Nudge or Shove? The Many Shades of Financial Paternalism
Discussions about the value of paternalism have been in vogue these days. The latest contribution: In “Mandatory Retirement Savings” (PDF), a Financial Analysts Journal article just released ahead of print, behavioral finance expert Meir Statman advocates what he calls a “fully paternalistic shove.” He argues that individuals should be (figuratively) “shoved” into mandatory retirement saving plans for their own good and for the good of society so that they do not become a burden on their adult children or tax the system with excessive transfer payments.
Paternalism has long been a subject of study in philosophy and applied ethics. In medicine, for example, one is concerned with the ethics of empowering a doctor with unilateral decision-making authority based on his or her expert knowledge versus involving the patient in the process. With decisions as complex as medical ones, selective paternalism may be the best approach, because sometimes patients can put themselves or their dependents in harm’s way due to their emotional distress or confusion about the options.
In economic and financial matters, paternalism — protecting an individual from himself or herself — comes in many guises with one common theme: the maximization of welfare. Yet it raises a question with no easy answers: When exactly should individuals or investors be protected from making their own bad choices? While many commentators will balk at a plan as overtly paternalistic as Statman’s proposal, there are softer shades of paternalism built into common industry practices (e.g., regulations, codes of ethics, etc.).
Because Statman raises a concern about taxes and transfer payments, one is led to consider the externalities involved and ask whether economics can shed some light on the times when interference is appropriate. If I continually drink too much soda or avoid saving, I may become a burden on the health care system or the social safety net and thus create a market inefficiency through my negative externality.
Paternalism does indeed appear in normative economics through the two fundamental theorems of welfare economics, one highlighting the role of the market, which we will call market paternalism, and the other of the government. Normative economics straddles market efficiency and equity: Market efficiency calls for a laissez-faire approach, equity for redistribution. The mathematical theorems behind these ideals are clear enough to prove but difficult to apply as they run quickly into political science.
Paternalism is all about protecting individuals and can come in the form of one individual influencing another or in the form of corporate or government programs. As Statman points out, the social security program in the United States is a hard paternalism program. Aligned with influencing savings, investor protection programs depend on the consistent overview of such regulators as the Securities and Exchange Commission (SEC) in the United States and the Financial Conduct Authority (FCA) in the United Kingdom. In the United Kingdom, the retail distribution review led to improvements in financial conduct supervision. In the absence of expected moral behavior on the part of firms, some financial experts advocate that the SEC act as a parent to the firm, which plays the role of a child, developing financial products within the rules. Others have advocated that the SEC should insist on firm disclosures of political contributions.
In a practical application of one individual influencing another, financial advisers get more help from behavioral rather than from normative economics as they manage emotions and expectations, guiding clients away from the irrational compulsion to buy high and sell low. With tools such as investment policy statements, financial advisers try to protect investors from themselves. Nevertheless, sometimes clients with a moderate risk profile choose the height of a bubble to pressure brokers into aggressive growth funds. While many would agree that advisers should practice soft paternalism (intervening to protect a client from an imminent danger that he or she does not see), others might even encourage the practice of hard paternalism (interfering when the client is aware of the danger). Advisers occasionally need the courage to “fire” clients who insist on hurting themselves.
Paternalism need not take the form of advice or mandates. Hidden persuaders provide information and tilt wants, and behavioral experts can try to “nudge” people with default provisions that encourage what the experts view as better outcomes. Libertarian paternalism seeks better outcomes while protecting the individual’s freedom to choose. For example, based on the theory that inertia will keep the employee saving once in the plan, nudges in defined-contribution pension plans generally involve automatic enrollment but allow employees the freedom to hurt themselves by opting out.
In his FAJ article, Statman judges such nudging as insufficient and argues it is “time to switch from nudging to shoving . . . and to replace libertarian-paternalistic voluntary defined-contribution accounts with fully paternalistic mandatory defined-contribution plans for all.” He notes that “nudges are largely ineffective among the poor” and that “more than 20% of employees with income lower than $20,000 did not enroll [in a defined-contribution plan] even when enrollment was automatic.” He also points out that “even high incomes do not ensure savings because spending temptations abound.”
Although Statman acknowledges that “people with no income will continue to have no source for savings,” is it really so surprising that less than 80% of employees earning less than $20,000 a year stayed with the plan? Living off of less than $1,700 per month (before taxes and social security) poses challenging budget issues for those with dependents. Nudges may not be totally effective among the poor, but are shoves then the answer for retirement savings? Could it be that the retirement savings problem is as much a problem of income inequality factors as it is of the savings factors that Statman mentions (genetics, personality, and parental influence on an individual’s savings behavior)?
To solve the retirement savings problem, Statman has six recommendations. Two regarding financial education and plan-fee limits are only tangential to the paternalism issue. Keeping in mind the distinction between saving and investing, we might divide the remaining four into three hard-paternalism recommendations on saving and a soft one on investing. The three savings recommendations are:
- contributions by the employer and employee must total 12% (it’s instructive to compare this recommendation to the US 12.4% social security tax, which is split equally between employer and employee);
- there must be a central agency to administer plans for employees whose employers do not provide defined-contribution savings plans; and
- borrowing from retirement funds must be prohibited.
In the United States, a $20,000 annual salary may rest above the poverty threshold, but does shoving such earners into a savings plan solve their income-smoothing problem? As a founding father of the libertarian approach, Friedrich Hayek would have argued perhaps that individuals with such low earnings would still know their own situation best.
Statman’s three hard paternalism recommendations can be expected to create unintended consequences as instituting rules (think, soda laws) or removing them (think, Glass-Steagall) generally leads to unanticipated outcomes and financial innovation. In the United Kingdom, there has been a problem of companies seeking to avoid strict governance. How then will a 12% total contribution rule work, and what will be its consequences?
Moving from the saving to the investing side, we see Statman making his soft paternalism recommendation: default offerings of passive, well-diversified target-date funds set in one-year intervals. Such life-cycle funds provide decreasing equity exposure with shorter horizons on the faulty assumption that stocks are less volatile in the long run.
There are problems with target-date funds as a default provision. First, the fund has the implicit appearance of being recommended by an expert, the plan sponsor who put the default in place. Second, increasing equity exposure with longer time horizon has no basis in economic theory. Third, the frequent appearance of active funds with their alpha-seeking orientation adds unnecessary fees in what is primarily an asset allocation approach (a fee problem that Statman avoids by his suggestion that the funds be passive).
Influencing outcomes lies at the core of the various shades of paternalism. In perfect markets with no agency costs, market paternalism might lead to optimal welfare. In imperfect markets, regulators acting as parents can stem the tide of overly aggressive financial innovation. Soft paternalism has certainly nudged individuals away from investing equal amounts in every fund offering of a plan. Even hard paternalism might have worked with social security, if the plan had been managed more effectively. As long as optimal welfare is a concern, questions about the role and nature of paternalism will persist.
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