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Our guest this week is James Choi. Dr. Choi is a professor of finance at the Yale School of Management, where he teaches and conducts research on behavioral finance and economics, household finance, and sociology, among other topics. He is a two-time recipient of the TIAA Paul A. Samuelson Award for outstanding scholarly writing on lifelong financial security, and his work on automatic enrollment into retirement plans has had a major influence on retirement plan policy and design. Dr. Choi is a co-director of the Retirement and Disability Research Center at the National Bureau of Economic Research and an associate editor of the Journal of Finance, among other professional and scholarly affiliations. He received both his bachelor’s degree and doctorate from Harvard University.
Retirement and Disability Research Center
Academics vs. Bestsellers
“Popular Personal Financial Advice Versus the Professors,” by James Choi, nber.com, October 2022.
Choice Architecture and Retirement Plan Design
“Nudge: Improving Decisions About Health, Wealth, and Happiness,” by Richard Thaler and Cass Sunstein, researchgate.net, June 2009.
“Contributions to Defined Contribution Pension Plans,” by James Choi, nber.org, August 2015.
“Small Cues Change Savings Choices,” by James Choi, Emily Haisley, Jennifer Kurkoski, Cade Massey, Journal of Economic Behavior & Organization, August 2017.
“Plan Design and 401(k) Savings Outcomes,” by James Choi, David Laibson, and Brigitte Madrian, National Tax Journal, June 2004.
“Saving for Retirement on the Path of Least Resistance,” by James Choi, David Laibson, Brigitte Madrian, and Andrew Metrick, scholar.harvard.edu., Dec. 1, 2005.
“Which Early Withdrawal Penalty Attracts the Most Deposits to a Commitment Savings Account?” by James Choi, John Beshears, Christopher Harris, David Laibson, Brigitte Madrian, and Jung Sakong, Journal of Public Economics, Feb. 8, 2020.
“Present Bias Causes and Then Dissipates Auto-Enrollment Savings Effects,” by John Beshears, James Choi, David Laibson, and Peter Maxted, hbs.edu, 2022.
Retirement Readiness and Policy Response
“Borrowing to Save? The Impact of Automatic Enrollment on Debt,” by John Beshears, James Choi, David Laibson, Brigitte Madrian, and William Skimmyhorn, nber.org, July 2019.
“The Effect of Providing Peer Information on Retirement Savings Decisions,” by James Choi, John Beshears, David Laibson, Brigitte Madrian, and Katherine Milkman, The Journal of Finance, June 2015.
“Building Emergency Savings Through Employer-Sponsored Rainy-Day Savings Accounts,” by John Beshears, James Choi, J. Mark Iwry, David John, David Laibson, and Brigitte Madrian, journals.uchicago.edu, 2020.
Saving, Spending, Investor Behavior
“Economists Confirm It’s Actually OK to not Save Money in Your 20s,” by Sarah Hansen, money.com, Sept. 2, 2022.
“Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds,” by James Choi, Xavier Gabaix, David Laibson, and Brigitte Madrian, nber.org, December 2005.
“Does Aggregated Returns Disclosure Increase Portfolio Risk Taking?” by James Choi, James Beshears, David Laibson, and Brigitte Madrian, National Library of Medicine, Oct. 19, 2016.
“Brigitte Madrian: ‘Inertia Can Actually Be a Helpful Thing,’” The Long View podcast, Morningstar.com, April 22, 2020.
Morningstar Investment Conference 2023
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(Please stay tuned for important disclosure information at the conclusion of this episode.)
Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Ptak: Our guest this week is James Choi. Dr. Choi is a professor of finance at the Yale School of Management, where he teaches and conducts research on behavioral finance and economics, household finance, and sociology, among other topics. He is a two-time recipient of the TIAA Paul A. Samuelson Award for outstanding scholarly writing on lifelong financial security, and his work on automatic enrollment into retirement plans has had a major influence on retirement plan policy and design. Dr. Choi is a co-director of the Retirement and Disability Research Center at the National Bureau of Economic Research and an associate editor of the Journal of Finance, among other professional and scholarly affiliations. He received both his bachelor’s degree and doctorate from Harvard University.
James, welcome to The Long View.
James Choi: Thank you for having me.
