A leading behavioral researcher discusses the importance of setting the right retirement-plan defaults and how the current crisis puts urgency around "rainy day accounts."
Our guest on the podcast is Dr. Brigitte Madrian, a leading light in the field of behavioral economics. She is the dean and Marriott Distinguished Professor in the Brigham Young University Marriott School of Business. Dr. Madrian has a joint appointment in the Department of Finance and the George W. Romney Institute of Public Service and Ethics.
Household savings and investment behavior have been key focuses of her research, and her work in these areas has influenced the design of 401(k) plans and pension reform legislation. She also uses the lens of behavioral economics to understand health behaviors and improve health outcomes.
Brigitte Madrian bio and research archive
Emergency Funds/Decision-Making Under Financial Duress
Beshears, J., Choi, J.J., Iwry, J.M., John, D.C., Laibson, D., & Madrian, B.C. 2020. “Building Emergency Savings Through Employer-Sponsored Rainy Day Accounts.” Tax Policy and the Economy, Vol. 34, National Bureau of Economic Research.
Benartzi, S. 2020. “People Don’t Save Enough for Emergencies, but There Are Ways to Fix That.” The Wall Street Journal, Feb. 17, 2020.
Harvey, C.S. 2019. “Unlocking the Potential of Emergency Savings Accounts.” AARP Public Policy Institute, October.
Tergesen, A. 2019. “Employers Help Workers Build Household-Emergency Funds.” The Wall Street Journal, June 13, 2019.
Pension Rights Center. 2019. “How Many Workers Participate in Workplace Retirement Plans?” July 15, 2019.
Eisenberg, R. 2017. "R.I.P. myRA Retirement Account, Gone Too Soon." Forbes.com. July 28, 2017.
Benz, C., & Levine, J. 2020. “What Does the CARES Act Mean for Retirement Accounts?” Morningstar.com. April 3, 2020.
Madrian, B.C., & Shea, D.F. 2000.“The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior.” The National Bureau of Economic Research, May 2000.
Finke, M. 2015. “Brigitte Madrian’s Power of Suggestion--and How It Improved Retirement.” ThinkAdvisor, Aug. 31, 2015.
Madrian, B.C. 2014. “That Was Easy: The Importance of Auto Features in Promoting Retirement Savings.” AARP Public Policy Institute, October 2014.
Rosenberger, J. 2019. “The Woman Behind the Way You Save for Retirement.” Guideline blog, April 4, 2019.
Choi, J.J., Laibson, D., & Madrian, B.C. 2007. “$100 Bills on the Sidewalk: Suboptimal Investment in 401(k) Plans.” The National Bureau on Economic Research, December 2007.
Choi, J.J., Laibson, D., & Madrian, B.C. 2007. “Mental Accounting in Portfolio Choice: Evidence from a Flypaper Effect.” The National Bureau of Economic Research, September 2007.
Choi, J.J., Laibson, D., & Madrian, B.C. 2001. “For Better or For Worse: Default Effects and 401(k) Savings Behavior.” The National Bureau of Economic Research, December 2001.
Carroll, G.D., Choi, J.J., Laibson, D., Madrian, B.C., & Metrick A. 2005. “Optimal Defaults and Active Decisions.” The National Bureau of Economic Research, January 2005.
Beshears, J., Choi, J.J., Laibson, D., Madrian, B.C., & Skimmyhorn, W.L. 2016. “Does Borrowing Undo Automatic Enrollment’s Effect on Savings?” The National Bureau of Economic Research, August 2016.
Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance for Morningstar, Inc.
Jeff Ptak: And I'm Jeff Ptak, global director of manager research for Morningstar Research Services.
Benz: Our guest on the podcast today is Dr. Brigitte Madrian, the Dean of the Marriott School of Business at Brigham Young University and a leading in the field of behavioral economics. House saving and investment behavior have been key focuses of her research and her work in these areas has influenced the design of 401(k) plans and pension reform legislation. She also uses the lens of behavioral economics to understand health behaviors and improve health outcomes.
Before coming to BYU, Dr. Madrian was the Aetna professor of Public Policy and Corporate Management in the John F. Kennedy School of Government at Harvard University from 2006 to 2018. She was also a faculty member at the University of Pennsylvania Wharton School, the University of Chicago Graduate School of Business from and the Harvard University Economics Department. She is also a research associate at the National Bureau of Economic Research and served as co-director of the NBER Household Finance working group. She received a PhD in economics from the Massachusetts Institute of Technology and studied economics as an undergraduate at BYU.
