An Ounce of Prevention

“I never think of the future. It comes soon enough.” – Albert Einstein Retirees are questioning the sustainability of Social Security, rising healthcare costs, and freezing of private pension plans. Despite a heightened sense of urgency, savings rates have only mildly improved and most Americans remain unprepared for retirement. The chart below shows the decline in personal savings rates since 1947. From 1947 until 1975 personal savings increased, peaking at 15% in June of 1975. Thereafter the rate declined, reaching a low of 2.5% in 2005. The rate has since increased back to 5.2%. Moreover, savings rates seem to be more correlated with interest rates. Higher interest rates don’t appear to be coming quick enough for our future retirees.

The savings rate is a problem of inertia in habits, rather than a decision to not save. We are dissociated from our future selves and thus, the reward of safety in retirement is too intangible to be realized by most. This dissociation is known as the intertemporal choice: the choice made today affecting what option becomes available in the future. Examples of these choices include (and are not limited to) who to marry, how much schooling to obtain, whether to have children, how much to save for retirement, how to invest, or which house to buy. Essentially, all big life decisions (non-technical term) are intertemporal choices (technical term). The “here and now” is more important to us than the “then and later”. Theoretically, we know a dollar today is worth more than a dollar in the future. This is due to compounding interest and the time value of money. However, in practical terms, a dollar is only worth more today if we let it be.

Currently, the average American plans to work until they are 66. The average retirement age stands at 62. This means by the time a person reaches the age of 44, he is halfway to retirement. If this person continually says “I’ll start saving later”, he would be making a massive financial mistake. Procrastination can be very costly:

If a person saves $100 per month and earns a conservative 5% for 30 years, she will have saved $83,225. If that same person decides to delay and only saves for 20 years, she will only have saved $41,103 by comparison. Just by starting to save something as small as $100 per month at age 40 versus age 30 can cost over $40,000! Compounding money over a long period of time has a huge advantage. The lesson here is: save early, save often.

Even knowing this, we still don’t save and we are not alone when it comes to spending. We are a nation of spenders and boy do we have excuses to continue spending! Consumption expenditures in the US continue to rise, with a long term average annualized growth rate of 6.6%. With long term average annualized inflation at 3.3%, consumption continues to grow 3.3% on a real basis.  Total US personal savings stand at $705.4 billion, while consumption is 17x that at $12.39 trillion! (Note: consumption numbers include foreign spending in the US, while personal savings numbers represent US households, not exactly an apples to apples comparison). For most, the problem isn’t lack of money, it is misspending. It is filling our homes and closets with things we don’t need. It is renting storage space for those things when we need to make room for more things. It is not discipline we need, but an overall change in lifestyle and behavior towards our finances.

Research has shown people are most likely to save when their employers save for them. In a 2007 study done at the University of Chicago, it was discovered that even when very beneficial retirement plans are offered at companies, employees do not join. For example, a common 401k plan employers offer is to match 50% of employees’ contributions up to a threshold of salary, such as 5%. In this instance, many employees did not put in the minimum to receive the match and many did not even join the program at all. Taking advantage of this match should be a no-brainer for all households, except the most impatient and/or liquidity strained. Yet enrollment rates are far from 100%. A more extreme example comes from the UK, where some pension plans do not require any contributions from employees at all. The plans only require employees to  take action by signing paperwork to join the plan. Thaler and Benartzi’s data on 25 such plans revealed that only 51% of the eligible employees signed up for a plan that was literally giving out free money! It seems employees are much more likely to be compliant with savings with they are automatically enrolled in programs. Under automatic enrollment, very few employees drop out of plans suggesting the savings problem may be more closely linked to inertia rather than an unwillingness to save.

Queue the Cue

What is it about human nature that compels us to make decidedly wrong choices for ourselves in spite of all the evidence showing us the way? We determine what we want to achieve and the value of achieving it. Then, we look at our options and decide which will best suit us.

Each habit starts with a cue, involves a behavior and ends with a reward. Here are some cues that will end with a reward. The behavior, of course, is saving! Here are 10 cues to help you save in 2016:

