Danger strikes when foolish humans are left in charge of their financial futures


Much standard economics research is based on the “homo economicus” decision-maker. This is an entirely rational being. An unbiased, unemotional, non-psychological maximiser of the expected usefulness of things and events. Furthermore, this perfect decision-maker is far-sighted, and has complete self-control.
If that seems instinctively problematic, then you’ll be pleased to know that behavioural economics research instead recognises that real-world “homo sapiens” decision-makers are not fully rational, are biased, are emotional satisfiers. Furthermore, such decision-makers are myopic, and lack self-control.
For a long time though, policy-makers have based policy on that “homo economicus” model, not least in the world of financial decision-making, such as investing, saving and pensions. On this basis, there has been a move to give more financial responsibility to individuals.
Benefits trap
In the world of pensions, this has meant moving from defined benefit to defined contribution schemes. In defined benefit, you know what you will end up with and it’s up to your employer to dictate the amount of pensioncontributions and how the fund should invest those contributions. In defined contribution, the onus is very much on the employee to decide how much to save each month and how to invest it into assets like shares which introduce an element of risk.
The “homo economicus” approach is a normative (prescriptive) model: it prescribes how the perfect decision-maker should behave. Given this approach, those defined contribution schemes make sense. The fully-rational all-calculating, unemotional employee chooses their optimal pensions-saving plan. They use sophisticated techniques to calculate the correct balance between monthly consumption and savings for future retirement from monthly salary.
In contrast, the “homo sapiens” approach is a positive (descriptive) approach. It describes how people actually behave in the real world, given their psychological and behavioural biases and emotions, limited rationality, myopia, and lack of self-control.
This behavioural economics approach reveals the dangers in passing the responsibility to employees: a danger of insufficient pension-provision as myopic actors, lacking self-control and having limited financial literacy, spend too much today and save too little for retirement. Indeed, Lucy Ackert and Richard Deaves argue that employees who are required to manage their own retirement accounts through a defined contribution scheme are not like other investors. They are drafted in for the job, and it is reasonable to assume that they would suffer from cognitive biases and limited financial literacy compared to other, professional, investors.

It was this conclusion that led behavioural economists Richard Thaler and Shlomo Benartzi to develop a practical tool to encourage saving for retirement. This tool is known as SMART (save more and retire tomorrow).

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