Behavioral Economics & Its Role In Retirement Savings

 “One of the big lessons from behavioral economics is that we make decisions as a function of the environment that we're in.” is a quote very simply and beautifully said by Dan Ariely, Professor of Psychology and Behavioral Economics at Duke University.

Behavioral Economics is the study which is an amalgamation of the effects of psychological, cognitive, emotional, culture, and social factors on the economic decisions of individuals, group of individuals, institutions and how these decisions may vary from those implied by classical theories.

Personality characteristics as behavioral constrains play a major role in the aspect of retirement savings. Personality traits significantly affect the economic decision making in any household, or even at a bigger level, like, the entire nation. Every individual thinks differently and decides according to what is right in front of his/her own eyes; which is why, decisions are highly volatile and vary from person to person.

Personality traits are already recognized in the psychological literature and are now slowly being recognized in the economic literature as well, as it has been proven that such traits do affect economics as a whole and is a part of the behavioral economics study. Major economic decisions like asset allocation, the retirement time, the savings that will be consumed after retirement, resource allocation for the post retirement period, etc. are highly influenced by personality traits.

According to many contemporary personality psychologists, there are five basic dimensions of personality, referred as the “Big-Five” personality traits. These traits are extra-version, agreeableness, openness, conscientiousness, and neuroticism. To remember these 5 traits easily, researches have set an acronym for the same, known as “OCEAN”. Every single trait mentioned here is a connotation of two extremes, either very high or very low.

Openness, is described as a trait wherein, if somebody is extremely open, is creative, open to new ideas, adventurous, likes taking risks, and ready for challenges. When we commence to relate such a trait with its effect on retirement savings, we reach to a conclusion that anybody who is highly open is not going to be sacred about their post retirement journey. He/she tends to believe more in the present and likes going with the flow, instead of worrying about the future and letting the present suffer. However, on the other hand, if somebody is on the other extreme of this character trait, is going to be the opposite in nature. Such a person dislikes change, resists new ideas, follows the path everyone chooses, is not very imaginative and is definitely not spontaneous. Relating this with the concept of retirement savings, he/she will plan well in advance and save enough money for the future that does not lead him/her into any trouble later.

Conscientiousness, on one extreme is when a person is highly goal oriented, very thoughtful, extremely punctual, prepares well, focuses on every minute detail, and is likely to have a set schedule for everything he/she does. such people are bound to prepare well for the future by investing in fixed deposits, or an alternate asset that makes them financial secured post their retirement. Whereas, somebody on the other extreme is someone who is flexible, does not enjoy rigidity, is likely to be irresponsible, hates structuring, inhabits forgetfulness, and procrastinates important tasks. Somebody on this end is highly seen not caring about their post retirement stances and is never fully prepared about the future.

Extra-version is a personality trait that highly belongs to the social standing of any person. People who are high in extra-version are highly social, likes attention, communicative, outgoing and friendly, love meeting new people, always excited, and generally do not think before they say something. In short, they are extroverts. Such people tend to discuss about their future planning and take advises from other people in order to make a sensible decision about their post retirement phase. They like a person advising them about important decisions which enables them to inherit the best advises. On the contrary, people on the lower stand of extra-version, also known as introverts are the exact opposites. They do not like making small talks, prefer solitude, likes being by themselves most of the time, are not very outgoing, have a very small circle, do not discuss about their personal life in open, and carefully think twice before saying anything. They do not like being the center of attraction and are easily exhausted when asked to socialize. Such people often tend to make their decisions themselves and are protective towards their financial withstanding in the future. Hence, they plan accordingly and save enough which would secure them after their retirement.

Agreeableness is the personality dimension that includes attributes like trust, selflessness, affection and other pro-social behaviors. People who are highly agreeable are more cooperative than the ones who are not, are extremely helpful, think about others before themselves, are empathetic, and highly care about them. Such people are generally loved by all and are of the thought who like to secure their family’s future before their own, which makes them think about their post retirement phase and the savings to run their family thereafter. They make decisions in favor of their family and make sure that there is enough financial and social happiness for every family member even after they retire. Whereas, people low in agreeableness take little interest in others, does not care about anyone except themselves, are manipulative, and belittles others. Such people are highly selfish and only think about themselves and their own goodness. They make decisions both in the present and future that solely benefits them and makes saving decisions accordingly.

