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September 4, 2008

Making savings the default option

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Americans don't save anymore. The U.S. savings rate actually went negative in 2005 -- the first time that's happened since the Great Depression.

Failure to save is particularly risky for those with modest or low incomes. They have no cushion for sudden needs -- like emergency medical or car-repair bills. They have greater difficulty keeping pace with sudden price increases. (It was Americans with little to no savings who got lured into no-down-payment mortgages.)

And they build no nest egg for retirement.

But how do you get people to save? It's typically not that they lack funds. Even households earning less than $13,000 "invest," on average, 9 percent of their income in lottery tickets. They just don't choose to save it.

Ads promoting saving don't seem to work. Employers find it hard to get people to sign up for 401(k)s. Tax incentives spur saving among the affluent, but have little impact on people who don't pay much in tax anyway.

A group of researchers -- drawn from disparate think tanks and universities like the Brookings Institution, the Heritage Foundation and Georgetown University -- are promoting a simple but creative idea to reverse the dismal savings trend: "auto-enrollment."

It's based on a blend of economics and psychology, known as "behavioral economics," which recognizes that people often make decisions based more on habit and human nature rather than on textbook economics.

Basically, the idea is to change the default for saving from opting-in to opting-out. So instead of having to decide consciously to save at your place of work, you would be automatically enrolled in a saving plan unless you consciously decide not to save and take steps to opt out.

This could substantially increase saving by relying on behavioral inertia. We tend to just go with the flow. That's why having default withholding of taxes at the workplace leads most people to put aside enough for their taxes each year -- often more than enough. People essentially can opt out of tax withholding and pay little before April 15th. But they usually don't do that.

It's also why car-rental agencies can get so many of us to buy supplemental car insurance we don't really need. You can avoid buying the insurance just by initialing a few spaces on a form, and your bill would be lower. But an amazingly high number of people just go along and pay more. That's human nature.

These behavioral realities contribute to the savings problem, but also give a clue to the solution. Research indicates that getting people to opt in to savings plans is an uphill struggle. You can hold seminars, telling people how much they will gain from regular savings. People will commit to save. They will take the forms. They will intend to sign up. But most never get around to it.

The research also shows that if people are signed up automatically in a savings plan - with money taken out of their paychecks - and then told that they can fill in a form to opt out, most just never get around to opting out.

This switch in the saving default can produce dramatic results. Research shows that switching 401(k)-style retirement plans to an automatic-enrollment default typically boosts the average participation rate from 75 percent to around 90 percent.

Even more significant, a leading study found the enrollment rate leaps from just 13 percent to a staggering 80 percent among savings-starved lower-income workers (those earning below $20,000).

Working together in an organization called the Retirement Security Project, an ideologically diverse group of think tank analysts has used this important research about human nature to craft a concrete proposal for an "automatic" individual retirement account (IRA).

Under the proposal, companies that sponsor retirement plans would get a new, temporary tax incentive to set up an automatic-enrollment system for their employees. The employer tax break would cover the start-up costs, while employees would enjoy the long-term tax benefits of IRA-type savings plans.

The automatic enrollment would channel employee money and any employer matching contribution into the IRAs. Employees could specify a particular IRA, but if they do nothing, the money would go into a low-cost default IRA.

What are the odds of this potentially dramatic boost to savings becoming law? Very good.

Already, bipartisan legislation has been introduced by key members in the Senate and the House. Groups like AARP and the Minority Business Roundtable backed the proposal. And both presidential candidates, Sen. Barack Obama and Sen. John McCain, have endorsed the concept of automatic enrollment.

It's a breathtakingly simple idea that everyone can be for, and it would make a huge difference to the economic prospects of millions of Americans.

Stuart Butler is vice president for domestic policy issues for the Heritage Foundation (heritage.org).

First appeared in the Washington Times

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