Response to the Freakonomic episode “People Aren’t
Dumb. The World is Hard.”
I recently listened to the above interview on Freakonomics
of Richard Thaler. Thaler is one of the
people who helped develop the concept on Behavioral Economics.
Thaler is a genius and is a very entertaining
interview. In general I am sympathetic
to the concepts of behavioral economics pointing out that human behavior cannot
simply be described by utility maximization.
I do want to comment a little on something in particular
that Richard Thaler said when asked what has… “been the greatest kind of specific
contribution of behavioral economics?” His answer was a little more involved
than this but Thaler basically said that the biggest policy contribution is the
practice that companies now have of pre-enrolling employee’s into 401K plans
and that they have to opt out of the program if they don’t want to save their
money in the tax deferred retirement savings plan which includes additional pay
from the employer typically. In the past,
before the Thaler “nudge” policy was widely adopted, the common practice was
for employees to have to choose / opt into the program. The result of this change in practice has
been to significantly increase participation in these programs.
Thaler’s assessment of all this is “We are also not trying to tell them to do what
we think is smart. We’re trying to help people do what they want to do.”
I disagree with this
assessment and would analyze the situation in the following way.
Point 1:
When a choice is extremely complicated and almost impossible
to know what the best choice is, it makes sense to do nothing.
Point 2:
The 401K investment decision is one such choice.
The reason this is complicated is it is impossible to know
if putting your money into a 401K is a good idea. Any number of the following things could
happen.
- The economy may roll along for the next 20 to 70
years much as it has in the past and the employee could have a very nice nest
egg to help them with their retirement.
- 20 to 70 years from now when the employee starts
to draw on his or her 401k the government could raise the tax rate and the
employee could end up paying more in taxes in the future than the taxes they
are avoiding now. The great deficits the
government is running will need to be dealt with some day and higher taxes may
be part of the solution.
- The employee might die before they have a chance
to draw on the funds.
- The investment companies may fail either because
of unethical practices or bad decisions and lose much of the money invested.
- The economy might collapse in the next 20 to 70
years and most of the investments might be lost.
- War, nuclear or otherwise, could break out in
the next 20 to 70 years and wipe out the factories and infrastructure
underlying the investments, ruining their value.
- Runaway inflation might occur in the next 20 to
70 years undermining the value of the investments.
I and many smart people may think that the first bullet
point above is the outcome we should expect but it is impossible for any human
to know what will happen
In this decision, with the time horizon under consideration,
I would argue that the world is not just complex and hard, it is impossible to
predict.
In instances like this when the choice is not clear the only
way to come to a decision is to base it on your values. If you have learned / acquired the “value”
of saving for the future, you are likely to opt into your 401K to support that
value. If you have the value of focusing
on the now in preference to the future you are likely to opt out. However,
if you have not developed strong values in this space you are likely to do
nothing because it is impossible to assess the best decision in this
complicated scenario.
Point 3:
I feel the nudge is essentially unethical as by default it
is having the employee buy a service that unless they value the service it is
almost impossible for them to know if the service will be good for them or bad
for them. The service they are buying is
the management of their investments for which they pay a fee. This is the equivalent of saying, we believe
people should have more fruit in their diet and so we are going to
automatically sign them up for buying fruit out of their paycheck twice a
week. They can opt out if they
want. The only difference is it is very
hard to figure out what the costs of the 401K plan (service fees) but it is
easy to figure out the costs of the fruit deal.
By defaulting people into this program in a situation where
a normal person would have the propensity to do nothing because it is impossible
to know what to do based on the information available and it is very difficult
to understand what fee the individual is paying for the service you all but
guarantee that people just take the service unless they have a strong personal
value to not use that service.
This seems ethically questionable at best.
One thing that is certain is that the investment companies
benefit from this program because they collect more fees than they otherwise
would. And they collect these fees now,
today, in the present and for them that is unquestionably a good thing. Nothing complex or hard about that.