Ptak: It’s our pleasure. Thank you so much for joining us. We wanted to start off with a little bit of background. To get started, for the benefit of those listening who might not be as familiar with your work, can you talk briefly about topics you focused on in your research and what sparked your interest in those areas?
Choi: Generally, I’d say that I work in behavioral finance and household finance. I tell people that I study dumb things ordinary people do with their money. I’ve done a lot of work in retirement savings behavior. Some of my earliest papers had to do with studying what happens when you automatically enroll people in 401(k) savings plans. So, it goes from opt-in to opt-out and showed that that made a big difference in the fraction of people who end up participating in their 401(k) plans. That’s really some of my earliest work and which had a fair amount of policy impact around the world. I’ve gotten more interested recently in just thinking about what should people be doing in their personal finances. I’ve have created a personal finance course at Yale and still developing that and thinking about what are the good ways to give people advice.
Benz: We want to delve into some of your research certainly in the course of the conversation. But you’ve collaborated with other researchers on many of the papers you’ve written, some multiple times. I know we’ve previously interviewed Brigitte Madrian here on this podcast. Can you talk about what you look for in a potential collaborator and also what lessons has that experience imparted more generally about what makes for a good collaboration?
Choi: I don’t know if I’ve necessarily been that strategic in the choice of collaborators that I’ve worked with over the course of my career. I think a lot of it is happenstance accidents of history; right person there at the right time has the right opportunity, the right idea. And so, then you start working with them and see if the idea has any legs, and then sometimes, it becomes a relationship that lasts for decades actually, because you just have a good dynamic with the person and they stimulate you, they make you a better thinker, a better person than you would have been on your own.
I think that what does make a collaboration work really well in the long run is first a shared conception of what makes good research, a shared vision of how a paper should be crafted to have the best impact, the most contribution intellectually. And then, something that people talk about, which I think is very true, is in a collaboration there just has to be a safe space to say stupid things and just to try things out and you won’t get laughed out of the room or ridiculed because you said something stupid. So, you just are able to try things out and if what you said was stupid, then you are led to that conclusion gently rather than being told to your face, my gosh, I can’t believe you just said that.
Ptak: And we’re going to spend the remainder of the conversation delving into your research, which I can assure you is anything but stupid. But the first place I wanted to turn to was some work that you did, widely cited work, examining personal finance advice that’s dispensed by academics and then also by bestselling authors. That paper examined how the personal advice dispensed by those bestselling authors differed from the advice academics gave on saving and investment. Can you tell us what you found broadly speaking?
Choi: I think there were areas of agreement and areas of disagreement. I think the areas of most profound disagreement had to do with savings and paying off debt. And then, on asset allocation, I think that the academics and the popular authors are broadly in agreement, but often for different reasons. So, let me talk about the savings first.
From the perspective of economists, the fundamental thing is you want to smooth your consumption over time to have a fairly consistent level of spending over time. And that’s because the fifth slice of pizza that you eat is never as satisfying as the fourth slice of pizza that you eat, which is never as satisfying as the third slice of pizza that you eat. And so, instead of eating 14,000 calories on Sunday and zero for the rest of the week, life is just more pleasant if you eat 2,000 calories every single day. And similarly, if you are spending a fairly consistent amount from year to year, that’s what economists say is the right thing to do. And that means that when you’re young, say you’re in your 20s, your income is fairly low by the standards of the rest of your life, and in your 40s and 50s, those are your peak earnings years. And so, if you’re spending a consistent amount over time, you’re not going to be saving all that much in your 20s and you’re going to be a super saver in your 40s and 50s. So, that’s the economist conception of the wise financial life planning.
The popular authors have a pretty different view on these things. So, instead of smoothing out your consumption over time, they say that you should be smoothing out your savings rates over time. So, you should be consistently saving 10% to 15% of your income through thick and thin, whether you’re young or you’re middle-aged, or you’re fairly old. This is the discipline that you should be building up—that you should basically become the type of person who saves, who lives within their means, and that’s the way that you’re going to assure a comfortable financial future for yourself. So, I think that’s the biggest kind of divergence that I saw between the popular authors and the economists.
Benz: What could academics learn from these personal finance bestsellers to make their research more useful? And conversely, what could the bestseller authors take from academia to make their own work more rigorous, do you think?