Dean Madrian, welcome to The Long View.
Dr. Brigitte Madrian: Thank you. I'm happy to be here.
Benz: We're thrilled to have you here. We are talking at an unusual time. We're in the midst of this unfolding coronavirus crisis which has implications for public health as well as household finances. What does the research suggest about how a stressful environment tends to affect consumers' ability to make financial decisions? It's not good, right?
Madrian: Yeah. So, financial decisions are tough for many households to make even when they are not under distress, and in times of financial stress or times of stress in general can make financial decision-making even more difficult. A lot of the important financial decisions that the households make involve inter-temporal trade-offs, trade-offs about things today versus things tomorrow. And when you are in a situation of stress like today, you're going to be much more focused on the here now to the exclusion of the future.
Benz: One of the issues we're seeing in stark relief amid the crisis is that many people live paycheck to paycheck without any emergency fund or a cushion built into their plans. Let's talk about the research that you've done on this topic, the idea of rainy day emergency savings funds, especially in the context of the workplace. And I'd like to talk about whether your research suggests that this would be a good idea, sort of, formalizing emergency funding so that people are in better shape when crises like these hit.
Madrian: I think the crisis will really illustrate how important it will be to help households build up emergency savings going forward. So, about half of the workforce has a job where they have a retirement savings plan. And those households will probably do OK, because there are already mechanisms in place for them to tap into their retirement savings and the government has in fact been talking about maybe allowing provisions that would let people do that without the penalties that are currently in place.
But the other half of the workforce doesn't have a retirement savings plan and many of them don't have other savings as well. And so, when they run out of their next paycheck, if they are furloughed or laid off from their job, they could be facing really difficult circumstances and having to make important trade-offs about things like healthcare and food for their children or gas to get places, things like that. And those aren't the trade-offs you want households to be thinking about making right now. If someone is sick, you want them to get the medical care that they need and not to be at home worrying about whether or not they can actually pay for it.
Ptak: What should be done?
Madrian: I've got a proposal out there that would allow employers to set up rainy day savings accounts for their workers and defend those through payroll deduction and to set them up automatically. So, right now, an employer could set up such an account, but there's a lot of regulatory uncertainty about how to do that and how to do it effectively. And this is a proposal that's ended up as an academic paper, but it's also being talked about in Washington ways to do it. I don't think it's really controversial politically. I think there's bipartisan support for it and it's just a matter of getting it high up the queue so that it can happen.
Benz: Was the MyRA idea kind of a go at the problem but maybe in a slightly different way? And can you talk about how your idea differs from the MyRA, and also what went wrong with MyRA?
Madrian: The MyRA was a government proposal set up during the Obama administration. And it was a bit politicized. And it wasn't relying so much on private sector mechanisms to facilitate savings. It just never really got very much traction. So, there are lots of different ways you could set up rainy day savings accounts for employees, but at least the way I've envisioned them along with the collaborators I've been working with, is a great way to start out would be to piggyback these on the existing 401(k) savings infrastructure. So, companies that are already set up to offer a workplace retirement savings plan, it wouldn't be that much more difficult to add on an emergency savings plan to go along with it. Now, of course, there are a lot of employees that don't have a retirement savings plan, and we'd like to make something accessible for them, as well. But it would be a way to jumpstart the overall infrastructure system to help that happen.
Ptak: If that was implemented, what would it look like for those that are fortunate enough to have retirement plans, they would enroll in their retirement plan and as you imagine it, what would they be availed of to ensure preparedness, a rainy day sort of fund, so to speak?
Madrian: Yeah. So, there are a couple of different ways you could set it up. One way you could set it up is under the 401(k) umbrella. So, you could have part of your savings go to a traditional 401(k) plan set aside for retirement and then you could have another chunk of savings be set aside for emergency savings through a Roth IRA, something like that, an after-tax account. That's a mechanism that's available under the umbrella of a 401(k) plan. Those are mechanisms that already exist. And so, it wouldn't be that much extra work for a company to take advantage of those.
