It’s no secret that saving money for retirement is difficult.
Personal savings rates have plunged in the past several decades to reach negative levels in recent years. Similarly, according to Employee Benefit Research Institute, the average 401(k) balance was a mere $57,000 in recent years. Clearly, something is not working with current retirement savings practices.
There are four key psychological principles that contribute to the retirement savings dilemma.
- Self-Discipline: Saving money requires self-discipline to forsake immediate pleasure for the promise of a future benefit. Many people lack this will-power.
- Procrastination: Saving money is easier to accept if restrictions on spending are put-off to a future year. Unfortunately, that future frequently gets put-off indefinitely.
- Misperception: Money saved is perceived as a loss even though it is building an asset because there was no instant gratification from spending.
- Nominal vs. Real Delusion: A pay increase, even if it’s less than the rate of inflation, is viewed as a gain. People value nominal increases in spending more than real but can’t understand why nothing is left for savings.
To solve these problems and develop an alternative savings strategy designed to work with people’s inherent psychological limitations, economists Richard H. Thaler from University of Chicago and Shlomo Benartzi at U.C.L.A developed an innovative solution called “Save More Tomorrow.”
Workers participate by allocating a portion of each future pay raise to future savings. They are allowed to spend some of the money with the rest going automatically to 401(k) savings.
The key to this strategy working is that it happens automatically. Previous studies (Madrian and Shea (1999)) demonstrate how automatic enrollment plans were highly effective in increasing retirement plan participation by automatically enrolling employees as soon as they were eligible. Unlike the typical 401(k) where the default is to not join, automatic enrollment plan’s default is to join. This small change made all the difference in helping employees afford to retire.
The “Save More Tomorrow” strategy simply takes the automatic enrollment concept one step further by automatically increasing 401(k) contributions with each pay raise. The employee doesn’t have to do anything except choose to participate. The employee never sees the money and never has to make a decision to save it. They don’t feel any sense of loss or deprivation because people don’t miss what they never had.
For example, assume a worker in his mid-30s earned the median household income of $49,777 and dedicated two-thirds of each annual 3% pay raise to his 401(k), earning an average annual return of 8%. Amazingly, by the time he reached age 65, he would have nearly $1.5 million put away. Not only that, he still would have enjoyed one-third of each annual pay raise in current spending.
There are two important principles that make this retirement savings strategy so effective. The first is the automatic saving of the money. By making participation automatic, it takes advantage of people’s natural inertia in making decisions.
The second important principle at work in this strategy is to control lifestyle costs. The mistake most people make is to increase lifestyle as income grows. If you want to build wealth you must control lifestyle and defer your income growth to savings. Automatically allocating pay increases helps to automatically control lifestyle increases as well.
In summary, the key to building a secure retirement nest-egg is to overcome the inherent obstacles that stand between you and your goal. You have natural human tendencies that limit your ability to save money. Automatic savings programs are effective because they overcome these tendencies by putting money away before you ever see it, thus eliminating any sense of loss and eliminating any requirement for discipline.
This provides a simple solution to help you grow retirement savings – automatically.
Guest contributor Christa Blair is a staff writer for http://FinancialMentor.Com – a firm specializing in money coaching and advanced personal finance education.