Choi: I think that the personal finance authors have the great virtue of giving advice that’s relatively easy to understand and to implement. Economic models are often quite complicated to even get to the solution of what should you do. And sometimes, you need a supercomputer to get to the solutions from these economic models. And of course, none of us is going to do that in our own personal financial lives. So, I think there is some real social value that’s created from giving advice that is easily distilled and is easily computed. And that’s something that the personal finance authors do that the economists have not really been paying much attention to over the years and decades. So, that’s something that I think that we could learn.
I think there’s also this notion that the popular personal finance authors have, which is that you need to make concessions to human nature in the advice that you give. I often think of spending as having an analogy to diet. So, the best diet is the one that’s reasonable that you can stick with. If that means that occasionally you need to have some cheat meals and eat a lot of junk food one day a week, and that’s going to help you stay on the straight and narrow for the rest of the week, well, that’s the right diet for you. Because it’s not possible for you to only eat healthy food all the time. Similarly, sometimes the popular authors will say, look, this is maybe from the arithmetic perspective, not the wealth-maximizing best thing for you to do, but this is going to give you motivation to stick to your financial plan. And that’s a consideration that’s really not present at all in academic economic research or thinking. I think that’s something else that we economists could learn from the popular authors and actually bring some scientific evidence to bear on which strategies actually work to motivate people and to keep them on the straight and narrow. I think that we basically have no idea. So, we’re left with what these popular authors are telling us, and they are just going off of folk wisdom and introspection without really an evidence base.
Conversely, what can the popular authors learn from the economists? I think the economists have spent a lot of time looking at data and trying to produce evidence, and sometimes these popular authors make assertions that are just not in the data at all. So, it would be good for them to be more in touch with what the academics have examined and tried to uncover evidence about.
Ptak: And we don’t have to spend a lot of time in it, but is it safe to say that their view on housing and the prudence of investing in a home is one of those places where perhaps there isn’t the ironclad support in the literature that they might assume in making that assertion?
Choi: Actually, on housing, they were more aligned with economists’ view than I thought. I think that when you just talk to people casually, they think that housing is this fantastic investment, and everybody should have a house. And I think that I found that the weight of the popular authors’ opinion was that a house is something that you live in. You should buy a house for its properties as a dwelling place, not necessarily as a great investment vehicle. So, there I think there was more alignment. Where I thought there was less alignment was on mortgages. So, the popular authors will strongly recommend getting a fixed-rate mortgage because they think that that is safe, whereas if you look at the academic economic models, they tend to think that adjustable-rate mortgages are awesome for a lot of people. And that’s because, on average, adjustable-rate mortgages have lower interest payments; they have lower interest rates because their interest rates are pegged to a short maturity interest rate rather than the long maturity interest rate that fixed-rate mortgages are pegged to. So, often the economist model would say that unless you’re really stretching your budget to afford this house, the adjustable-rate mortgage is better for you.
Benz: You’ve done a lot of work on choice architecture, both within and outside of the context of retirement plans. To begin with, can you explain what you mean by choice architecture?
Choi: I can’t take credit for the phrase myself. Choice architecture was a phrase that was coined by Cass Sunstein and Richard Thaler, and they used that phrase to refer to an emerging body of research that had come into being at the time that they’ve coined the phrase that indicated the circumstances and contexts within which a choice is made can make a big difference to what choice is ultimately made. And so, even the small things will matter is the takeaway that they pushed from that phrase. The biggest example of choice architecture that’s used today is opt-in versus opt-out, particularly in the finance context in retirement savings plan. So, if you have to opt-out savings, then you’re much more likely to end up saving in the retirement savings plan than if you have to opt in. This was a big discovery at the time. This was about 20 years ago where this really became known, because economists thought retirement savings, it’s such a high-stakes decision that something as minor as have to opt-in versus opt-out couldn’t possibly have a material impact of what people end up doing, and what we’ve discovered is that actually that very minor change in the choice architecture has a big impact on what people end up doing.
Ptak: I wanted to build on that and ask you about the implications of what’s referred to as active choice for retirement plan design. Specifically, when is it better for the plan sponsor to choose on a participant’s behalf and when is it preferable for the participant herself to actively make the choice?
Choi: So, let me back up for a second and just define what active choice is, because your listeners might not be so familiar with that phrase.
Ptak: Yes. Please do. Thank you.
