In sixth grade, I’d take my allowance to Phil’s Pizza, exchange the bills for quarters, and feed a week’s worth of funds into the Pac-Man machine. Within 15 minutes, I was broke. To behavioral economists, I was a case study in poor self-control. I preferred to think of myself as a hyperbolic discounter. (More on that later.)
Whatever I was, I was demonstrating the kind of behavior that can undermine the savings programs of middle-schoolers and middle-age workers alike.
As Vanguard celebrated National Savings Week from February 25 to March 2, I reviewed some of the academic research about saving. I found valuable insight into why saving can be a challenge and what we can do to improve our chances of paying for ambitious goals such as a child’s education or our financial security in retirement.
Consuming, saving, and the life-cycle hypothesis
The basis for most academic discussion about saving and consumption is the life-cycle hypothesis, which was developed in the 1950s by Nobel laureate Franco Modigliani and Richard Brumberg.
When we’re young and income is low, we consume more than we earn by borrowing to pay for things like education. When income rises during our working years, we consume less than we earn and save the difference. In retirement, we spend our savings, again consuming more than we earn. At each stage of life, we have the same level of consumption. This level is based on our forecast of our lifetime earnings.
From theory to reality
The model is consistent with the way most of us think about consuming and saving. But from the purely subjective perspective of a onetime Pac-Man fiend, one assumption strains credulity: that we’re able to forecast our lifetime earnings and figure out an appropriate lifetime consumption level.
Behavioral economists such as George Lowenstein, Richard Thaler, and David Laibson have found that we’re not in fact very good at making and acting on these forecasts. We struggle with self-control. More mathematically, we’re hyperbolic discounters. That felicitous phrase means that we place an unduly high value on consumption today and an unduly low value on consumption in the future, short-changing our older selves and those who may depend on us.
This research has led to innovations to combat these biases. Until recently, employees had to make active decisions to sign up for their workplace retirement plans and increase their level of savings. Many did, but too many didn’t. Their present selves hesitated to share resources with their future selves. Now some plans automatically enroll employees and then increase their level of savings each year until they reach a target savings rate.
People can “opt out” of the plans and the savings increases, but they tend not to. (How America Saves 2012, published by the Vanguard Center for Retirement Research, includes information about the use of autoenrollment in Vanguard-administered plans.)
We can use similar “pre-commitment” devices outside of a retirement plan. I can pre-commit to save by signing up for an automatic investment program that deducts money from my paycheck or checking account. The money is gone before it becomes the subject of heated negotiation between my hyperbolically discounting current self and my future self.
In fact, I can’t think of a better way to celebrate National Savings Week. Oh, you missed this year’s festivities? Don’t despair. Vanguard offers a number of ways to help you celebrate National Savings Week all year long.
Note: All investing is subject to risk, including possible loss of principal.