In the past decade, there has been a rapid shift among employers from defined benefit plans (pensions) to defined contribution plans (401(k), 403(b) plans). As a result, employees now bear much more responsibility for their retirement savings.
“Spend less, save more” is always on the list of popular New Year’s resolutions, but as with commitments to get fit or lose weight, we find it hard to follow through. Overall, only 8% of Americans successfully achieve their goals.
But you can save money, even $1 million for retirement, without necessarily spending less. It turns out you’re likely to stick to your goals if you save a portion of your future income, rather than cut into current spending. It can be that simple, especially if you start early in your career.
To tackle the problem of inadequate retirement saving in defined contribution plans, Richard Thaler and Shlomo Benartzi have developed a plan called Save More Tomorrow (SMT), described in their recent paper “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving.” (https://faculty.chicagobooth.edu/Richard.Thaler/research/pdf/SMarTJPE.pdf)
Using principles drawn from psychology and behavioral economics, the plan gives workers the option of committing themselves now to increase their savings rate later. Once employees join, they stay in the plan until they opt out. Making the likelihood to stick to the plan much higher.
The SMT plan has four basic components: First, employees are approached about increasing their contribution rates approximately three months before their scheduled pay increase. Second, once they join, their contribution to the plan is increased beginning with the first paycheck after a raise. Third, their contribution rate continues to increase on each scheduled raise until the contribution rate reaches a preset maximum. Fourth, the employee can opt out of the plan at any time.
The economists report that one group of workers who adopted the strategy saw their retirement savings rates go from 3.5% before receiving the advice to 13.6% four years later. About 80% of those employees stuck with the strategy throughout that whole time.
What makes the SMT plan work? In order to design a savings plan that would be both effective and easy to use, Thaler and Benartzi took into account several major roadblocks to saving.
One reason why households aren’t saving enough is the basic problem of figuring out how much to save. According to the life-cycle theory of saving, households decide what level of consumption they would like over their lifetime, and then borrow or save to attain that amount. The theory suggests that individuals borrow when they are young, due to lower incomes at the early stage of their careers, and then save for retirement during their prime working years.
Making this strategy work
Use automatic deposit – Most investment platforms have features that automatically take money from your checking account, allowing you to set an investment strategy and manage your investing goals.
Choose the right account for your goal – Those working for an employer with a 401(k) plan should take full advantage of any employee match, and consider which retirement vehicles make the most sense for them. Once you’ve captured an employer match, you may want to begin funding an IRA. And if you’re saving for college, consider a 529 plan.
Apply this method to any sudden windfall. The SMarT strategy shows how investing little bits of money can add up quickly over time. To super-charge your savings, consider applying this strategy any time you come into extra cash. If you receive a tax refund, consider investing it. When you pay off a monthly debt — such as a car loan — direct those payments into an investment account instead.
Let the power of compounding work to your advantage.