Choi: When people first started talking about defaults in retirement savings plans and default contribution rate or default asset allocation, there was this thought that maybe we don’t like defaults because they’re quite paternalistic in who is the employer or the plan administrator, or whoever, who do they think they are to choose as a default. But actually, if you give people the option to do nothing, then something has to happen when they choose nothing. And that something is the default. And so, the only way that you can get away from choosing a default is if you take away the option for people to do nothing. So, that’s what an active choice regime is. It says that by a certain deadline you must actively state what your preference is. So, in the 401(k) retirement savings plan context, I do want to save in the 401(k) plan at this contribution rate and asset allocation, or no, I do not want to save in the 401(k) plan at any positive contribution rate. So, no matter what you want, you have to actively make a statement of your preference. So, that’s an active choice regime.
Honestly, it has not been a very common implementation within retirement savings plans. You see it more often in benefits elections. So, in open-enrollment periods at companies, you have to choose actively what health insurance plan you’re going to be in, for example. In what context will we think that active choice is better than setting some kind of default? I think it would be in situations where there’s a lot of heterogeneity in the right decision for people. So, you can’t just say, oh, 99% of the population would be better off with Choice A rather than Choice B. Well, then, maybe we should just choose Choice A for everybody and let the small sliver of people for whom Choice B is better actively choose to opt out of that default.
It’s also probably going to be better to have a default rather than active choice if people just don’t have a lot of expertise in choosing one option versus the other, in which case you might want to step in and provide more guidance to the individuals rather than saying you’re on your own, you have to make a choice, but we’re not going to tell you what it is.
Benz: I have to ask, is the point at which people leave their employer-provided plans and have to make decisions about decumulation and spending from their portfolio and whether to buy an annuity and so forth, has that piece of the life stage planning been underdiscussed with respect to defaults, do you think?
Choi: The decumulation decision has been a thorn in the side of, I think, the retirement finance industry for a long time. And I remember even 15, 20 years ago, people said, oh, we don’t talk about decumulation nearly enough, but here we are. And I don’t think that the conversation has advanced all that much. And I think it’s because it’s a hard problem and to know exactly what the right rate of decumulation is for any given individual is pretty hard not only because of considerations of, say, life expectancy or family circumstance, but also we know now from some JPMorgan Chase data that when people retire, it’s not that they spend smoothly over the course of their retirement. It seems like at the beginning there’s a lot of spending that happens as people try to figure out what’s right for them at this stage of life. So, they might buy a boat, and then they discover, oh, I don’t like boating at all. And so, they’ll try a few different things, and it costs money to try these things. And then, eventually, they’ll settle down into maybe a more consistent pattern of life in retirement. It’s these very idiosyncratic features of what people want in their spending path that makes choosing on their behalf, say, through some default mechanism, I think, fairly difficult.
Ptak: Wanted to switch over and talk about retirement plan design, which is an area in which your research has been quite influential. More than two decades ago, you were writing about how 401(k) plans needed to make “the path of least resistance,” a key design feature. That was before features like auto enroll and default investment choices were a thing in defined-contribution plans. What led you to the conclusion back then?
Choi: Well, so even though these features were not common back then, there were a small number of companies that implemented automatic enrollment at the time. So, that’s why we were able to study empirically what happens when you switch from opt-in to opt-out, and it turned out to have such a powerful effect that it just seemed crazy not to be thinking about as a first-order consideration in retirement savings plan design. In fact, these effects were much more powerful than the effect that you would get from, say, matching contributions. In the old days, we thought if not enough people are saving in our 401(k) plan, how do we get them to save? Well, let’s bribe them. So, let’s institute the matching contribution. That’s the way that we’re going to get them in. And matching does have a modest positive effect on retirement savings plan contributions, but nothing close to what you get from automatic enrollment. So, it was really those few pioneering companies in the late ‘90s and early 2000s that led the way and tried something new that allowed us to study what happens when you change the path of least resistance, when you change what the default action is and being able to see that that has a really, really powerful effect.
Benz: We’ve clearly made progress in increasing participation in plans in part because of some of the defaults that you’ve been discussing. What other key design features are still lacking if we want to get fuller participation from employees and also just improve retirement preparedness?
