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