Aging Americans are facing a perfect storm when it comes to retirement. Many have done little saving over the past two decades and have now seen what they have saved, either in their 401(k) or their home equity, decline sharply in value. Once they face these facts, Americans will have to relearn the saving habit.
To figure out how, we need more than standard economic thinking, which is based on an idealized conception of behavior. Instead we need to focus on how people actually behave—a sensibility that defines the new field called "behavioral economics." Traditional economists bestow upon humans the mind of a computer and the willpower of a saint; I like to call these imaginary creatures Econs. These Econs have no difficulty saving because they rationally calculate how much wealth they need for retirement, reduce their consumption accordingly and then invest optimally. Econs never splurge or speculate. But the world is not populated by Econs—and if we understand how humans really behave, we can come up with ways to get them saving again.
It wasn't so long ago that Americans were good savers. From 1950 to the early 1980s the saving rate was a satisfactory 8 to 10 percent. But even then, Americans never showed much willpower for stashing away cash. The most important ways households saved were in pensions, cash-value life insurance, and by paying off their home mortgage. What these have in common is that the saving occurs automatically and effortlessly.
But institutional changes have made saving more difficult. Under old-fashioned pensions, employees didn't even have to sign up—much less make investment choices. The new 401(k)-style plans require both the willpower to put money away and deliberation about how to invest it. Meanwhile, financial institutions have made it easier to borrow and more difficult to stick to a budget. The old habit of "saving up" for a purchase was replaced by the credit card. Likewise, home-equity loans and easy mortgage refinancing eliminated the social norm of paying off the mortgage by retirement—once a key source of automatic savings.
In getting us back on the savings track there are two basic principles of behavioral economics to remember. First, make saving automatic. Second, put savings away in a specially designated account, such as an IRA or 401(k). These accounts, like piggy banks, help reduce the temptation to spend. Families, companies and governments can all make use of these concepts.
Workers should make sure they enroll in their company's retirement plan or arrange to have deductions from their paycheck deposited into an IRA. Also, those who take advantage of low-interest rates to refinance their mortgages should consider a shorter-term loan (15 years instead of 30), with the goal of reducing mortgage debt as much as possible before retirement.
Companies can help their employees get on the right path by good design of their 401(k) plan. Firms should make sure the plan has a solid, low-cost, diversified investment strategy that can serve as the default fund for employees who have no idea what to do. Then, employers should also automatically enroll employees, giving the employees the option to opt out. Next, give workers the option to increase their contributions automatically whenever they get a raise, a program my colleague Shlomo Benartzi and I have called Save More Tomorrow. Employees love this, and it works.
As for the federal government, many good steps have already been taken. One excellent example is the Pension Protection Act of 2006 that included a provision meant to nudge firms to incorporate desirable features into their retirement plans. Specifically, any company that includes a suitable match, automatic enrollment and a primitive form of Save More Tomorrow gets a free pass from an annoying compliance report. Going forward, the Obama administration has announced its blueprint to create a national 401(k) plan for workers whose companies do not offer such a plan, and to automatically enroll people.
Policies like these will help households navigate the complex financial world. If employers, financial-services companies, policymakers and individuals keep in mind that we are all humans, not Econs, we'll have a better chance of restoring our economy to solvency and prosperity once the current crisis ends.