Choi: I think that there are probably two things I would think about. One is on the early withdrawal margins. So, we know that a huge amount of money leaks out from the retirement savings system before the age of 59.5. We know this from IRS tax records that people are withdrawing this money well before retirement. I think that there’s a lot of decumulation that’s happening in ways that I think were not really intended for the system when it was erected piecemeal over the decades. I think there is a serious conversation that we could have about whether we want to plug some of those holes in the retirement savings plan, make the system a lot less liquid. And indeed, if you look across the world at other developed countries, their pension systems tend to be a lot more illiquid than the U.S. system is. So, that’s the one dimension.
The other dimension is that we don’t have equal access to common savings plans across the adult population in the U.S. So, about half of U.S. adults actually don’t have access to a 401(k) through their employer. And I think that there’s not rigorous evidence as to exactly what a 401(k) does for your retirement savings accumulation, because of course, it’s not random who ends up at a company that has a 401(k) plan versus doesn’t. But it does seem reasonable to think that having this mechanism where out of every paycheck a certain amount is deducted and put away in the retirement savings plan is helpful for actually building up some retirement wealth for yourself. And so, I think that for the half of the adult population that doesn’t have this, it would be nice if there were a better mechanism for getting them to participate in the retirement saving system.
Ptak: Well, since you’re mentioning that, do you think we’d be better off if there was a single government-sponsored retirement plan styled after the Thrift Savings Plan instead of the current employer-led patchwork approach that you’ve been talking about?
Choi: I think that if we could run the system as its Platonic ideal was if it was, say, hit or run by the Singaporean bureaucrats, then yeah, I think that would be good. Maybe even run Thrift Savings Plan. It’s actually a fairly well-run plan. So, if that could scale up, then I think that that could be quite a good thing. But of course, whenever you scale things, there are complications and you do have concerns about lack of competition and so on. So, I think the political economy of all that, I don’t have necessarily a strong opinion on.
I think one thing that you have seen that’s trying to increase access and democratize access to the retirement savings system is these automatic IRAs that have been springing up at the state and local level across the U.S. So, what’s happening here is that you do have employers that don’t offer a 401(k) plan. They are now being required to automatically enroll these employees in a payroll-deduction IRA. And so, a portion of each paycheck does go off into an IRA that’s sponsored by the state or the locality. So, I think that this is progress. But what I don’t like about the way that this is emerging is that the system is very piecemeal. For example, in Connecticut, the system is being set up. Connecticut is a small state, and people leave Connecticut. So, what happens to your small-balance auto IRA when you leave Connecticut? Well, you’re not going to get anymore contributions from your payroll deduction going into that account. So, you end up having this small account that is accumulating administrative fees, which might be subsidized by the state but might not be in the long run. And you could have a situation where somebody has five or six of these small-balance accounts just scattered across the nation. And we know that it’s a problem that when this kind of thing happens, people forget. They lose track of their money. And so, what would be a better solution is some kind of national auto IRA, where even if you move from California to Nevada to Iowa, you’re going to be able to keep that same account without going through a lot of hoops and just make that administratively much easier for the individual. But we’re not there yet and Congress has not acted with any kind of speed to create that sort of system.
Benz: I think SECURE 2.0 had something about helping people not lose track of old 401(k) assets, but I guess it’s to be determined whether that will truly be useful. You conducted a study in which you asked whether a form of peer pressure or social comparisons might induce retirement plan participants to save more. The results were surprising. Can you talk about what you found?
Choi: This was an experiment that was using a technique known as social norms marketing. This is a technique that originated on college campuses, I believe, where the idea was that people aren’t really aware of what their peers are doing and so they have a distorted view of what’s actually normal. So, the social norms marketing campaign in colleges was, did you know that your peers, your fellow students, actually don’t drink as much as you thought they do? This is exactly how much they drink per week. And the idea was that that would cause the students that saw the message to drink less themselves. Because their sense of what was normal was recalibrated. We tried to test this kind of approach in the retirement savings context. So, we worked with one company to send their low-savings employees messages that said, did you know that among your co-workers in your age bracket, X percent of them are saving something in the 401(k) plan, or X percent of them are saving up to the max threshold—which was I think 6% of income in the 401(k) plan? And then, if you would like to also save at 6% of your income in the 401(k) plan, then you can just check this box in this form and mail it in.