Another mechanism that you could use is just a traditional bank savings account. One of the challenges with a bank savings account right now is that whether or not you could automatically enroll employees into a bank savings account is questionable. With something under the 401(k) umbrella, the legal rulings are in place that would allow employers to automatically enroll employees into that type of an emergency savings account. And the reason that's important is we know that automatic enrollment is the way that you get really high participation rates. So, in the retirement savings space, when employers are using automatic enrollment, you get participation rates, you know, 90%, 95%. Almost everyone is participating in the plan. Very few people opt out. And so, if you were to use a bank savings account without some clarification from legislation or regulation that you could use automatic enrollment, you can't use that, you're going to have many fewer people that actually go through the steps that would be required to sign up. So, you might only get 30% or 40% participation.
Benz: Your research indicates that promoting these rainy day funds would harness a healthy kind of mental accounting that we tend to engage in, in general, where we might put money for different purposes in different buckets. Let's talk about mental accounting in this context. I think sometimes people think it's not a good thing, but in this case, it sounds like it's a good thing.
Madrian: Mental accounting is the process that we use to categorize different aspects of our financial life. And one of the problems with having a system in which many people only have one type of a savings account, and for many households, that would be their 401(k) plan. And the problem with that is, although that type of a plan was set up as a way to supplement your retirement income, if that's the only substantive savings account you have, it's essentially your everything savings account and not a retirement savings account. And if you only have one account like that, it's easy to convince yourself that you have lots of different – because you have lots of different ways to spend the money, you've in fact saved more than you actually have.
Let's suppose I put an extra dollar into my 401(k) account. I could use that dollar for my retirement if I left it alone. I could use it to buy a new car. I could use it to go on a vacation. I could use it to pay for my children's education. I could use it for a rainy day. Now, the fact of the matter is, I can only use it for one of those things. But while it's just sitting in the account without a designated use, I could convince myself mentally that it's available for all of those different things. Whereas if I have to have a different account for all of these different savings motives, it forces some discipline in terms of how much money I actually have saved for retirement, for a new car, for a vacation, for my kids' college education and things like that.
Another problem that happens if you've only got one account and it's serving these many, many purposes, if one of the purpose is retirement, you'd like to save a lot of money in that account, because many of us are going to live 20 or 30 or 40 years in retirement and you need a sizable nest egg to cover all of that time out of work. But if you're also using that account for a rainy day, the problem is, when the rainy day happens and you go to access that account, it probably has a lot more money in it than you actually need for whatever the problem is on this particular rainy day, and it's very tempting to then spend more money than you need to actually spend.
You may remember the TV commercials, the Lay's potato chips TV commercials, and the tagline was, you can't eat just one; you open up the bag of potato chips, and you're going to eat the whole bag of potato chips. And if you've got a giant bag of potato chips, you'll eat a large quantity of potato chips and if you have a little lunch box size bag, you'll eat much less.
And so, another reason it makes sense to have separate accounts is so that, you know, the big bag of potato chips, the retirement savings account, is designated for retirement and you leave it alone. And for other purposes, where you don't need as much money, you're giving someone the lunch-sized bag of potato chips and they'll stop spending when they've reached the smaller amount of money that's in that account.
Benz: You referenced the provision in the stimulus package, which isn't quite yet final, but it would enable consumers to take a penalty-free withdrawal of up to $100,000 from their 401(k)s and pay the taxes back over a three-year period. So, that's the system we have now. We just have that one account. Is that a good idea? I suppose if people are in financial distress, you have to give them that option. But there are risks there, right?
Madrian: There are risks there. And the risk is that they don't end up building that nest egg back up. So, what you'd really like to do is allow people access to the money and they are putting a limit on how much money you can have access to. For most households, $100,000 would be a pretty generous amount. Many households wouldn't even have that much money in the account to access in the first place. But what you'd really like to do is give households the opportunity to put that money back into the account over the next two or three or four or five years, so that even if they tapped into it, they can make additional contributions above and beyond what we would ordinarily allow them to make.
Benz: Do you think the presence of more escape hatches for defined contribution plans as we know them could actually make it more likely for people to use them knowing that they do have a little bit more leeway to get their hands on their money if they need it?
Madrian: That's a great question, and it's one that policymakers have been talking about for quite some time. We don't actually have any really good evidence that would allow us to answer that question. Certainly, make sense that people might be more willing to save in an account if they know that they have access to that money in an emergency when they really need it. I think we just don't know how big that effect is. Does it lead people to save 10% more on those accounts than they might otherwise? Does it lead them to save 40% more in those accounts than they would need to save otherwise? We don't have good evidence on that.
