Commitments to Save - Effective but Dangerous?

Among the useful insights from behavioral economics (or behavioral science, if you prefer) is a greater understanding of the difficulties everyone faces following through on our good intentions to save for the future. People routinely say that they would like to save more—to build a cushion, for retirement, for a future vacation—but when the time comes to put money away, it gets spent instead.

Some of the most well-known and oft-cited policies and products influenced by behavioral economics address this issue: defaulting people into a retirement savings account, Save More Tomorrowpre-paying for fertilizer, and commitment savings accounts for instance. The nudge of a commitment, even when reversible at relatively low cost, seems to help people listen to the better angels of their nature. The idea, at least, of commitments is catching on. See, for instance, this suggestion for commitments to boost investment in energy efficiency.

There are two main explanations for why these interventions work: 1) They help deal with people’s varying time preferences (Today I’d prefer to save the money I earn next week, but next week, I’d rather spend it); 2) Limited attention (I have so many things going on, I forget to make the savings deposit).

Scarcity, a recent book by Sendhil Mullainathan and Eldar Shafir, delves into the problem of limited attention and tight budgets. Suffice it to say it’s a big problem for poor households. Commitments, at first glance, appear to be a useful way to deal with this problem—particularly in economies where penetration of formal financial services is high. In those contexts it can be simple to set up automatic account drafts that limit people’s need to pay attention and therefore help them live up to their commitments. Such automatic drafts can allow a person to save by setting up an automatic draft into a savings account (or having a portion of each paycheck direct deposited to savings). Perhaps equally important for lower-income households with high attention demands, automatic bill payment, by avoiding late fees and penalties, is essentially saving.

But commitments may not, in fact, be a workable solution. Why? Because they may actually demand more attention. Some of the early analysis of our data from the US Financial Diaries project illustrates the challenge of income uncertainty. Based on our preliminary analysis, the coefficient of variation of monthly income is 40% in the median household, which means if your average monthly income was $3000, you may have gotten this much only half of the time, while the other months varied between $1300 and $4700. With that kind of volatility and uncertainty, households have to pay a lot of attention to their balances and to their commitments to avoid overdraft fees which can be quite high.

A new paper from Victor Stango and Jonathan Zinman (forthcoming in The Review of Financial Studies) looks at how people react to being reminded about overdraft fees. These reminders are not specific and not about fees actually paid—just a survey question about the existence of overdraft fees. But the reminders seem to focus attention and people who get them incur fewer overdrafts after being reminded. How? Many of them cancel automatic withdrawals from their accounts.

The bottom line: while commitments can help people live up to their savings goals, automatic drafts can be dangerous for people with volatile incomes and limited attention. Dangerous enough that simple reminders of fees cause them to forego automatic drafts. Reminders to save, rather than commitments and automatic withdrawals, though likely much less effective, may be the most help we can offer—without causing harm.