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When it comes to the Nobel Prize for Economics, I’m often mystified at some of the work that wins it. Economic science is challenging.
But I don’t have any reservations to who should win the coveted prize (eventually). If I were allowed to nominate a winner, it would be Richard Thaler, the University of Chicago economist who created a major disruption in how we save for retirement and view personal finance. Note: Scottish economist Angus Deaton was awarded the prize today.
Thaler, a behavioral economist, is behind the “Save More Tomorrow” program that dramatically boosts retirement savings. This idea was pioneered by Thaler and UCLA economist Shlomo Benartzi.
The reason this idea works is that it short-circuits our bad decision making on savings. We save more because we are defaulted into a savings plan.
Let’s stay you’re starting a job with a company that offers a 401(k). Since this retirement plan is voluntary, you can elect to not save a dime, which is easy to do, but against your best long-term financial interests.
Save More Tomorrow automatically puts you in the 401(k). You have to make a conscious decision to opt out of it, which many don’t do. Not only do you put contributions on auto-pilot, you raise your contributions every time you get a raise.
In the initial research on Save More Tomorrow, employees who participated nearly tripled their savings rate. That disrupted the old paradigm of begging employees to save more. Automatic defaults work in a big way.
The reason that automatic savings work is that we are largely separated from our emotions of loss and sacrifice if we don’t have to think about it that much.
As any credit card or financial services company will tell you, once you’re in a plan, it’s hard to get out of it. Inertia rules the day because we have a hard time saying no.
Of course, you can do this with any savings plan — even IRAs and high-dividend stocks through reinvestment plans. But most people don’t save that way. They wait until they have enough disposable income and often come up short in retirement saving.
Countless studies have proven that automatic savings always boosts the amount of money we put away for retirement. One recent study showed that those who elected to automatically boost their savings rate and were auto-enrolled in 401(k)s saved more than 7% more than those who didn’t.
While that doesn’t sound like a lot, consider this: If you make $50,000 a year, 7% of gross income is $3,500. Keep in mind that you don’t have to pay taxes on contributions and it compounds tax deferred (you get taxed when you take it out of conventional IRAs.)
Let’s throw in some more carrots. Let’s say your employer gives you a raise every year of 2% and boosts your contribution by matching half of your monthly savings. You retire at 67. After that period — assuming a 7% return — you’d have $1.6 million. And that’s just starting with measly balance of $1,000, according to the bankrate.com 401(k) calculator.
Needless to say, you could save much more if you contribute more, your opening balance was higher, you work longer or the rate of return is better. But that’s a discussion for another day.
The important takeaway here is automatic contributions with compounding over time is a powerful way to save. Beyond a doubt, that strategy is not only worth a Nobel Prize, it’s a game changer for building a dignified and prosperous retirement.
Want to know more about Thaler? See my Forbes profile here.
John Wasik is the author of “The Debt-Free Degree,” “Keynes’s Way to Wealth“and 13 other books. He writes and speaks about investing across the globe. Follow him on Twitter and Facebook.