Benz: One recurrent theme in your research is that inertia is such a powerful force in how we all make choices, especially retirement-related choices, and the right defaults can help get people headed in the right direction. I guess, the question is, at a time like this, do people remain inert if they're feeling financially distressed either for themselves or for the economy as a whole? Or does inertia tend to prevail no matter what is going on with the economy and the markets?
Madrian: And the answer is, there's a bit of both. So, there's a big chunk of people, and they won't do much of anything. They'll keep their jobs. They'll keep on making contributions to their retirement plan. They won't change how much they're saving. They won't change their asset allocation. It will just be business as usual. There will be another chunk of households, however, for which the gyrations in the economy will motivate them to take action. And for some of those households, that action might be reasonable, like tapping into your 401(k) plan if you've lost your job and you're in dire financial straits, that might be a sensible thing to do and a different way of what you'd be doing in the past overcoming inertia. For other households, they're going to be panicked at what's happening in the stock market. And they might decide to stop saving altogether, stop contributing, even if financially they could continue to do so. Or they might decide that they're going to change their asset allocation. So, the equity markets look like they might be a scary place to be right now. And so, this might motivate them to go into their account, trade out of stocks and put all of that money into a bond fund or a money market funds, something like that.
And what we know from lots of research is that individual investors don't do a very good job at timing the market and are more likely to get out just when things are turning around. So, from that standpoint, inertia can actually be a helpful thing because it can protect you from overreacting to bad events in the markets.
Ptak: Have you researched ways to keep investors from making particularly poor choices like raiding their 401(k) plans in times of market stress if it's unwarranted, or as you described, making a pretty dramatic change in their asset allocation that ultimately works to their detriment?
Madrian: That's a great question. I mean, what my research shows is that many people aren't going to react in the short term just because there are costs associated with taking action and people have other things on their mind. For the people who are inclined to take action, I don't think we have a lot of great research on what would get them to do otherwise. I think a general principle is the more costly you make it to take action, the less likely individuals will be to actually follow up. So, it's interesting to watch over the last couple of weeks the responses of financial institutions that are dealing with retail customers and what they're doing in the wake of the crisis. So, I don't know what your inbox looks like, but I've gotten emails from every financial institution that I have arrangements with. And some bank branches are shutting down entirely, which is going to create an additional barrier for households to make certain types of changes. I know I've got one financial institution and they said, you can drive up, but you can't come into the branch. And then, there are others that I primarily deal with online, and they're sending me emails and touting just how easy it's going to be for me to now get online.
Another interesting aspect of our current situation is that in contrast to previous financial crises, a lot of people are home now. They're working from home. And we don't actually know anything about where people make important financial decisions and where they take action. Are they doing it at home? And are they doing it from work? And how does this change from where you're actually spending all of your time? How, if at all, will that impact the types of financial decisions individuals make?
Benz: I guess a related question is that everyone is experiencing a lot of stress elsewhere in their lives, not just in their financial lives right now. So, would that tend to be kind of a diversion potentially from over-focusing on my 401(k) plan and what's been going on with my balance?
Madrian: Yes, and that could certainly be a diversion. I mean, another thing we know is that one of the – I mean, there are a couple of factors that tend to put people into financial distress. One is job loss. And the second big one is healthcare crises. And we've got both of those going on, sometimes for the same households, sometimes for different households. But certainly, if you're sick, you're probably not spending a lot of time thinking about what to do with your retirement portfolio.
Benz: I know you've done work on the uptake of target-date funds and their role in consumers' behaviors. From our standpoint, at Morningstar, it seems like the default choice of target-date funds has been a good development for consumers. But I'd like your thoughts and you reflect on your research about why that is, why when we look at 401(k) participant behavior in target-date funds, we tend to see a pretty good picture of people just adding money, staying the course.
Madrian: I think you have to look back and say what were people doing before target-date funds existed. Before we had target-date funds and before they were widely used as the default investment option, most retirement plans had specified a pretty conservative default investment option, either a money market fund or a stable value fund. And if you were to look at the types of portfolios that were held, you would see a lot of investors invested in the default option, a lot of money in these very conservative funds. And then, you would see a lot of other people that were putting all of their money in equities or some other type of fund. And what the move to target-date funds has done is it's created less variance in the types of portfolios that we see.
