We all want to make better decisions and just knowing about the mistakes we make is it enough. We need to understand what we do well so that we can identify the tools we already have and can you use those tools in the right way at the right time.
Precommitment and preretirement
One of the most powerful tools for making better decisions is the pre-commitment – when you pre-commit to something you are making a binding decision ahead of time. Essentially locking in a choice option now rather than keeping flexibility for the future.
It seems strange to want to pre-commit ourselves to a course of action, we usually value flexibility in our decision-making, we want to keep our options open. But, giving up that flexibility can often lead to better decisions. Let’s start by considering the largest and longest term financial challenge faced by most Americans: saving for retirement.
There are three primary contributors to retirement savings for workers in the United States:
- The government managed Social Security System by the defined benefit to each worker based on their tax mandated contributions, but Social Security is rarely enough on its own to support a comfortable retirement; it typically replaces a little less than half of the preretirement income of the average taxpayer;
- Some Americans have employer-sponsored defined benefit plans; often those are in the form of a pension. Those plans guarantee a specific income each year after retirement, simplifying planning, but they are increasingly rare in large part because of the financial uncertainty they introduce for employers.
- The remaining Americans depend on their own ability to save for retirement often through defined contribution savings plans offered through those employers these are known by a variety of names including 401(k) and 403(b) plans. There are two important reasons for saving for retirement through one of these plans rather than through other investment vehicles.
Financial circumstances matter
There are typically significant tax advantages and employers often contribute matching funds to the plants. Now, defined contribution plans can provide a very effective method for people to take control of their retirement savings.
If there is an employer match on say up to 6% of annual income, then a worker can contribute 6% of the their income annually pretax, but actually save 12% annually.
Current balances can be easily tracked over time so that people know exactly how much is been saved and how much is still needed and the vesting period for benefits is usually much shorter than for traditional pension plans.
These plans can be very effective, both for individuals and for society, there’s just one problem: many people don’t bother to enroll. Enrollment rates vary dramatically from company to company for reasons you might expect.
Financial circumstances affect whether someone has the capacities us to save for the future and workers with higher incomes and more education are more likely to enroll and it’s not necessarily the case that everyone should enroll in a retirement plan.