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In the U.S. and U.K. alike, there is growing concern that people aren’t saving enough for retirement. In the U.S. specifically, around 20% of adults age 50 or over report having nothing saved for retirement, according to a recent AARP survey.
Nudging behaviors — such as automatic enrollment or auto-escalation in a 401(k) plan — have historically been popular among policymakers to get people to save.
However, there has been little investigation into how people adjust their spending patterns when more money is taken out of their paychecks. Do they cut their spending to cover the difference? Make purchases with a credit card more often?
It turns out that people do both, according to new research from MIT Sloan professors and
“One thing we’ve never really understood about retirement savings is, when we design some clever mechanism to help people save more for retirement, where does that money come from? What are people cutting out when they put more money toward retirement?” Palmer said. “No one has been able to answer that.”
The pair’s research sheds light on the nuances of retirement savings behaviors and has significant implications in terms of how retirement savings plans should be designed to be fairer to lower-income earners.
Getting and spending
Findings from Choukhmane and Palmer’s research paper, “How Do Consumers Finance Increased Retirement Savings?” show that most people finance their retirement savings by cutting their spending, an effect that is especially prominent for people who don’t have a lot of liquid savings to begin with. Evidence also indicates that people put more on their credit cards.
The study used data from the U.K., where there are three main ways to save for retirement: a government-backed state pension plan, employer-sponsored workplace pensions, and individually established personal pensions. As in the U.S., workers in the U.K. also aren’t saving enough for retirement, with one report estimating that around 90% of Brits aren’t saving enough.
The authors looked at the spending habits of 614,000 people via anonymized deposit, credit, and pension account data held by a large U.K. financial institution from January 2016 to November 2019. They examined the effects of a U.K. national auto-enrollment policy (as mandated by the Pension Act of 2008) that gradually increased retirement contributions from 2% to 8% of a person’s salary.
Because the dataset included information on both banking and retirement, the authors could drill down to see how people adjusted their spending behaviors in response to the policy. The financial institution also categorized each purchase so that the authors could see what people were spending their money on and where they cut back.
The researchers discovered that most consumers cut back on spending, but not by enough, while some increased the balance on their credit cards.
Specifically, they found:
1. For every £1 ($1.32) reduction in take-home pay allocated toward retirement, employees curtailed their spending by only £0.34 on average (primarily on dining out and leisure activities). There was no effect on spending on essential items like groceries and rent, though Palmer said people spent slightly less on categories that included streaming services and clothes.
Taking away income from people forces them to spend less on activities that make them feel good in the here and now, such as going to restaurants. “If you were worried that people aren’t saving enough for retirement because they’re present-biased and not thinking enough about the long term, you would also expect that they would be overspending on categories that provide short-run enjoyment, and sure enough, those are the categories that they cut out when you nudge them to save more for retirement,” Palmer said.
2. People with significant savings relied on their deposit balances to offset the reduction in take-home pay, shifting the money that they were ordinarily saving in a bank account into a retirement account. On average, checking account balances decreased by £1 per month.
Because the financial data extended for only two years after the policy was enacted, the authors built a model and then simulated what would happen 20 years out.
“For people with high savings balances, our model predicts that eventually they will run down those accounts and then cut their spending,” Palmer said.
3. Less-wealthy people with lower or no initial deposit balances cut their spending the most and also put items on a credit card. Younger customers and customers with lower current account balances cut their total spending the most.
Credit card balances increased modestly as well.
Having any increase in a credit card balance is worth noting, especially in a high interest rate environment. “If people kept spending the same amount as they were before, and they just used a credit card for the difference, they’d have more in retirement savings but would also have more credit card debt,” Palmer said. “They’d be earning, for example, an extra 5% on their retirement account, but could be paying 15% a year in credit card debt. That would be a failure.”
Lessons for the design of retirement policy
These findings have important implications in terms of how retirement savings plans should be designed, Palmer said.
Because tax incentives and employer matching subsidies are more likely to be used by employees who already have more money to start with, changes to retirement plans should target those who have less money and are less likely to have a lot of money saved for retirement.
Palmer offered the following policy ideas to achieve that goal:
Give 3% to everyone.
The results of the research show that existing retirement programs are poorly targeted. They don’t work fairly for everyone: The people who can afford to save for retirement are the same people who have the highest checking account balances to begin with, while people who don’t have enough money are opting out of the system entirely.
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“One thing companies could do is be less high-powered in their matching incentives to save for retirement,” Palmer said. “Instead of saying, ‘If you contribute 2% or 3%, we’ll contribute 5%,’ you could say, ‘We’re going to contribute 3% no matter what, and then, on top of that, we encourage you to save for retirement too.’ That would be really helpful in helping target the people that need to save more for retirement.”
Lower withdrawal penalties so that the less affluent will participate.
Penalties for taking an early withdrawal on retirement funds encourage people to keep their money in a 401(k) plan, but they may also deter low-liquidity households (the group with the most to gain from saving) from participating.
“Our research shows that withdrawal penalties can keep people who have low wealth and low levels of savings from participating in retirement programs in the first place,” Palmer said. “So to get broader participation in a retirement plan, you might want to have lower withdrawal penalties.”
Implement an asset or income cap on tax incentives.
While retirement tax incentives were designed to help average people build a nest egg, these incentives have also helped the wealthy get even richer by allowing them to invest more money tax-free.
“The people that are at the top of the wealth distribution don’t need these subsidies to save for retirement — they’re already saving for retirement,” Palmer said. “We are spending a lot of money for them to save the same amount of money they were before, but they’re just doing it in account A instead of account B.”
Choukhmane and Palmer’s research offers something to think about in terms of why we might want to consider implementing incentive limits.
“It’s worth exploring whether income or asset limits for tax subsidies would improve the targeting of retirement savings programs,” Palmer said.
Read next: How retirement saving incentives amplify wealth gaps in the U.S.