And I think one of the reasons that's the case is, if you look at the types of financial decisions that individuals have the most trouble with, asset allocation is more problematic than whether or not I should be saving or even how much I should be saving. So, most people seem to understand that they should save. And even if they can't do a great job of telling you exactly how much they should save, they have good frameworks that help them should I save 5% of my pay, should I save 10%? They have kind of useful benchmarks that they can use in thinking about that. But when it comes to asset allocation, there's a lot of evidence that shows that people really don't understand even the basics of making a good asset-allocation decision.
People don't understand which types of investments are more risky or less risky. They don't understand how different investments respond in different types of economic circumstances, you know, that stocks and bonds are going to react in different ways. They don't understand how inflation interacts with investment returns. A whole host of things. And what the target-date funds do is they give investors a really simple way to think about that investment allocation. Here is a fund, it's being managed by someone who knows what they're doing, and it's designed for people who think they're going to retire in 2020, in 2025, in 2030, in 2035. So, all I have to think about is, when do I think I'm going to retire. And once I figured out when I think I'm going to retire, then this is the fund that is probably pretty good for me. And they're diversified. And someone else is managing the money and the asset allocation changes over time automatically as I get closer to retirement. So, they are a way for people that have their money managed in a sensible way, without having to exert the same level of control as having to pick your own asset allocation from several dozen or maybe even hundreds of options.
Ptak: Earlier in the conversation, we were talking about some of the benefits that investors and savers accrue from having these different buckets. One of them is maybe the rainy day fund, then you have the pot of money that's earmarked for retirement. But then when we talk about target-date funds, it seems like one of their most salutary attributes is the fact that they stitch all of these things together into a cohesive whole and the rebalancing is taken care of. And so, I wonder if you could reconcile those two things, why in one context, it can be useful to have these separate buckets, where we can use mental accounting to our advantage, but then in the defined contribution context, we have this single investment where it's beneficial just to keep all the different pieces stitch together?
Madrian: That's a really great question. And the way I would think about it is, they're two separate problems even though they're related. So, the first problem is, how much should I be saving? And I've got a lot of different reasons for which I could be saving. And the retirement bucket and the rainy day bucket and the new car bucket and the vacation bucket – those are different mechanisms to help me save enough for each one of those purposes. And then, the second piece of your question was asking about the investment allocation side. So, what is the amount that I'm saving going to be invested in stocks, bonds, stable value fund, international stocks, domestic stocks, all of those things?
I think the distinction is that on the savings side, people understand what they're saving for. People understand what retirement is. People understand what a new car is. They understand what a down payment on a house is, what a kid's college education. These are all things that people understand. And they have a price tag associated with them. For some of them, the price tag is pretty clear. The price tag on a car, you know, pretty transparent. The price tag on retirement, less so, but people understand that there is a number out there they should be aspiring to. And the buckets are a way to help them solve the problem of how much to save. So, the buckets are actually making it easier for them to manage their money as opposed to having it all in one account and then having to back out and reverse engineer how much money do I have for each of these different purposes.
On the asset-allocation side, people understand much less about the different pieces of their asset allocation. Many individuals are not particularly financially literate. They haven't had a class in investing or economics or something like that. And they can't articulate what's the difference between putting my money in a stock fund or putting my money in a bond fund. They don't understand what it means to be diversified. They don't understand the role of investment fees in part because those things aren't transparent. And so, when you're adding more options to the investment menu and giving individuals control over it, you're actually making the decision more difficult rather than making it easier. So, the target-date fund is taking a difficult problem, how do I invest among the several dozen options that I have and making it easier by giving individuals a single account that they can focus on and try to understand. Whereas on the savings side, if you only have one account, you're making that how much money do I have to spend problem more difficult because that money could be spent in so many different ways. And having the separate accounts makes it easier for you to think about, oh, yes, this is how much money I have set aside for my vacation this summer. This is how much money I have set aside for my kid's college education.
Benz: Speaking of difficult problems, people seem to have a really hard time figuring out how much they need to save for retirement. You said they might have some vague notion. But there have been recently a few attempts to help people figure out the adequacy of their retirement savings, translating it into sort of an annual cash flow in retirement estimate. Do you think such measures make sense? Will they help people?
