(October 2009) The financial decisions facing older adults as they reach retirement age are increasingly more difficult. Not only does the older population have more wealth and resources to manage than in the past, but with the introduction of IRAs and 401(k)s in the 1970s and 1980s, older adults have had more savings and investment options than previous cohorts. Even before recent financial crises brought into question the financial decisions made by individuals of all ages, cognitive aging patterns and the prevalence of dementia raised concerns about the ability of many older adults to manage their financial resources.1
Studies in behavioral economics and neuroeconomics have shed light on how individuals make decisions and have implications for the design of public and private pension plans and for management of chronic diseases.
How Individuals Make Decisions
Using behavioral experiments that ask participants to decide between options where they receive rewards within a few days or over a longer time horizon, economists find that immediate gratification tends to win out over healthier or more financially sound choices that pay off in the more distant future. After all, we all think we can eat cake today and exercise tomorrow.
Studies that use brain scans suggest that some systems in the brain are more responsive to rewards in the present. The mesolimbic dopamine system is present-centered. This system is the brain pathway predominantly involved in motivation and reward processes. Enhanced activity in the mesolimbic system has been associated with food, sex, and drug addiction. The cortex system, which governs more analytical processes, is not biased toward the present. A debate between these two systems produces internal conflict. One implication of these findings is that to improve the decisions people make, important choices ought to be framed to reduce this conflict. One way to do this is to decrease the time horizon for a decision such that the effect is felt in the present and not the distant future.
Behavioral economists have learned a lot about the benefits of automatic enrollment in programs such as employer-offered pension and health insurance plans. Under automatic enrollment, individuals are enrolled in a plan unless they elect to opt out. Marketers have used this strategy to sell everything from magazines to credit card protection. Automatic enrollment is a key feature of the Obama Administration’s proposed Auto-IRA mandate, which would require companies to invest a portion of their workers’ pay in a defined contribution plan such as a 401(k). Workers would be automatically enrolled but could opt out of the program.
Research suggests that individuals may have every intention to save but fail to follow through. The default option for many retirement savings programs is nonenrollment, with employees having to actively choose to participate. However, when employers switch to automatic enrollment, participation rates are higher, and workers prefer this option.2 A greater proportion of eligible workers will enroll in savings plans if the decision to enroll cannot be postponed and the initial cost of participation, such as finding out about the program, is small.3 Setting a deadline for enrollment and automatically providing information and forms for enrollment are effective strategies for increasing retirement savings.
Some research suggests that financial education is not the key to helping adults make better financial decisions. In an experiment where participants had to allocate $10,000 among four index funds and were paid whatever gains they made, individuals chose high fee funds, paying more attention to average annual returns since inception.4 Even after having the charges laid out, most participants continued to choose high fee funds, despite sensing that they were making a mistake.
Older adults tend to make bad equity loan deals, paying higher interest rates and fees.5 Minor changes in the structure of decisions and marketing affect how adult brains react and the choices individuals make. Regulating how brokers and others describe financial options may help adults make better choices.
Older adults also have more difficulties with memory and other cognitive functions than younger adults do. This is one reason why some older adults have difficulty taking drugs as prescribed. The benefits of automatic enrollment may potentially be extended to health decisions that people make. Chronic conditions such as diabetes, high blood pressure, and high cholesterol are often managed with regular use of medications. Unfortunately, people make bad decisions, such as waiting until they have run out of their prescription drug before requesting a refill. These bad decisions can interfere with proper disease management. Incorporating automatic mechanisms into treatment—for example, home delivery every three months unless the patient actively rejects the option—could improve adherence to drug regimes. The health effects of this type of mechanism should be tested.
Marlene Lee is a senior research associate at the Population Reference Bureau. This article is based on David Laibson’s presentation for the symposium in honor of the 15th anniversary of the National Institute of Aging P-30 Centers on the Economics and Demography of Aging at the Rand Summer Institute on July 8-9, 2009, www.rand.org/labor/aging/rsi/2009/rsi_agenda.html. David Laibson is a professor of economics at Harvard University. Also see: James J. Choi et al., “Reinforcement Learning and Savings Behavior,” Journal of Finance (forthcoming); and Gabriel D. Carroll et al., “Optimal Defaults and Active Decisions,” Quarterly Journal of Economics (forthcoming).
- Cleusa Ferri et al., “Global Prevalence of Dementia: A Delphi Consensus Study,” The Lancet 17, no. 366 (2005): 2112-17.
- Brigitte C. Madrian and Dennis F. Shea, “The Power of Suggestion: Inertia In 401(K) Participation and Savings Behavior,” Quarterly Journal of Economics 116, no. 4 (2001): 1149-87; and James J. Choi et al., “For Better or for Worse: Default Effects and 401(k) Savings Behavior,” in Perspectives on the Economics of Aging (Cambridge, MA: National Bureau of Economic Research, 2004): 81-126.
- John Beshears et al., “Simplification and Saving,” NBER Working Papers 12659 (2006).
- James J. Choi, David Laibson, and Brigitte C. Madrian, “Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds,” Review of Financial Studies (forthcoming).
- Sumit Agarwal et al., “The Age of Reason: Financial Decisions Over the Life-Cycle with Implications for Regulation,” Brookings Papers on Economic Activity (Aug. 31, 2009).