Musings on why people don't plan for retirement

The following three days of posts are from Lessons from Behavioral Finance for Retirement Plan Design by Olivia Mitchell and Stephen Utkus


There is a movement worldwide to the idea of the individual become more responsible for his/her own retirement funding/planning. This is being done by moving away from the traditional pension plan that defines a benefit for an employee when the employee’s retires. (This is called a defined benefit [DB] plan) toward a participant-directed defined contribution (DC) plan. 


These plans are rapidly becoming the cornerstone of the private sector retirement system around the world.

Participant-managed DC plans are the main feature of national pension reforms already implemented in many Latin American nations, as well as in Germany, Sweden, Russia, Australia and most recently, Canada

Underlying this movement is an implicit assumption about behavior. The assumption is that the individual is well-informed and understands economic theory and who also acts rationally to maximize her/his self-interest. To this end, it is assumed that he/she can interpret and weigh information presented regarding options offered by employers and governments, appropriately evaluate and balance these choices, and then make an informed decision based on weighing the alternatives

There are a number of problems with this assumption.

1.  There are certain types of decisions and problems that may be simply too complex for individuals to master on their own.

2.  Individuals may have the right intentions or beliefs, but they may lack the willpower to carry out the appropriate changes in behavior

3.  Many people do seek to maximize their personal welfare, yet they prove far more cooperative and altruistic than traditional economic theory predicts they will be.

Neoclassical economic theory states that people will examine the trade-off between current and future consumption. People who hold this theory believe people are able to compare the benefit gained from consuming their income today, with the benefits of deferring some of that income to the future. Those who believe in this theory think this is what drives contributions to individual retirement plans, with the goal of the individual being to save for retirement.

There is another theory of savings (the life-cycle theory), which states that individuals are rational planners of their consumption and saving needs over their lifetimes, taking into account the interests of their heirs. Therefore, during their younger years, workers tend to be net dissavers, borrowing now to boost their current consumption; middle-aged individuals become net savers and purchasers of financial assets and enter “accumulation” phase, during which they stockpile assets for the final, retired phase of life. On balance, the life-cycle theory is thought by business, government and economists to do a reasonable job of explaining patterns of household saving and spending behavior.

If middle age (defined by the US Census as between 35 to 54) is when individuals begin to plan for retirement at 65 what happens when we move the retirement age to 67? How long before they implement a change should the government give its people. Our government is talking about the changes affecting those who are just turning 58. Maybe they should move the timelines back so those who are just turning 35 have time to prepare properly.

The problem is that being good at retirement savings requires accurate estimates of uncertain future processes including lifetime earnings, asset returns, tax rates, family and health status, and longevity. In order to solve this problem, the human brain as a calculating machine would need to have the capacity to solve much decades-long time value of money problems, with massive uncertainties as to stochastic cash flows and their timing.

In fact, survey and empirical research suggests that individuals are not particularly good at retirement savings. Furthermore, the empirical evidence suggests that failing to save enough also has serious negative consequences