Madrian: I do think that people think more intuitively about spending flows than they do about a large lump sum of money. So, what does a million dollars buy me in terms of how many years of consumption in retirement? I don't think that's an easy question for people to answer. It's not an easy question for me to answer. And I have a PhD in economics, and I study this. So, it's easier for people to think about how much income am I going to need, because that's how people think about things right now. I know how much income I'm earning in my job right now. I know what standard of living I get from that particular amount of income. And so, if I can translate retirement savings into this mode of thinking that I'm already really familiar with, that's an easier way for people to think about things.
Even in that frame, however, there's just a lot of uncertainty associated with thinking about retirement. Individuals don't know how long they're going to live. You don't know whether you're going to be in good health or poor health. Are you going to have 20 years of good health, 30 years of good health, if you're going to be in poor health the minute that you retire? There's a lot of uncertainty about pieces of the income stream that you don't have any control over like Social Security. So, how much money will you actually get out of the Social Security system? And none of us know the answer to that. Those of us who pay attention to Social Security know that there are some problems with the system. But we don't know will the government step in to fix it. We don't know what's going to happen to returns in the asset market, and that helps influence the value of your savings in your 401(k) plan.
There's just a lot of uncertainty, and that uncertainty gets magnified as you project things out 20, 30, 40 years into the future. And it makes retirement savings a really difficult and challenging problem even for the experts.
Benz: Are there any defaults that you could contemplate that could help smooth the way for people during the deccumulation years? It seems like we've made a lot of strides for people during the accumulation years to default them into better choices. How about during the deccumulation period? Is there anything we could be thinking about or talking about on that front?
Madrian: Certainly, people who work in this space have been talking for years about what a sensible deccumulation default might look like. And I think the challenge is that there's so much heterogeneity in what people really need or what would best serve their interests. So, the best default for someone who has been running marathons and has long lived ancestors going back several generations might look very different than the best deccumulation strategy for someone who is in poor health and all of their relatives have died young. It's going to look different for someone who is married and has a spouse that might outlive them relative to someone who is single, someone who has got younger children who still need support relative to someone whose kids are all grown up. And there's so much variation in the circumstances of households when they reach retirement that it's really hard to specify what a sensible default is that would do right by a large fraction of people. And I think that's what's standing in the way of setting up such a default.
An alternative approach would be to help everyone make an active choice when they reach retirement about the best deccumulation strategy. So, I think right now, to the extent that's happening, it's because individuals when they reach retirement, will go out and on their own, find a financial planner who might help them think about what their options are and what options might be best for them. But a role that employers could play given that so much of our retirement assets are coming through employer-sponsored plans would be for the employer to bat a set of financial advisors who will give good advice to employees who are retiring. And then, as employees get near retirement, assign them to sit down with an advisor and figure out what the best strategy is for them, so that they're actually making a choice taking into account the circumstances that they have, but they're doing it with the benefit of someone who can actually help them make a good decision. And for some individuals that decision might be, let's actually consume some of your savings today so that you can postpone taking Social Security as long as possible and delay claiming Social Security until your until you're 70 so that you're getting the most you can out of the Social Security system, and for other households, it might be starting to claim Social Security earlier using your savings in another way.
Ptak: Important as advice is, I would imagine that some employers would be loath to refer their employees to an advisor for fear that it could expose them to certain risk if you know that advice turns out to be inadvisable, and the investor has – the retirement plan participant, let's say, has a bad outcome down the line. Do you think that there are things that need to be done in order to encourage or protect employer so that they can make advice more readily available without fear of suffering a repercussion in the event that there's a bad outcome?
Madrian: I think you've hit the nail on the head in terms of one of the challenges of making that actually happen, which is, who bears the liability of bad advice. And if you've got a big employer who's in the picture and the employer has deep pockets, that's who people are going to go after. And if you're a big employer, you're going to be more reluctant to do that. So, there are things you could do with the legal system to help mitigate that. If you're talking about a big company that's providing financial advice, you could actually allow that organization to assume the liability from the employer. That's one approach.
Benz: A lot of your work has focused on these defaults. And I think it might be tempting to kind of look at them as this unequivocal good. But I was interested in some of your research that showed if the default contribution rate, for example, to a defined contribution plan is too low, that people might under-save relative to what they would do without that default. So, let's talk about that, how really setting these defaults correctly is super important in terms of getting people to their best outcome.
