Saving for retirement with your credit card (Overcoming loss aversion and temporal discounting)

Why would anybody in their right mind pay pension fund contributions in installments with his or her credit card is the question most would ask after reading the title, but if you give me a bit of “credit” I will try to explain the logic. 

Retirement saving is unfortunately plagued with behavioral biases that negatively affect various stages of retirement saving, from why we don’t start saving, to where we invest and how we draw down our savings. Renowned behavioral economists like Shlomo Benartzi, Richard Thaler and Brigitte Madrian, just to name a few, identified many biases in retirement saving more than a decade ago and among the more prevalent are also loss aversion and temporal discounting. 

Loss aversion was described nicely by Kahneman & Tversky with “losses loom larger than gains”, meaning the pain of losing is psychologically more powerful as the pleasure of gaining an equal amount so “it is better to not lose $5 than to find $5”. That is why, when we are faced with paying contributions in a pension fund, we only feel the pain of paying. To make it even worse, we get nothing back in return as the “reward” of retirement saving comes only decades later, when we retire. 

Now we come to the second bias which is temporal discounting. Research shows we value more present rewards than future ones. If the reward is very distant in the future our perceived value of it goes towards zero. If we promise someone to save for 40 years and after that you will have a $400.000 pension pot, the 40 years of temporal distance reduces the psychological value of the savings close to zero. 

So what can we do about it?

In the pension fund I work in (Pokojninska družba A, Inc.), we experimented with a surprising solution that comes in a form of a Diners Club credit card that enables payment of various goods in up to 12 installments. Most people use Diners Club cards, or any other credit cards, to purchase in installments a new sofa or a new ultra HD television, but we decided to use instalments in another way. As in most countries, the government in Slovenia also incentivizes private retirement savings with special tax incentives. If you save on your own the contributions reduce your income tax base and you get part of the contributions back the next year. For example, if you pay annually €2.000 and are in the highest tax bracket, you get refunded €1.000. Not bad, right. The catch is, you have to pay contributions until the end of December in order to lower your income tax for the current year. 

The challenge

Many people don`t pay contributions regularly during the year and would then like to pay all of them in December, which is also a month that is “heavy” on the wallet with expenses for Christmas and New Year`s. Every year I had many talks with clients, who would like to pay their annual contributions, but were running low on cash because of gifts and in the end they missed the payment and by January all was forgotten. The story repeated every year and one day, when I was thinking how we could fix this, it came to me. Why not pay pension fund contributions in several instalments with your credit card in the same way you use it to pay for a new sofa? This way you could still get the tax incentive and lower your income tax, even though you would actually pay contributions in the next year. To test if the theory could be put in practice I called up the Slovene franchise of Diners Club and after their initial surprise we came to the conclusion, that it could work. 

We decided to go for online payments only via our website where anybody can fill in a special web form to first become a member of our individual retirement plan and at the end they have a choice to select online payment of contributions with Diners Club credit card. Once selected they input the annual contribution amount and select the number of installments (limited to 12). Then they are redirected to the payment gateway where they finish the transaction in the same way as buying a new book on Amazon. The whole process takes minutes and the next working day we receive the payment of the whole annual contribution from Diners Club which goes immediately on the individual saving account and also reduces the income tax base of the member. The cost of the payment in instalments is also low and transparent at €1 per installment. 

Photo by Pixabay on Pexels.com

It works

This new payment option addresses the behavioral biases of loss aversion and temporal discounting mentioned before, as it allows people to receive the full tax incentive on the payment and by that giving them some gratification now. Secondly, the pain of paying contributions is pushed into the future and the same temporal discounting is now working for us positively to reduce the pain we feel when making pension fund contributions. There is an added positive effect of instalments which split the annual contribution into smaller amounts thus reducing the pain of paying even more. The whole service is fully digital and someone can complete the whole process with a few clicks, thus simplifying and removing behavioral burdens of retirement saving. We launched the program at the end of 2016 and so far it’s been a great story. In majority, we found people who used this option did not save before for retirement which proves it solved a real practical problem. At the end of last year more than 10 % of all annual individual contributions to our fund were made with credit cards. Increased contributions mean people will have a better retirement because of it and that’s what it’s all about.  

