A common way to help people with their finances is to gently nudge them to make better decisions.
There are automatic credit card payments and automatic enrollment in a 401(k) plan. Some companies automatically increase their employees’ retirement plan contributions each year.
Although these nudges seem to be effective at first, some recent research shows that in the long run some are not as effective as promised, and some may have more harmful consequences. is shown.
The findings highlight the limitations of changing people’s financial situations one small step at a time, but also make these policies more effective over the long term to help people achieve financial security. It also provides tips on how to make it work.
“Nudges are not a panacea,” Jialan Wang, an associate professor of finance at the University of Illinois at Urbana-Champaign, told Yahoo Finance. “But that doesn’t mean that smartly designed nudges can’t help people on average.”
“These can definitely be very powerful tools in our toolkit.”
Although financial “nudges” seem to work at first, some recent studies have shown that some may not be as effective as promised in the long run. (Photo: Getty Creative) (d3sign via Getty Images)
“Potential negative effects”
Wang came to this insight after more than a decade of research into how Americans pay with credit cards. In her recent study, which focused on automatic payments for credit cards, cardholders were given the opportunity to enroll in automatic payments for a minimum or full amount each month when they opened their account.
According to Wang, Autopay has more than doubled the percentage of cardholders making minimum payments, improved individuals’ credit scores, and reduced deductibles, which are critical to avoiding late payment fees. The automatic minimum payment was also very persistent. People continued to use that option for 10 months after account opening rather than paying additional fees.
“It has useful features and helps you avoid being late,” she said. “However, it leads to a new stream of potential negative consequences, including further debt accumulation and higher interest payments.”
Wang theorized that more automatic payment options available could prevent people from getting stuck in a minimum payment loop.
I wish it were that easy. Just ask Benedict Gutmann-Kenney, assistant professor of finance at Rice University.
Read more: The best way to pay off credit card debt
“Unfortunate discovery”
Guttman-Kenney and colleagues designed a study in the United Kingdom that encouraged cardholders to choose an automatic payment option that was different from the minimum amount.
When cardholders are presented with the automatic payment option, one subset can choose from three options: minimum amount, fixed amount, or entire balance. The other subset could only choose between a fixed amount and the full amount.
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Initially, the results seemed promising. When no minimum payment option was offered, more people signed up for automatic fixed payments. But after seven months, it became clear that fixed-price audiences weren’t doing as well.
The reason their debt hasn’t changed is because they chose a low, fixed amount, often just above the minimum payment, and even if they use the card for months and add on balances, that fixed amount remains at the minimum. I didn’t even reach the amount I paid.
“Overall it was a disappointing discovery,” Gutman-Kenny said.
Read more: What happens if I only make the minimum payment on my credit card?
Change the money but not the pattern
Of course, not all economic nudges backfire. Some people turn out to be just so-so. Let’s take a look at saving for retirement.
In 2006, Congress passed the Pension Protection Act, which encouraged companies to automatically enroll employees in 401(k) plans. This is a pioneering initiative to increase participation and increase savings.
The bill is based on research similar to that of James Choi, a finance professor at Yale School of Management. In 2002, he and his colleagues published one of the first papers showing that automatic enrollment has a significant impact on 401(k) participation and contribution rates. This year, Choi and his co-authors revisited these findings.
“The spirit of a scholar should be to try to be the harshest critic of one’s own research and seriously try to determine where the limits of the results are,” Choi said.
Choi also wanted to consider the automatic increase in contribution rates required by employers starting next year under the recently passed Secure 2.0 law.
What Choi and his colleagues discovered, again only over time, is that the benefits of auto-enrollment and escalation are significantly diminished given that people change jobs frequently. When they do, many cash out some or all of their 401(k), commonly referred to as a leak.
So why don’t financial “nudges” work as intended? In some cases, nudges don’t take into account people’s actual circumstances, one expert says. (Photo: Getty Creative) (Yuliia Kokosha via Getty Images)
Additionally, since contribution rate increases typically occur once a year, turnover leads to less impressive automatic escalation results. If the worker retires after a year and a half, the contribution rate will not increase as much. When you start with a new employer, your copay rate may be set at a lower starting rate.
“We’ll be back to square one,” Choi said. “This is a big part of the story of why the automatic escalation of employment conditions that Americans find themselves in isn’t having as much of an impact as we originally thought.”
And there’s also an overall tenacity of auto-escalation. Choi said previous research has found an 85% participation rate in auto-escalation, but his research found that only 40 of the employees who defaulted to auto-escalation actually accepted the initial escalation. It turned out that it was %. Many people opted out, and over time, many more opted out.
“Far more people are opting out of the automatic escalation default than previously understood,” he said. “So that was a surprise.”
Another recent research paper by Taha Chokmane, an assistant professor of finance at MIT Sloan School of Management, and colleagues shows that people can cut spending and get better results by putting extra income toward retirement savings. It turned out that. But they also reduced their net bank savings and reduced their credit card payments. The results weren’t that good.
And among people with large savings in bank accounts, the increase in retirement savings did not encourage spending cuts at all, leading to no actual increase in overall savings.
“Any kind of savings promotion may not be as effective for high-income earners, because what they’re trying to do is not actually change their spending patterns, but rather focus on certain accounts. All you have to do is move the money from one account to another.” . ”
“One piece of that puzzle”
So why don’t financial nudges work as intended? It’s not that people don’t want to stay in debt or save for retirement.
In some cases, nudges do not take into account people’s actual circumstances.
“If you don’t have the money, you don’t have the money,” Gutman-Kenney said, adding that credit card holders with limited money in the bank are choosing lower payments. I discovered that there is. “It’s going to be hard to do that kind of soft nudge to get people to pay back more.”
These nudges often work on their own. They don’t take into account what’s going on in other aspects of their personal finances. Again, we’ll cover auto-enrollment and escalation.
“The goal shouldn’t just be retirement preparedness; it should be financial resilience retirement preparedness in case your car breaks down,” Chalkmane said. Ta.
“That’s one of the things that I find interesting about these economic nudges, because they’re probably addressing one piece of the puzzle, but what are the other pieces of the puzzle? Will it have an impact?”
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For the future
This doesn’t mean you should throw nudges out with the bathwater. But we need to be smarter about designing our economic nudges and be diligent about testing them, especially in the long run.
Otherwise, consumers will be faced with a litany of ineffective nudges, leading to what Wang calls “nudge overload.”
“They’re going to coordinate everything.”
Policies are expensive to implement, so new nudges should not be made haphazardly.
The US Card Act of 2009 required credit card issuers to show the impact of paying only the minimum amount on monthly billing statements in order to change payment behavior. But subsequent research has shown that this is not the case, Gutman-Kenney said. Gutman-Kenny conducted a similar study on disclosure in the United Kingdom, but it was also unsuccessful.
“In this case, we found that this doesn’t work,” he said of the latest research. “Therefore, it made no sense for regulators to decide policy.”
“At least it was a good policy outcome.”
Janna Herron is a senior columnist at Yahoo Finance. Follow her on X @JannaHerron.
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