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.
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.
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:
- 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
- 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
- Kahneman, Daniel & Tversky, Amos. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263-291. doi:10.2307/1914185
- Bickel, W., Odum, A., & Madden, G. (1999). Impulsivity and cigarette smoking: Delay discounting in current, never, and ex-smokers. Psychopharmacology, 146(4),447-454.