Further Reading & References:

  1. Thaler, Richard & Benartzi, Shlomo. (2007). Heuristics and Biases in Retirement Savings Behavior. Journal of Economic Perspectives. 21. 81-104. 10.1257/jep.21.3.81. https://www.researchgate.net/publication/4981794_Heuristics_and_Biases_in_Retirement_Savings_Behavior
  1. Brigitte Madrian (2018), LESSONS FROM BEHAVIORAL ECONOMICS FOR PROMOTING RETIREMENT INCOME SECURITY, Retirement Research Consortium Annual Conference, Washington DC, August, 2018 http://www.nber.org/2018rrc/slides1/2.5%20-%20Lunch%20Speaker%20-%20Madrian.pdf
  1. Kahneman, Daniel & Tversky, Amos. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263-291. doi:10.2307/1914185
  1. Bickel, W., Odum, A., & Madden, G. (1999). Impulsivity and cigarette smoking: Delay discounting in current, never, and ex-smokers. Psychopharmacology, 146(4),447-454.

Tax incentives for retirement saving don`t work (what does?)

Most countries, if not all, encourage saving for retirement by taxing retirement savings in private pension plans more favourably than savings in alternative vehicles. The goal is to increase how many people save for retirement and how much they save and with that enable them a better life in retirement. 

Most countries apply a variant of the “Exempt-Exempt-Taxed” (“EET”) regime to retirement savings, where both contributions and returns on investment are exempted from taxation while benefits are treated as taxable income upon withdrawal. There are also other regimes (EEE, TTE, …), but I won’t bore you with them. The main question remains, do tax incentives actually increase retirement savings and at what cost?

Do they work? Not really.

There is a growing body of literature confirming the effect of tax incentives on retirement savings is very limited and also very expensive. According to John Friedman, retirement saving incentives in the US reduced in 2016 the government revenue by $180 billion, which is just over 5 percent of the total federal tax revenue. He finds tax subsidies for retirement saving have a limited effect on how much households actually save and that an increase in savings is in most cases attributed to shifting assets from taxable accounts to retirement accounts, which does not increase the total savings rates, as incentives largely benefit wealthy households who would save anyway. 

A very vivid example of how tax incentives have a limited effect on retirement saving is my home country of Slovenia, whereas in most countries, the government incentivizes private retirement saving. If you save on your own the contributions reduce your income tax base and you get part of the contributions back the next year. For example, if you invest in a pension fund annually €2.000 and are in the highest tax bracket, you get refunded €1.000. Not bad, right and for sure lots of people take advantage of this fantastic tax incentive. Not really, as approximately only 2% of all employees in Slovenia have individual retirement plan. For sure the tax incentive is not the only one to blame for this low number, but it also clearly demonstrates that in the last 19 years, that the tax incentive exists, it convinced almost no one and the percentage of savers did not change over time. You can read more on private pension plans in Slovenia in my LinkedIN article.   

The same findings are confirmed by a large sample study from Denmark that finds tax incentives for retirement accounts, which rely upon individuals to take an action to raise savings, mainly induce individuals to shift assets from taxable to retirement accounts. They estimated that fewer than 20 percent of people respond to changes to tax incentives and that each $1 of government expenditure on incentives increases total saving by only 1 cent. On the other side they find policies that raise retirement contributions if individuals take no action – such as automatic employer contributions to retirement accounts – increase savings rates substantially. Automatic contribution policies also have lower fiscal costs, generate relatively little crowd-out, and have the largest impacts on individuals who are paying the least attention to saving for retirement.

What works?

Automatic enrolment in retirement saving is a great example of behavioral economics in action, where workers are defaulted into saving, but can always opt out. The United Kingdom is a great example of a successful implementation of automatic enrolment in retirement plans which was phased in from 2012, and now after 8 years it is still going strong with opt-out rates of only 9 percent. To date it has helped over 10 million people to start saving for retirement making it a great success. 

Some US states are also following the lead with implementations of state-sponsored retirement savings plans in which employees are automatically enrolled. Oregon’s plan called OregonSaves began in 2017, Illinois began its programme in 2018 and California started its  CalSavers programme at the end of 2018. Even better, more and more states are following their lead. Results so far from all the state plans are very encouraging and many new employees are now covered by retirement plans making a huge impact on their future life quality, showing jet again it’s not about tax incentives, but about designing smart retirement plans incorporating the latest findings from behavioral economics and with the help of modern information technology sky is the limit.   