Neuroticism, last but not the least, is a trait characterized by gloominess, emotional instability, anxiety and other such negative personality characteristics. People who are eon the high extreme of this trait experience a lot of stress and anxiety, are very worrisome, are extremely emotional, gets upset easily, have dramatic mood swings, and struggles in even the smallest of situations. This makes them worry about the future even more and the anxiety kicks in very easily which makes them save extremely well in advance and makes their retirement savings a major goal during their current work life, too. However, people on the lower level of neurotic-ism are emotionally very stable, make wise decisions, deal well with stress and anxiety, are very relaxed and rarely worry about what is going to happen next. Such people do comparatively well than the former and plan greatly in favor of their retirement savings. They keep a balance in their present happiness and future joyfulness.

These 5 traits are found out to be universal and are highly influenced by biological and environmental factors.

Retirement savings is one of the behavioral economists' greatest success stories. It is a prototypical behavioral-economics problem because saving for retirement is cognitively hard - figuring out how much to save - and requires self-control. Savings is an aspect that is the most crucial for any household but is often looked over because of the opportunity costs that are involved. In order to save for the future, one needs to cut their current expenses, and hardly anybody likes to cut short their present consumption thinking about the long term future. Savings for retirement comes with great planning and determination and is proven to be a great help for people after they retire. It not only makes them financially stable in their later days but also ensures a healthy lifestyle even after no regular income. In respect to health, retirement savings again play an important role. When one saves sufficiently enough for the future, they are mentally eased out about the same. After they retire, they no longer have to worry about how their expenses will be managed and lead a happily independent life. 

In India, at present, only about 33% of the population successfully saves enough to cater their post retirement living. According to the Economic Survey of FY19, India’s gross domestic savings have fallen about 60 basis points as a share of GDP in two years to 30.5 per cent in 2017-18.

Households are saving less than they should which is also affecting the net financial savings and the economy, as a whole, is suffering due to the same. Indian households have been considered the biggest savers ever on the face of earth. But the picture has taken a toll with more Indians taking home loans and spending way more than their capacity through credit cards. Home loans have been found out to be doubled in the recent times, whereas unsecured borrowings have trebled. This has been causing major problems for people to be able to save as most of their salaries go into paying for loan EMI’s and credit card bills. This leaves them with no savings in the end and having little or no savings often leads to financial crises and increases dependency of the parents on their children.

Inflation. I would say, also plays some role in the savings rate. With high inflation on board real incomes of people do not tend to increase. When the real income does not tend to increase, the person is seen to be at the same level where he/she was, earlier. On 1st February, 2020, the budget for the financial year of 2020-2021 was presented by Ms. Nirmala Sitharaman, Minister of Finance and Corporate Affairs of India where she talked about the multiple tax slabs that will now be implemented. Individuals, though given a choice to either follow the old tax slabs or the new ones, will majorly suffer financially, especially the ones with home loans. This would further impact the savings rate among households and draw it down even more. Savings for retirement thus becomes a very complex pattern to conquer.

           Though, the government does play its role in promoting savings for retirement among every individual, whether in the private or the public sector. Schemes like National Pension Scheme, Public Provident Fund, Provident Fund, Superannuation Scheme, etc. are the initiatives taken by the government to cover each individual’s retirement savings plan, which makes it relatively easier for people to plan, spend, and save.  

This is where behavioral economics comes into picture; the psychology of a person matters the most when it is about spending or saving. If a person is of the mind set of being carefree and living life in the present, their saving rate will stoop low. This psychological vulnerability refers to our tendency to prefer immediate rewards to rewards more distant in time. Temporal discounting is explained by the fact that individuals attribute more value to a reward obtained immediately than to a greater reward obtained later.

However, a person who spends carefully and is concerned about the future is likely to save more and plan their post retirement days. People’s preference for immediate rewards declines and eventually reverses as the time horizon lengthens. They then begin learning and drafting a proper retirement plan and save accordingly, as their retirement days approach closer. The closer the days are, the tighter their planning becomes. This fear of not having enough after they leave their jobs is what pushes them to save and procrastinate about their post retirement phase.

Behavioral scientists and economists work together with governments to solve the problems affecting the pension systems and help citizens to save more for retirement. Nevertheless, more time and effort is needed to design better and more robust strategies, that would help minimize opportunity costs for individuals and prompt them future to save for their later days. A growing body of work in behavioral economics now focuses on ways in which an understanding of human psychology can help people save more for their retirement, and this segment of behavioral economics has been taking a toll for the past few years now.

Over the years, citizens of India and all around the world have understood the need for savings, especially retirement savings, and have started acting upon the same. More and more people are now taking up savings as a serious concern and are making sure that they save at least some part of their income for future purpose, by drafting a well settled plan through the various schemes available. Yet, compared to the huge population of India, there is a long way to go when every person understands the need of retirement savings and starts with this practice.