Our thought was that when these low-savers saw just how many of their co-workers were saving the 401(k) plan that they would want to do the same. And we saw that actually, for many of them, there was a perverse effect where they became less likely to join the 401(k) plan when they saw how many of their peers were in already in the 401(k) plan. And it turned out that the higher that peer number was, the more discouraged they seemed to be from coming into the plan. Our speculation as to why this happened is that when you see just how far behind you are and just how many people you’re behind, it just discourages you. You just want to tune out and stop thinking about it. And so that’s what caused people to be less likely to join the 401(k) plan after receiving that message. So, it was quite a surprising result for us.
Ptak: Wanted to shift and talk for a bit about emergency savings, and we’ll also talk about SECURE Act 2.0. But you’ve been a proponent of building rainy day retirement savings accounts into retirement plans. So, quite apart from SECURE Act 2.0 and what it does to advance that, maybe you can talk about what form ideally such accounts would take? For instance, are they a sidecar option on a plan menu that someone could opt to direct a portion of their savings into? Like when somebody does it right, what does this look like?
Choi: I don’t know if we necessarily know exactly what right looks like because these are relatively new, not a lot of employers are doing them. I think that we believe that if these were auto-enrollment accounts, by default were contributing to them rather than not, that would be helpful. We think that if they were pretty liquid but not extremely, extremely liquid, so you have to pause for a little bit before you tap this body, so you couldn’t spend it on really frivolous stuff. But when you really needed it, it was there for you and administratively striking that balance I think is pretty difficult. So, I think that the implementations that we see tend to be just extremely liquid. But that would be another feature that would be nice. I think it would be nice if they were somehow integrated with the regular retirement savings account. So, once you hit some kind of dollar-limit accumulation in the emergency savings account, then the additional contributions that would have gone into that rainy day savings account would instead be redirected into the 401(k) or the retirement savings portion of the plan. I think that would be desirable.
There’s a question of how matches are handled in a rainy-day saving system. So, suppose that you’re being auto-enrolled in the rainy-day savings account. But there’s also a match in your 401(k), and you’re not being matched on your rainy-day contributions, then employees might be annoyed and say, how come you are directing some of my contributions by default into the rainy-day savings account when I’m not maxed out on my matching contributions in the retirement savings side of the ledger? So, one way to address that concern is to actually match these contributions to the rainy-day savings account. That could be a match that goes directly into the rainy-day savings account, or it could be a match that goes into the retirement savings portion of the account. That does raise a concern that some people might try to gain the system where they will just contribute money to the rainy-day savings account and immediately withdraw it because all they want to do is to reap the matching contributions. I think that’s a complication. I think that that’s not going to be a very common behavior, but it could become a problem in certain contexts. So, that’s an issue that we need to keep an eye out for. I think there are a lot of design choices that have to be made and we’ll see as hopefully these things become more prevalent, what does work and what doesn’t work.
Benz: Delving into SECURE 2.0 and the emergency savings provision that’s part of SECURE 2.0, can you talk about that and whether, in your view, it goes far enough in terms of helping savers establish emergency funds and helping employers help their employees with emergency savings?
Choi: I think it’s a good start. I think there are things to quibble with. My understanding is that there are some substantial administrative complications and questions that remain around the emergency savings accounts that are allowed to be established under SECURE 2.0. And there’s this other out that employers have, which is now it becomes much easier to just withdraw up to $1,000 from your 401(k) plan to cover emergencies. So, a natural response by employers will be, look, I don’t want to deal with the headache of creating these separate rainy-day savings accounts and dealing with the regulatory questions and the IT complexity of setting up these different accounts. I’m just going to take the easy way out and allow my employees to now essentially take $1,000 hardship withdrawals. It’s a very easy adjustment to make in the plan and not do anything else. I think it’s fine to have this $1,000 withdrawal option, but really the ideal is that any contribution that goes into a rainy-day savings account is additional savings on top of what you were already saving in the retirement savings plan. So, by simply opening up the $1,000 withdrawal option without changing anything else in the plan, it is opening the door to more leakage without actually putting more money into the system. I think that’s a significant potential weakness of this new act.
