Lock into Savings

The retirement debate depends on a disagreement between economists.

Listener : 23 October, 2004.

Keywords: Social Policy;

About 30 years ago economics sharpened its theory of behaviour with the assumption that everyone took economic decisions that gave them the best outcome. We might call this the “neoclassical paradigm”. It simplifies analysis enormously, and was used in policy extensively in the 1980s and 90s. In practice, the paradigm recognises that individuals don’t actually maximise, but it assumes that people are always taking actions that move them closer to the optimum, so the assumption of best outcomes is near enough to be true.

Before we sneer at the paradigm – or giggle at the economist who, failing to solve the equations that said whether you should go to university, implicitly proved that you needed a degree in mathematics to make the decision – we should not forget that the ideological underpinning is that people generally know best for themselves and we should not patronise them.

Even so, observation of individuals shows that people are much more likely to use rules of thumb when making complex decisions. These rules do not always give optimal outcomes, although they usually give good ones. If you are thinking about going to university, the uncertainties of what your courses will teach you, and the future financial and non-financial return they will generate, means that optimal calculations are useless and students usually make guesses. It is such considerations that led to the “behavioural paradigm” challenging the neoclassical one.

Richard Thaler, a pioneer of the behavioural paradigm and a University of Chicago professor, summarises the observed human savings behaviour in the following rules:

(1) Live within your means. Do not borrow to increase consumption except during well-defined emergencies (such as unemployment).
(2) During emergencies, cut consumption as much as possible.
(3) Keep a rainy-day account equal to some fraction of income. Do not raid the account except in emergencies.
(4) Save for retirement in ways that require little self-control.
(5) Borrow only on the security of a real asset.

Sounds plausible? Yet the last rule of thumb conflicts with the student loans scheme, which requires borrowing against an intangible asset. Neoclassical economists say impatiently that it makes sense to borrow against the additional earnings that a university degree may generate. But students know it conflicts with “the rules”, and borrow reluctantly, failing to take courses that are in their best interests. Here we have an example of how behaviour conflicts with the theory that neoclassical economists articulate.

Rule four is especially relevant to our retirement provision debate. The neoclassical theory says that people will save the right amount for their old age. Some economists have tried to demonstrate they do (often using a database that a statistician would think is wholly unreliable). The behavioural theory says they won’t, unless they lock themselves into a savings plan.

In practice we lock ourselves when we buy a house and systematically pay off the mortgage, and – sort of – when we expect the government to look after our New Zealand Superannuation. There are other locked-in arrangements, the largest of which is occupational superannuation where each payday some of the pay is diverted into a long-term savings account. Even so, very few people are in such a scheme, although a good number of retirees now wish they had been.

New Zealand First campaigned in 1996 for a compulsory occupational pension scheme that would top up the government-provided New Zealand Superannuation, and was not unlike the scheme introduced by Labour in 1975 (but repealed by Robert Muldoon in 1976). Somehow the idea got transmuted into the very different 1998 referendum scheme that would have abolished New Zealand Superannuation, albeit in an incredibly clumsy and confused way. Fortunately, we rejected it.

There is now a proposal to resurrect the 1975 Labour-NZF scheme, except it will be voluntary to participate. If implemented, workers will be able to lock themselves into a retirement savings scheme by a deduction from each pay. Rule four makes it sound eminently sensible, especially as it is voluntary. Thaler supports a similar scheme in the US.

Why will anyone join the scheme? Why not procrastinate until next payday? There is a case for joining incentives. Employers may make regular co-payments. Booster payments are allowed: why not lump-sum contributions from the family? “Son [or daughter], you join the scheme and we’ll put in $10,000.” Sweeteners are suggested. I favour deferring income tax on the deposited savings, taxing them when they are withdrawn. An absolute must for young contributors is that they can use their fund in some way for house purchase.

Neoclassical anti-Thalerians will resist such common sense. But it is wiser to inculcate the rules into your children than confine them to a neoclassical economic education.