Richard Thaler is one of the most important economists of our era. His work on behavioral economics reshaped economics and had far reaching implications for public policy which earned him the Nobel Prize in Economics last week.
Economists traditionally assumed that each person made totally rational choices in pursuit of their own self-interests like so many little “econs”. Building on these assumptions economists then constructed elaborate theoretical and mathematical models to explain how markets work to efficiently allocate resources and set prices.
These models are highly useful, but an underlying premise that we all make informed choices was wrong. Nevertheless, traditional economists loved their models and were stubbornly reluctant to give them up. So, when Thaler started upsetting their apple carts by pointing out systematic individual irrational decision making, initial reaction was less than enthusiastic. For instance, Gene Fama, another Nobel Prize winner and giant in the field, once said of Thaler: “His work is interesting, but there’s nothing there.” Early on in his career Thaler’s friends feared that while he was undeniably brilliant, he might never get tenure because his theories were not considered economics. It was in fact an uphill battle to have his ideas accepted.
In fact, Thaler along with his colleagues Amos Tversky and Daniel Kahneman demonstrated that individuals consistently make illogical choices that sabotage their economic interests while simultaneously believing that they are totally rational. Kahneman won the Noble Prize for his work in 2002, and Tversky surely would have shared it with him had he not died at a very early age.
By the way, it’s not just the great unwashed masses. Even highly evolved individuals like you and I are prone to many logical errors. We are not nearly as rational as we like to think we are. There are at least a dozen ways our brains are hard wired to short circuit.
Recognizing our mental foibles is interesting and potentially useful in helping us to make better decisions. But, perhaps Thaler’s greatest leap forward was using this knowledge to shape public policy to promote better outcomes in a variety of settings.
One great example of how Thaler’s work is changing the world is his paper with Shlomo Benartzi, “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving”. That paper revolutionized leading edge pension design.
In recognition of their great ideas, just a few years ago the Department of Labor announced support for automatic enrollment, automatic deferrals, automatic escalation of employee contributions, and safe harbor for a Qualified Default Investment Alternative (QDIA). These measures when adopted by plans have been a huge success. MarketWatch just estimated it increased employee savings in plans that adopted it by $29.6 billion! To illustrate how it works let’s look at two 401(k) plans.
– Company A informs new employees that the company maintains a plan and that down the road they can enroll.
– Company B informs new employees that they will be enrolled in the company plan, that they will contribute an initial percentage of their salary, that this contribution will increase each year by half of their salary increases, and that if they make no further choices they will be assigned to a target date fund that is designed to automatically control asset allocation along the way towards their assumed retirement date. The employee can always opt out of any of these provisions, but few do.
As you can imagine, participation in Company A’s pension plan is dismal. Few employees can look forward to a decent retirement. Inertia takes over, few employees know how much they need to contribute to have a decent retirement, few have any idea how to adjust their asset allocation to meet their time horizon, objectives, or risk tolerance. Few employees will engage with the 401(k) and make all the decisions necessary for their future. The whole project gets pushed to the bottom of their pile and forgotten.
On Company B’s plan, all that is necessary for the employee to have a decent outcome is that he do nothing. If the employee doesn’t opt out, basic decisions in his/her best interest are designed into the plan defaults, and down the road he/she will have a sizeable retirement nest egg. In practice, very few employees opt out, and their path of least resistance leads to a good outcome. In plans adopting the Save More Tomorrow (SMART) design philosophy, employee participation and deferral rates soar. If you told the average new employee that he would be contributing 15% of his pay to a retirement plan, he would immediately drop out. But, because it’s easier psychologically for him/her to commit to save a little more next year, he is happy to have his contributions accelerate. And the best predictor of success as measured by adequate savings for retirement in 401(k)s is employee deferral rates.
Investment Advisors and plan sponsors have grappled for years with the problem of employee engagement in retirement plans. We know that they will spend far more time researching a wide screen TV than planning their retirement. But, SMART plan design defaults rig the process in favor of the employee so that they are guided or nudged gently to the right choices.
It’s important to note that employee choice is never restricted. They can always opt out of any design feature. But by gently nudging them in the right direction success rates dramatically improve.
This approach works and is being implemented across a wide variety of social issues from organ donation to health care choices. But framing program defaults to encourage good choices, outcomes improve.
To learn more about behavioral economics and public policy implications read Misbehaving: The Making of Behavioral Economics by Richard Thaler, and Nudge: Improving Decisions About Health, Wealth and Happiness, by Thaler and Sunstein. Both are fascinating reading for laymen that never even thought about economics, psychology or decision making. Best of all, there’s no math or formulas.
Thaler is not just another pointy-head academic. In the real world, he’s making a difference.