Tuesday, August 3, 2010

Can behavioral economics save us from ourselves?

The University of Chicago Magazine
February 2005

Traditional economics holds that humans, as rational beings, make choices to maximize their welfare. Chicago’s Richard Thaler argues that policy makers—including those working on President Bush’s plan to partially privatize Social Security—would do well to remember that rationality has its bounds.
The advertisements appeared in late August 2000 on Swedish television and in women’s magazines, traveling to billboards and bus stops and the pages of daily newspapers. They were variations on a theme. Two people have a discussion. One has made provisions for old age, the other has not. Then comes the good news: Sweden is partially privatizing its social-security system, so it’s not too late for the slacker to catch up. Last comes the tag line, which translates, “There is another way to secure your future. Make sure you choose where to invest your premium pension this autumn.”

A few weeks later Sweden’s 4.4 million working-age adults received blue packets in the mail. They had four weeks to select an investment portfolio and return the form in a postage-paid envelope. They could, a personalized letter explained, invest 2.5 percent of their annual pay in the new funds, while the rest of the 18.5 percent of their annual income contributed to social security would remain in the traditional pension system. A “What to Do” brochure described the procedure in four steps. A catalog gave an “easy to understand” list of 456 funds from which investors could pick. Although a default fund offered a low-cost, well-diversified allocation of assets, the overall message was clear: Swedes should take charge of their own financial futures.

So began what Richard Thaler, the Robert P. Gwinn distinguished service professor of behavioral science, economics, and finance in the Graduate School of Business, considers a massive field experiment into what could happen if every Lars, Olaf, and Kristina chose how to manage their social-security funds. In the American Economics Association’s May 2004 AEA Papers and Proceedings Thaler and GSB doctoral candidate Henrik Cronqvist analyzed early results from Sweden’s Pension Premium Authority (PPM). Moving beyond Sweden, the research offers timely insights as President George W. Bush renews his efforts to partially privatize Social Security. While most economic writings on social-security design focus on macroeconomic aspects such as funding, Thaler and Cronqvist’s approach is microeconomic. Analyzing the particulars of PPM’s set-up and how those details influenced the users’ behavior, they found some “undesirable” results: Swedes who actively invested their own pensions chose more expensive, less diversified funds than those picked by the default plan.


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