Think back to when you were just starting out in your career. You weren't making much money and you were just scraping by – you may have had student loans and/or credit card debt, you might have had a roommate to cut costs and having a car was merely a pipe dream.
Do you remember thinking something along the lines of "If I only earned an extra $10,000 a year I could actually start saving and get ahead?"
Eventually you made that extra $10,000, but somehow, getting ahead remained elusive. There always seemed to be something claiming that extra income: a car, a bigger apartment, dinners out with your friends.
When your income increased further you bought a home, a nicer car, etc. And that was all before the bottomless pit of spending – kids. In the blink of an eye you're in the back half of your earning years, and you're way behind on saving for retirement.
But what if someone had offered a program back in your 20s whereby half of all your future pay raises were automatically put away into long-term savings. You didn't have to think about it, you didn't have to do anything to make sure the money was saved and best of all, you never had to experience the pain of having to reduce your spending in order to start saving.
This was the thinking behind a program called Save More Tomorrow, that was borne out of research done by University of Chicago behavioural economists Richard Thaler and Shlomo Benartzi during the 1990s. The program invited participants in U.S. employer-sponsored pension plans, called 401(k)s, to commit themselves, in advance, to contribution increases that coincided with pay raises. By synchronizing pay raises and savings increases, participants would save more each year, but never feel the pain of their take-home pay going down.
Save More Tomorrow was developed to help combat the cognitive biases – or mental traps – that tend to create a gap between what people know they should do and what they actually do. Researchers have lots of technical names for these biases but two are particularly important to saving money:
1. Inertia – people's tendency to persist in habitual behaviours, even if they're known to have adverse consequences. For example, people know they should save money – or quit smoking, or go on a diet etc., – but they don't follow through.
2. Loss aversion – people's tendency to prefer avoiding losses to acquiring equivalent gains. For example, people hate seeing their paycheques go down, particularly if they won't feel the benefit until far in the future.
Save More Tomorrow combats these biases by:
1. Making the desired behaviours automatic – automatically taking a portion of future pay raises removes the need to change one's habits;
2. Reducing the perceived sacrifice of doing what's right – it takes savings from money you aren't yet accustomed to spending.
Efforts like this to counteract cognitive biases have become known as "nudges," and they've been proven to have a powerful impact. When Save More Tomorrow was implemented at a mid-sized U.S. manufacturing firm, 78 per cent of people who said they couldn't afford to start saving immediately joined the program. Better still, most of them were still in the program three years – and four pay increases – later.
We all have many opportunities to make small decisions today that will contribute to our financial well-being in the future. However, because each individual opportunity is small, and we suffer from inertia, we typically don't bother to make the necessary changes.
The financial services industry could help people save more – and have more assets to manage – if it redesigned processes to make it easier for people act on these opportunities.
How much more would you save if:
- “Save the change” round-up programs – in which purchases are debited up to the nearest dollar and the change is deposited into savings – most banks offer on their chequing accounts was a default feature that you had to opt out of, rather than one you have to decide to join?
- What if these savings could be automatically put into an RRSP to yield a tax refund, which was automatically rolled into long-term savings?
- When you were nearing repayment of a loan, the bank suggested you automatically roll over the payment amount into savings?
Next time you're talking to a banker or financial adviser, ask them why their organization isn't doing these things to help you save.
Amelia Young is the founder of Upside Consulting Group Inc.