Ptak: I wanted to shift if I could and talk for a minute about saving and spending, which is another area that your work is examined. Can you discuss broadly how academics have tended to define “optimal saving and spending,” and how those definitions have evolved over time? I think we talked about this a little bit in the context of differences between the academics and the bestselling authors, but I thought you could give a broader perspective on this notion of what optimal saving and spending has looked like and how it’s changed through the years.
Choi: I don’t think that the academic perspective on optimal savings and spending has fundamentally changed in probably 50 years. I think, fundamentally, we think that there are two competing forces that determine how much you should be spending. One force is this consumption-smoothing motive that you want a consistent level of spending over time. So, you want to eat 2,000 calories a day rather than eating 14,000 calories on Sunday and nothing the rest of the days. But there’s this other motive, which is that, in general, you tend to get a positive rate of return if you save. So, if I can delay gratification, then the total pie gets bigger for me. And so, it’s these two competing motives that determine how quickly my spending should grow over time. And then, the starting point of what my spending path is going to be is going to depend upon just the total lifetime resources I have. So, what’s the present discounted value of your labor income, plus any other wealth that you might have coming your way?
So, it’s really trying to determine what the optimal spending path is and then there’s some income that is coming in at different points in time over the course of your life and the optimal savings rate is simply the difference, whatever it happens to be, between your income in the moment and what your optimal spending level is. But really, it’s the spending level that’s fundamental and the savings just comes in as a residual between your current income and your optimal spending level.
I think the question of whether people are saving enough for retirement has been extensively discussed, I personally think that it’s not quite clear whether on the whole Americans are under-saving or not for retirement, because that whole problem of optimal saving and spending over the lifecycle is a very complicated problem, and you can add more and more complexity than you always wonder have I added enough complexities to this problem to get to a solution that’s actually correct? And so, it’s a bit of eye of the beholder as to whether you’ve gotten to the right place, and then when you compare people’s actual behavior to whatever your model spits out, if you see a difference, is it because people are making mistake, or because your model is wrong? So, I do maintain some level of agnosticism with regards to that. I think that the more obvious deficiency in a lot of Americans’ balance sheets is the lack of emergency savings buffer, that rainy-day savings account that we were talking about before. I think that life gets pretty hard when you have no liquid-asset buffer to handle the fairly predictable emergencies that come along your way. So, the fact that there are a lot of Americans that can’t come up with $400 in an emergency without borrowing something or selling something, I think that that’s something that seems hard to really justify.
Benz: We wanted to ask, what did the pandemic reveal about the state of financial security in the U.S. and resilience? And did it tell us anything about what’s the correct policy response in a situation like that where you have a lot of folks suddenly thrust out of work?
Choi: I think that the pandemic could have been an economic catastrophe. I think we came through it relatively well at least in the short and medium run. The federal government flooded the economy with money and in retrospect, they probably did that for too long, which is why we are suffering from the inflation that we have right now. It wasn’t just the stimulus, but I think the stimulus probably played a role in that. And because the federal government flooded the economy with money, I think people’s balance sheets actually improved fairly dramatically during the depths of the pandemic. So, that was a pretty interesting phenomenon where you had, what under ordinary circumstances, would be incredible economic distress being substantially smoothed over by the balance sheet of the federal government. In the long run, we did accumulate a lot of debt and that debt needs to be serviced somehow at some point. I think that there is this open question of how does the entire balance sheet of the United States, incorporating both the household and the federal government, evolve over time?
Ptak: Wanted to see if we could spend a little bit of time talking about yet another area of research for you, which concerns, broadly speaking, investor behavior and motivations. You’ve done research essentially reexamining how investors react to the way financial information is presented. I think you were interested in whether the nature and frequency of mutual fund performance disclosure would affect how much investors allocated to stocks. Maybe you could talk briefly about what you found when you conducted that re-examination?