Madrian: There are a number of important parameters in the retirement savings system that all need to be set well in order for individuals to have a good outcome. So, the first is, you want people to be participating in the system. You want them to be saving something. And the way to facilitate that is through using automatic enrollment. The second is that you want people to be saving enough in the first place. And I think that's the piece that you were getting at directly in the question. And if you're helping people save, but you're doing it at a savings rate that is too low that doesn't meet their needs, you might actually be making them worse off, because if you didn't help them save, some of them would step in and save more on their own. So, helping them save too little isn't really helping them. So, you want to default them in at a high enough savings rate.
You want to default them into an asset allocation that meets their needs. And that's why so many employers have turned to target-date funds because those are an alternative that's easy for individuals to understand and seems to do a good job at providing a well-diversified portfolio and the fees have come down quite a bit. And there's a lot of support for that on both the investor side and on the plan sponsor provider side.
Another piece that we talked a little bit about at the beginning in the context of the current economic crisis is to what extent do you want to allow individuals the ability to tap into their retirement savings before they reach retirement? And if we weren't in a period of financial crisis, the conversation we'd be having around that would probably be, many people are tapping into their money well before retirement under circumstances in which they would be ill advised to do so, because we have a system where we've made it really easy for people to get access to their retirement wealth, and would we be better served by making it more difficult for people to tap into those resources?
I think in today's current circumstances, the economic environment we're in, those concerns are a little bit less founded than they would have been six months ago or two years ago. And then, another interesting outcome that we also need to consider is, if we make it easier for people to save by having automatic enrollment with a good default savings rate, how do the savings outcomes in your 401(k) plan, how do those interact with other pieces of your balance sheet? So, if I get people to save more for retirement, how much of that is actually new saving and how much of that might be displacing savings that individuals would be doing elsewhere? Or how much of that might be offset by individuals taking on more debt in response to having lower take home pay, because they're now saving more?
So, along with some of my collaborators, we've got a paper that looks at some novel data on this in the U.S. And the good news is, we don't find a lot of evidence that individuals are taking on more consumer debt, things like credit card debt or student loans or things like that. That evidence is a little bit more ambiguous when you look at things like auto loan and home mortgages in terms of whether saving more for retirement is then being accompanied by higher levels of debt. I would not characterize the results as giving us a definitive answer, but they certainly kind of raise a provocative question about how all of these different financial decisions are linked in interesting and complicated ways. And we need better data to really understand the impact of any policy on the full financial picture for individuals and households.
Benz: It does seem like we're in a brave new world of auto loans specifically where you've got very long terms and even some cash out features. There are some worrisome things, I think, from the standpoint of consumers in that space.
Benz: Jeff and I had a really interesting conversation with John Lynch at the University of Colorado who has done some research on financial education. And a general conclusion of his seems to be that financial education mostly doesn't work and that we should put a priority on thoughtful nudging in what he calls just in time financial education, so kind of giving people that point of purchase information. What's your take on that question of how much we as a society should work to financially educate one another versus just nudging one another?
Madrian: That's a great question. And it's one that I've spent a lot of time thinking about. So, I think the way I would approach this is that there are two different outcomes. So, one outcome that we're interested in is, how well off are individuals financially? In terms of saving are they saving enough? In terms of debt, are they holding the right types of debt? Things like that. A related but separate question is, how financially literate are they? And you could think of financial literacy as a means to better financial outcomes, but you could think of financial literacy as an outcome in and of itself.
Now, the evidence on how well does improved financial literacy translate into better economic outcomes for households suggests that there is a relationship but it's not a particularly strong one. So, better financial education can lead to better financial outcomes, but the effect is not particularly large relative to other approaches to generate better financial outcomes. So, if we were going to look just at helping individuals save more for retirement, you're going to get a much bigger effect on retirement savings by setting up well-designed defaults, automatic enrollment at a high enough default contribution rate with a reasonable asset allocation, then you will get through financial education and then hoping that individuals will use that financial education to then make better decisions.
So, if the only outcome you're interested in is the actual financial outcomes, there are more cost-effective ways to achieve those outcomes than through financial education. Does that necessarily mean that it doesn't make sense to also invest in financial education? No. There might be other reasons you'd like to have individuals have a certain level of financial literacy, which means that you still want to invest in financial education. But you'd also want to set up the system so that you're going to lead people to good financial outcomes regardless of whether or not you're investing in financial education.
Ptak: Shifting gears a bit, some of your research investigates consumer decision-making in the healthcare space. Does that strike you in general a scenario where consumers make notably poor decisions simply because they don't often see what anything costs at the time they're making decisions?
