Elizabeth Dunn and Michael Norton are co-authors of “Happy Money: The Science of Smarter Spending” (Simon and Schuster) and professors at the University of British Columbia and Harvard Business School... Read More →
Thanks to advances in medical technology and a thriving society, Americans can now look forward to living much longer than ever before. In the early 1900s, average U.S. life expectancy was around 45-50 years; today, Americans who are alive at age 65 can expect to live, on average, another twenty years. 1
These numbers should make us all very happy, yet they also present some challenges. In addition to living longer, Americans have been retiring earlier than before. The average retirement age has dropped from 68 in 1950 to 62 in 2000. As a result, many Americans are now spending more than a quarter of their lives in retirement, and their retirement income is often insufficient to get them through these “extra” years. 2
Retirement planning is no easy task. It is difficult to know exactly how much we should be saving for retirement and how we should allocate our current investments to ensure we will be financially safe in the future. Despite the wide availability of retirement planning advice and information, most people have trouble thinking through these issues. In addition to these financial knowledge barriers, there are also psychological barriers that stand in the way of being prepared for those extra years. The most critical one is our inability to plan for the distant, long-term future. Research from both the fields of psychology and economics suggests that people care more about present outcomes than they do about future ones, a tendency called temporal discounting. 3
There are two main factors that contribute to this tendency. First, present rewards trigger stronger emotional reactions than do future ones. This tendency was powerfully illustrated in a series of experiments conducted with children. 4 Researchers wanted to know what might motivate children to wait patiently for a potential reward—namely, a marshmallow sitting on a table in front of them. Children who were asked to think about the informative properties of the reward—namely, the marshmallow’s color or shape—were more likely to wait for it than were children who were asked to think about potentially arousing properties of the marshmallow, such as its taste. Second, we mispredict how we might feel in the future if certain events were to transpire. 5 Specifically, we tend to overestimate how good a positive outcome, such as winning the lottery, will make us feel, and also overestimate how bad a negative outcome, such as not being promoted, will make us feel. These tendencies make it difficult for us to make good decisions about the distant future.
Despite significant psychological barriers to saving for the future, related work gives us important insights on how to combat these problems. Two lines of research have identified interventions that are particularly compelling.The first one involves changing the default for retirement plans, such that employees are automatically enrolled and must actively opt out if they so choose (as opposed to the typical plan, where employees must opt in to join a plan). This subtle intervention is effective because it involves no effort on employees’ part to join the plan. Thanks to this intervention, many organizations have witnessed large increases in the rate of participation of their employees in retirement plans. In 2004, Benartzi and Shlomo took this intervention a step forward by releasing a program called SMarT (Save More Tomorrow). Under this plan, employees’ contributions to their 401(k) plan increase automatically every year, in accordance with their salary increases. As a result, employees’ savings go up without affecting their take-home pay. The first organization that adopted this new program saw a dramatic increase in savings for employees who participated: from 3.5 to 13.6 percent over four years. Over 50 percent of the retirement plans in the United States now use automatic escalation, and annual retirement savings increased by $7.4 billion during this time. 6
This first intervention is in the hands of our employers, but a second intervention is under our control. It consists of trying to imagine your future self. Recent research demonstrated the benefits of this simple intervention by asking two groups of students to interact with realistic computer renderings of themselves. One group only saw images of themselves at their current age. The other group saw some additional images: age-morphed versions of how they might look by the time they retire. All participants were then asked how much they would save for retirement. Those who saw a picture of their older selves indicated they would save twice as much as those who saw a picture of their current selves. These findings are already affecting employees’ long-term financial planning. 7 The expectation is that employees’ savings decisions will be influenced by this glimpse of their future selves. Even if such software is not available to you, picturing your ‘future you’ seems to be a good first step to assure our decisions are not too present focused.