When a nudge becomes a shove The idea of directing people towards the “right decision” can be productive, if implemented well. By making sure uncertain investors still have autonomy while being guided by professionals, we could ensure that investors are o
was the seminal work by Richard Thaler and Cass Sunstein on choice architecture and the seemingly innocuous ways in which we can direct individuals towards the right decisions. The principles of the work can be applied in just about every industry from financial services to the way that grocery stores are laid out to encourage people to buy healthy foods.
The authors describe this way of directing people as “libertarian paternalism”, where libertarian means respecting people’s right to choose whenever possible, and paternalism means that the individual themselves would judge the sponsor to be acting in their best interests. Thus, the phrase implies the desire to create an environment where people are more likely to choose things that they themselves think is good for them.
In a 2009 interview with Yale Insights, Thaler mentioned that one of the industries that had received the greatest attention was the savings and investments space, in which defaults are often used. One industry that has certainly been applying defaults is the retirement fund industry, where one wellknown example of a default is the life stage investment model.
What makes a default attractive is that a process will happen without the member having to take any action. And for people who are simply not engaged with their retirement savings, it means that someone (hopefully) smarter and more interested in the problem is making a decision on their behalf. But the main problem with the default is that it is intended to be appropriate for the average member, which means that more often than not, it fails to meet an individual member's needs.
The answer to this problem has been the introduction of smart defaults in which the experts are often still in the best position to identify the right solution, but they use more information about an individual to get it right.
In many cases some demographic information about a retirement fund member will be available, like years to retirement or age, which can be used as a proxy for risk tolerance if it is assumed that the member will be purchasing an annuity at retirement. This had formed the foundation of the typical life-stage model.
But even smart defaults have their flaws. If we stick with the example of the life-stage default, we find that it fails to consider how much a member has saved when they start to de-risk or whether members will actually retire at their fund-instituted normal retirement age or at an earlier age. If we had those two additional pieces of information about the individual, we would be able to structure the investment strategy much more effectively.
Good governance requires the trustees of the fund to communicate with members about the default investment strategy. They have to give a description of the portfolios, the objectives, expected return and risk. And although there is a requirement under PF 130 for the trustees to ensure that the strategy is developed around the needs of the membership, very little is done to ensure that the member understands the implications of being invested in the default.
So does this way of structuring a default still ring true to the concept of libertarian paternalism?
What then is the alternative to a default that isn’t communicated well and very often fails to meet the needs of an individual member? This is going to sound controversial given how disengaged individuals are – but the answer may be more choice, associated with more guidance. There are very few financial products on the market that offer the individual user enough flexibility to structure them to exactly their needs and affordability