1. Use inertia to your advantage – If you don’t like to save or you don’t like the act of putting money aside, the 21^st century has you covered. Set up an automatic online bank transfer that pulls money out of your account and puts it into a savings account. If you’re worried about taking money back after you’ve saved it, you will need to take extra steps to open up a second account you don’t access and don’t have linked to your main account. Have a one way ticket out and no ticket back. The easiest place to start saving is to automatically divert a portion of your paycheck directly to savings. You can also automatically invest money you may be enticed to use in a low duration bond fund or something else with less than immediate liquidity (depending on your risk tolerance, of course). If you don’t want to do any of these yourself, work with an adviser to help set up automatic savings transfers. Your adviser can also act as a human barrier to withdrawals.
2. Prioritize your goals – If you feel overwhelmed by the sheer number of things for which you need to save money, it helps to rank your goals. Then, knock them out one by one. For instance, if you plan to max out your 401k or other retirement plan, make sure you calculate how much per paycheck you will need to put away to make that goal happen. Example: you make $200,000 pretax per year and can contribute up to $18,000 to your 401k or 9% of your salary. Plan to divert 9% of every paycheck to your retirement plan. If you’d also like to take a vacation to Aruba, similarly break down the approximate cost of the trip into smaller “payments” that are siphoned off for specific use. If you have high interest loans, these should be your highest priority. Retiring these loans first will save you the cost of interest, possibly even a higher return than you could earn in the market, depending on the rate.
3. Connect with your future self – Imagine what you will be doing in 15, 20, or even 40 years from today. How will you look or feel? How do you want to feel? What would you like to be doing? Planning for the inevitable (aging) is the first step to connecting with your future self, even if you can’t imagine what that world will be like. You may not see it now, but one day you will be older and more fragile than you are today. Empathize with the needs of your future self to ensure you provide for your future needs. You likely don’t need that 5^th pair of shoes this year or you can spend some time cooking a homemade meal instead of going out or ordering in each night. It’s important to sacrifice a little now to make sure you can pay for the things you will need later.
4. Use visual cues – A study done at the Center for Retirement Research at Boston College found people were more successful at saving when they were sent visual reminders of their savings goals. For instance, you can leave a picture of your children or dream home near the computer where you do your online banking or in a place you look at each morning. You are more likely to exhibit patience if you’re able to visually connect with your future retirement goals.
5. Ignore your raise or bonus – It’s good to celebrate your victory, but it may be best to do so in a nonmonetary way. Celebrations often lead to spending most or all of a bonus or raise. Additionally, windfalls generally create “abundance shock”, providing a misleading sense of freedom and plenty. The simplest way to ensure savings is to immediately direct the new money into savings. Set your retirement plan contributions to bump up the week you get your raise. Use your bonus to immediately pay off debts, contribute to savings or invest. If you are quick to put extra cash into savings, you’ll be just as quick to forget to spend it.
6. Cue the carrot or the stick (or both!) – A great way to help meet goals is to share them with friends or family. Have a (non-monetary) reward or punishment for not meeting your savings goal and be held accountable to it. Making a commitment with outside forces influencing behavior is one of the best ways to meet goals.
7. Keep spending under control – You can do all the saving in the world, but it will amount to anything if it is eventually spent, thereby undoing your budget. Studies show people are more likely to overspend on last-minute purchases in part due to defensive shopping. This is because shoppers are more focused on avoiding disappointment, rather than finding the best value. Ways to avoid this are: do your research before you shop. Always have a shopping list. If you find an item that is not on your list, give yourself some time to decide if you really need it. A trick I use is to either put the item on my Amazon wish list or to save it in my shopping cart for later (you should see how many items I have there!). I also play a game to see how little money I can spend in a week. I always find it rewarding, because the remainder of what I don’t spend gets transferred to my savings account. For instance, if my goal is to spend $700 or less per week ($100 per day), if I only spend $550, the remaining $150 gets transferred to my savings account.
8. Measure the price of items with a unit of measurement that makes sense for you – for example, is this $150 shirt worth the price of 15 sandwiches? How many hours of work (after-tax) will it cost me to pay for this new pair of shoes? Or if you’re retired use the percentage of your monthly (after-tax) income as a reference point. Additionally, it helps to think of monthly subscription prices in terms of their annual cost. $100 per month may not seem like a lot to you, but is that same product worth $1200 per year?
9. Feel guilty – Check your credit card and bank statement every month. People who want to save but can’t generally do not check their statements to avoid feeling badly. It’s important to feel guilty about this because “wants” and “needs” now make it much more difficult to pay for true needs later (like retirement expenses and long term care). Download your annual expenses from Amazon. Small items add up! Nothing seems egregious until it’s added together.
10. Revel in your successes, especially the small ones – celebrate when you save! Studies have shown when someone experiences a “small win” he is much more likely to change other unrelated behaviors. For instance, people who start going to the gym once per week are much more likely to stick to their new exercise regimes. Thereafter, changes in nutrition, concentration, and other habits fall into place, making it much easier to maintain the new lifestyle. By saving something as low as $10 per week, you could revel in your small win and benefit from your habit change. Don’t celebrate by spending what you save, but by recognizing your achievement and feeling good about yourself. You may even notice other small changes in your lifestyle that propel you into being the best version of yourself.

I wish everyone the happiest and healthiest holiday and New Year. January’s memo will recap 2015 and speak to our positioning and thoughts for the New Year. If you have any questions or comments, please feel free to reach out.  See you in 2016!

Sources:

Benartzi and Thaler. Journal of Economic Perspectives 2007, “Heuristics and Biases in Retirement Savings Behavior”

Benartzi and Thaler. ScienceMag Policy Forum 2013, “Behavioral Economics and the Retirement Savings Crisis”

Lusardi, Skinner and Venti. Risks and Rewards Newsletter 2013, “Pension Accounting and Personal Saving”

Benartzi and Thaler. Journal of Political Economy 2004, “Save More Tomorrow™: Using Behavioral Economics to Increase Employee Saving”

McKinsey and Company. 2009 “Restoring Americans’ Retirement Security, a Shared Responsibility”

Duhigg, Charles. 2012, “The Power of Habit: Why We Do What We Do”

Net National Savings Rates: http://data.worldbank.org/indicator/NY.ADJ.NNAT.GN.ZS

FRED Economic Data (St Louis Federal Reserve) for personal savings and spending rates

Disclosures

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