Choi: This was another surprising result to us. The conventional wisdom among behavioral economists was that if you show people their investment returns more often, they’re going to get scared, because of course, there are ups and downs, and sometimes you’re going to discover that your portfolio is at a loss. And so, the prospect of seeing your investment returns more often, so the theory went, would cause people to become more conservative in their investments because they anticipated the pain of seeing those losses. So, there were a bunch of influential laboratory experimental studies that showed this effect. So, my co-authors and I, we decided that we wanted to see whether those classic laboratory experimental results would hold up in a more realistic investing environment. So, we recruited a few hundred people, and we gave them a few hundred dollars each to invest in our experimental portfolio. This is actually quite an expensive experiment. And the returns on those laboratory portfolios, we had them track actual mutual funds that were out there in the market. And so, basically, these were index funds that were tracking equities, bonds, and so on. And then we randomly assigned whether these investors were encouraged to look at their portfolios every week or once every six months. The classic behavioral economics result, or the prediction, would be that those who were incentivized to look at their portfolios every week would invest less in equities than those who were incentivized to look at their portfolios only once every six months. To our surprise, there was absolutely no difference, on average, between what the frequent lookers versus the infrequent lookers allocated to equities in the portfolio. So, this was an example of something that looked quite powerful in the laboratory. But then when you brought that intervention into a more realistic setting there just was no effect.
I think that the real-life implication of this is that we actually shouldn’t be so dogmatic when we tell people, oh, you shouldn’t look your portfolio; you should just contribute money to your retirement savings account and not look at it until you’re 65. It seems that it just doesn’t really matter all that much whether people look often or infrequently.
Benz: Another experiment that you ran back in 2008, you asked subjects to hypothetically allocate $10,000 among for S&P 500 index funds that happen to charge different fees. You found that the test subjects didn’t allocate 100% of their portfolio to the cheapest fund as logic would hold. What did that tell you at the time? And how do you reconcile that with what we see now with investors resoundingly choosing the cheapest index funds? Again and again, we’re seeing all the flows go to the cheapest index funds and ETFs.
Choi: I’ll get back to the resounding flows going that way, which I agree with. But I think there’s a subtlety there. So, going back to the mystery of fee dispersion in S&P 500 index funds, we do see just no less fee dispersion in the S&P 500 index fund sector compared with other actively managed sectors of the mutual fund industry, and these are funds that are giving you exactly the same return, or almost exactly the same return pre-fees. So, why the heck are people willing to pay more for some S&P 500 index funds than others? And there was speculation hypothesizing among academic economists that these funds are providing something more than just a portfolio-return service. They are coming bundled with some customer service, maybe some financial advice, maybe some access to other mutual funds. And so, there are all these things that we weren’t observing about these funds’ quality that could be driving the difference in the fees.
So, my co-authors and I, we decided that we were going to try to create an environment where those nonportfolio differences between index funds just didn’t exist, and that’s the reason why we had people choose a portfolio among S&P 500 index funds that we were synthetically providing the returns to. So, basically, we told these subjects you have $10,000. You invest this $10,000 across these four S&P 500 index funds, and we will pay you in accordance to how these index funds in your portfolio actually perform over the next month. So, there was actual money at stake for these individuals. But because there was no actual investment in those mutual funds, there was none of this nonportfolio service that was being provided to the subjects. And now, there’s a very clear prediction about what the right thing to do is, which is, all the money should go to the cheapest index fund, and we found that in fact that didn’t happen, didn’t even come approximately close to happening. So, our conclusion was that a lot of the money that was going into these more expensive S&P 500 index funds is being driven by ignorance and financial illiteracy, and it wasn’t about these supposed nonportfolio services that the expensive S&P 500 index funds were providing.
As you noted, as the years have gone by, there has been a lot of flows that go toward the cheapest S&P 500 index funds, the cheapest index funds in general in the market. That being said, if you just look at all of the S&P 500 index funds that are offered, setting aside what fraction of assets they’re attracting, that dispersion in fees across index funds has not narrowed at all over the last couple of decades. It’s just the same distribution as it was before. So, my interpretation is that basically there are a bunch of funds out there that are just charging extremely high fees and they’re just hoping that somebody accidentally ends up stumbling across those funds and out of ignorance gives their money to those funds. I think there is a lot of guidance out there that’s helping individual investors who might not be so sophisticated, direct their money toward cheaper funds. I think, for example, in the 401(k) sector it is quite important doing this because the 401(k)-plan sponsor has a fiduciary responsibility to the employees of the firm to get them the best deal. I think that’s a powerful force in directing money toward cheaper index funds. But I do think that these bad deals still exist in abundance out there.
Ptak: Well, James, this has been a fascinating discussion. Thanks so much for sharing your insights and perspectives with us.
Choi: My pleasure. It was a lot of fun.
Benz: Thanks so much for being here.
Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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Benz: And @Christine_Benz.
Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
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