Madrian: We see lots of mistakes in the healthcare domain as well. And certainly, some of the healthcare decisions that people are making have a financial component to them. And individuals are no better at making decisions in the healthcare domain that involve financial trade-offs than they are in other domains. And then, of course, they're all the decisions in the healthcare domain that just involve health absent financial considerations.
I mean, one characteristic of both healthcare decisions and financial decisions is that many of those decisions are complicated, difficult for households to understand, and there aren't necessarily high levels of health literacy, just like there aren't high levels of financial literacy. So, when you're asking people to make decisions that are difficult on the basis of very little knowledge, that's a recipe for poor decision-making.
For example, we see a lot of households choosing health insurance plans that aren't best suited for their particular situation. That would be just one example of a financial decision in the healthcare domain. We know that individuals procrastinate certain types of healthcare. We know that they overreact to certain types of news and information. They underreact to other things. So, certainly, in the current pandemic, we've seen both under-reaction and overreaction. We see overreaction with people stocking up on toilet paper, which has many people scratching their heads and we see under-reaction in terms of taking precautionary measures like appropriate social distancing and things like that. So, that's definitely a domain where we see similar types of mistakes.
One difference, at least with some pieces of the financial decision-making that we've been talking about is that when it comes to something like saving for retirement, you can make a decision once and then leave it on autopilot for a very, very long time. And that can be beneficial. That inertia that we talked about can actually work to the benefit of consumers. In the healthcare domain, there are a lot of decisions that we need consumers to make day after day after day in order to have good health outcomes, like exercising, like eating healthy foods, like getting a flu vaccine every year, things like that. And so, you can't rely on inertia to generate positive outcomes in quite the same way in the health domain as you can in at least some financial domains.
Benz: Some of your research has looked at that idea of incentivizing people who are receiving treatment to get some sort of financial incentive if they stick with their suggested regimen. Do financial incentives work in the context of healthcare?
Madrian: So, they can work. They don't generate really huge effects, which is the same finding that we find in the financial domain. So, if we were looking at the role of incentives and helping people to save for retirement, and many employers offer an incentive, they had a match on your savings. If you save $1, I'll give you $0.50 and put that in your retirement savings plan. And the evidence on incentives in retirement savings is they have an effect, but it's a very small effect relative to some of the other tools that we've talked about. And in the health domain, some incentive schemes that have been studied find small modest effects from incentives. Some studies actually find no effects from incentives. But they're not the silver bullet in terms of leading to better outcomes.
Benz: You've been on the Academic Research Council of the Consumer Financial Protection Bureau. Are there any parts of the consumer finance marketplace that you think merit more attention than they've gotten to-date? Any areas where you expect you'll be digging in on the research front in the future?
Madrian: Oh, great question. Unfortunately, now that I've become a dean, I'm spending less time on research than I used to in the past. So, I wish I could say, oh, yes, there's a whole long list of things I'd love to do a lot of research on in the future. And realistically, that might be a pipe dream. I think one of the pieces of the consumer finance landscape that people are starting to get more interested in is student loan debt, and that's been growing quite substantially over the past couple of decades. And there are concerns about what that's doing to the ability of younger individuals and families to buy homes and to save for retirement. And I think there will be some interesting research on that that will be coming out over the next few years. I don't think I'm going to be the one doing it. But I know there are a number of researchers out there who are interested in those questions. And I'm excited to see what research comes out of that.
I think we're going to see a lot of interesting research come out of this economic crisis and pandemic that we're in right now that's going to inform how well-prepared individuals are for short-term financial crises and what the impacts are both on individuals but also on cities and counties and states, what's the geography of economic crises and how they play out. And I think we'll have probably a whole good decade's worth of research coming out of the financial decisions individuals are making today and what their circumstances were going into the crisis and how they were impacted as a result of the type of occupation they were in or where they were living. And there are a lot of interesting aspects of that that people will be looking at for the next decade.
Benz: Well, Dean Madrian, this has been a really thought-provoking and wide-ranging conversation. We very much appreciate you taking time out of your schedule to be with us here today.
Madrian: My pleasure.
Ptak: Thanks so much.
Madrian: Thank you. Have a good day. Stay safe and healthy.
Benz: You, too. Thank you.
Ptak: You as well. Take care. Nice talking to you.
Benz: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts. You can follow us on Twitter @Christine_Benz.
Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.
Benz: Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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