COVID-19 lessons for retirement saving

The reasons why most people, from the average Joe, to experts and politicians, initially did not take the coronavirus COVID-19 seriously are largely the same, as the reasons why most still do not take climate change seriously, exercise regularly or save for retirement. We can look for the culprits in an intertwined web of behavioral biases that affect our behavior, from the most trivial things, like why we buy that overpriced cinnamon dolce latte at Starbucks, to the most serious, as is the pandemic we are just living in.

Let’s be honest, no one imagined back in February that we would ever experience the closure of schools and kindergartens, that all bars and restaurants would be shut down, and we would not be able to hang out with friends or relatives even in our homes. Even the most pessimistic of us did not imagine the eerie scenes of empty streets and city squares, since the threat of the coronavirus COVID-19 was far away in a Chinese city of Wuhan, which most of us had never even heard of before. This great distance in a way calmed us down and gave us psychological comfort, as we all privately thought – this is far away, with all the preventive measures the virus will for sure never reach us. We will not go on vacation to Asia for a while and everything will be OK. Then, we pushed our worries into the subconscious and went back to our daily routine. Soon it all came crashing down and on March 4, the first case of coronavirus infection was confirmed in Slovenia, my home country, and on March 16 life as we know it was shut down. Even those of us who are more optimistic began to worry, when empty shelves were waiting for us at the supermarket.

Intangible threats

Why did we not worry about the first cases of coronavirus in China, and why did we suddenly run to the shops and start accumulating toilet paper, when the virus came to our countries? The threat of the coronavirus, or any other virus, is completely intangible to us and it also does not help, if the epidemic is happening on the other side of the world. An old proverb nicely puts it, out of sight, out of mind.

The coronavirus threat was hard to imagine and we could not grasp it, both physically and mentally. Unlike some other natural disasters, for example an earthquake in a neighbouring city. We see footage of damaged buildings, many also have acquaintances or relatives there and immediately we have a stronger emotional reaction to such a natural disaster. In our minds, we can quickly picture our own house being damaged by an earthquake and questions like, what would happen to my house, would my family survive, start stirring our imagination and fears.

Gretchen Chapman and George Loewenstein, both professors at Carnegie Mellon University, point out in their recent article the challenges of intangibility in relation to keeping up preventive measures against the epidemic, such as maintaining physical distance and hand-washing “as you can’t touch, taste, feel or see the benefits of, for example, wiping off your door knob”. They also point out, the benefits of preventive measures seem intangible, because people don’t get useful feedback about the effects of their actions, as the microbes are invisible and we have no idea if we have gotten rid of them by washing our hands or disinfecting our grocery. We also get no feedback about how protective actions have changed our probability of getting infected. Even worse, If our actions work, the outcome is we don’t get sick, but that is already the state in which we were in before we took the measures. This way it seems, the preventive actions cause nothing to happen as we can’t imagine the negative outcome that might happen, if we did not exercise preventive actions in the first place [1].

Photo by Anna Shvets on Pexels.com

On the other side, Kristen Berman highlights how people react strongly to visual threats such as wildfires in San Francisco, where most residents immediately put on protective masks when they see smoke in the air, even though there are other threats besides low air quality, that threaten their long term health much more, or as she puts it “Based on the reaction of Bay Area residents to smoke-filled air, compared to all other risks they face, an alien may logically conclude air quality is a threat we should prioritize above all others” [2]. Unfortunately, the coronavirus is not accompanied by smoke or other visual cues, which makes it more difficult to imagine and the threat is therefore much easily underestimated. The same goes for retirement saving, as workers get no visual or any other warnings, that they have insufficient retirement savings. Also the ones who are saving get in most cases no tangible feedback about their savings and how they will improve their future life quality once retired.

Intangible and distant

In addition to intangibility, our response to the coronavirus was also diminished by myopia or short-sightedness, which is our tendency to focus only on the current state. Myopia is well known in finance as it together with loss aversion makes investors view their investments only short-term. This means that in market down-turns, like we have just experienced, most investors react too strongly to losses and forget about the long-term potential of their investments [3]. This is known as myopic loss aversion.      

