divorce Management, LLC www.pacdivorce.com, in San Diego.

Robert A. Simon, Ph.D. www.dr-simon.com is a forensic psychologist, trial consultant, expert witness, and alternative dispute resolution specialist based in Del Mar, Calif.

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