Thus, despite the warnings at the beginning of February, we could not imagine the coronavirus would really spread to our countries, since at that time everyone was focused on their current affairs. We face similar challenges with regards to keeping up preventive measures against the spread of the coronavirus, as unlike wearing face masks in the case of forest fires, where the face mask offers immediate relief, as we breath less ashes and other harmful substances [2], we get none of that immediate relief in the case of wearing a face mask in a coronavirus epidemic. Remember the first weeks of the epidemic, when we all adhered to the preventive measures, the number of infected still increased daily and we did not receive any positive feedback. This made it all the more difficult to keep up with the measures and this will present an even bigger challenge for the future, when the epidemic will calm down, but protective measures will still be needed. 

It is similar to eating healthy or exercising regularly, we will not feel any better tomorrow, but the positive effects on our health will come only after years. Similar is with saving for retirement, where we set aside a certain amount of money on a monthly basis, only to receive an additional pension after 30 or 40 years. It is completely different when buying a new car or a house, where in exchange for a monthly instalment of credit, we can drive our dream car out of the salon today. Therefore, it is not necessary to say twice, the majority chooses to buy a new car, instead of saving for retirement.

Optimism bias

Going back to the coronavirus and our ignorance of the possibility of it spreading to our home countries, optimism bias also played a role. It is considered to be one of the most prevalent and robust cognitive biases as research found people of all nationality, age, gender and race, attribute to future positive events a much greater likelihood of realization than negative ones [4]. For the most part, we ignore historical evidence and statistics, because a car accident or Alzheimer’s will for sure never happen to us and public pensions will be enough for a decent living in retirement.

One of the world’s leading neuroscientists, Tali Sharot, interprets optimism bias as a cognitive illusion that humans live with, though without realising its impact on our behaviour. Since humans possess, as one of the few species, a unique ability of conscious foresight (mental time travel), this also means we are aware that somewhere in the future bad things, like death and illnesses, await us. Without developing positive biases during our evolution, we could not function normally [5]. Biologist Ajit Varki points out that without excessive optimism, humans’ greatest evolutionary advantage – our self-awareness, would become our biggest obstacle and ground us to a halt [6].

However positive for us, our overly optimistic outlook of the future hinders our ability to realistically assess future threats, like the coronavirus, or running out of money in retirement, or not being able to afford needed healthcare. Optimism bias is also dangerous in the current stages of the epidemic, as we interpret positive signs too quickly and forget the epidemic may return in the second wave. That is why, when assessing threats, we must be as realistic as possible and rely on numbers and not emotions. If you would like to read more about the threats of optimism bias on your retirement nest egg, and how to avoid them, you can read my article for The Decision Lab.

Coronavirus COVID-19 lessons

If humanity can learn something from the last pandemic, it is that even though certain threats are intangible and distant, that does not mean they are not real, That goes the same for viruses and retirement saving. And even though the consequences of some of our actions will only be visible in the long run, that does not mean we do not make urgently needed changes in our behaviour today and that goes for individuals and societies. As we have witnessed these days, the consequences of procrastination are unfortunately measured in human lives and we have crucial years ahead of us, where we can still do something more in the light of the inevitable climate and demographic crisis, for which we have today more than enough evidence, to make changes.

References:     

[1] Chapman, Gretchen & Loewenstein George. Hand-washing and distancing don’t have tangible benefits. The Conversation, 2020. Retrieved from: https://theconversation.com/hand-washing-and-distancing-dont-have-tangible-benefits-so-keeping-up-these-protective-behaviors-for-months-will-be-tricky-136457

[2] Berman, Kristen. Wildfires — the perfect behavioral problem. Medium, 2020. Retrieved from: https://medium.com/@bermster/wildfires-the-perfect-behavioral-problem-3c25c6209e2f

[3] Thaler, R. H., Tversky, A., Kahneman, D., & Schwartz, A.. The effect of myopia and loss aversion on risk taking: An experimental test. The Quarterly Journal of Economics, 112(2), 647-661. 1997.

[4] O`Sullivan, P. Owen. The neural basis of always looking on the bright side (Dialogues in philosophy, mental and neuro sciences), 2015.

[5] Sharot, Tali. The optimism Bias – A Tour of the Irrationally Positive Brain. New York, NY, US: Pantheon/Random House, 2012.

[6] Varki, Ajit. Human Uniqueness and the denial of death. Nature 460, No. 7256, 2009.