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Financial Insights

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Auto-Enrollment: A "Nudge" toward more debt?

16 April, 2018

At first glance, auto-enrollment seems like a no-brainer, a way to help employees “save first.” But when you go deeper, there are indications the outcomes may not be entirely positive.

It turns out that auto-enrollment does increase participation in retirement saving. And workers do adjust for this saving, but perhaps not always in the way that the “nudge” intended. Summarizing a recent study by academic economists at Yale, a January 5, 2018 Wall Street Journal article concluded:

“Automatic enrollment has pushed millions of people who weren’t previously saving for retirement into 401(k)-style plans. But many of these workers appear to be offsetting those savings over the long term by taking on more auto and mortgage debt than they otherwise would have.”

Auto-saving nudges people to more debt? That doesn’t sound good. Yet, according to the researchers, this additional debt may not be that bad. Apparently, even simple nudges can be complicated.

 Good Intentions, Sledgehammer Execution?

Saving for the future is a critical, if not the essential, activity in a personal financial plan. If there is no saving, there is no plan. But when individuals (or their employers, through auto-enrollment) make a qualified retirement plan their primary saving destination, they may end up funding one of their last financial events (retirement) to the detriment of other intermediate financial issues.

“Todays come first, tomorrows come next.” It’s true that the biggest saving project for most people – i.e., the one that costs the most and takes the longest to fund – is retirement. But it’s not the only project. Accumulating money for a down 

  • payment on a home, for a child’s college education, for business opportunities or emergencies, are saving projects common to many households. For both practical and psychological reasons, some of these other projects may need to be addressed before saving for retirement – even if it means opting out of auto-enrollment. 

The financial imbalance that comes from saving for tomorrow without taking care of today shows up in the high percentage of 401(k) participants who periodically raid their retirement accounts, either through loans or early withdrawals, to pay for things that could have (and perhaps should have) been saved in something other than a retirement plan. The loan repayments and penalty taxes that result are costs that could have been avoided if saving wasn’t tilted toward retirement accounts by auto-enrollment.

  • What about the debt? The study finds that those who are auto-enrolled appear to carry more debt, particularly larger mortgage and car payments. One obvious reason: by saving in retirement plans, where pre-retirement withdrawals are difficult and costly, there isn’t as much available for down payments. The result: bigger loan balances.

But consider: If your retirement account investments earn X percent this year, but you’re paying an average of X+1 percent interest (in car payments, on a personal loan, or for outstanding credit card balances), are you gaining or losing ground? How do you weigh saving versus debt reduction?

The authors suggest the higher-saving-with-higher-debt condition reported in the study can, in some cases, be a positive, because the mortgages are considered “good debt.” If a home’s value increases over time, a higher mortgage balance may be a shrewd leverage play, where a smaller deposit secures an appreciating asset, and what could have been a larger down payment ends up deposited elsewhere (like the retirement plan), diversifying the asset mix.

But there are opportunity costs that compound against you by continuing to pay interest. It is reasonable to question whether more money should be allocated to debt reduction instead of retirement. Or at least used to increase liquid cash reserves.

  • The study also suggests that auto-enrollment doesn’t necessarily get people to save more; it just changes the destination for those who already have the habit. John Friedman, an economist at Brown University, told the WSJ: “A big question is whether auto-enrollment makes you save more overall. My reading of the paper is that no, it doesn’t.” If this conclusion is true, it brings into question whether auto-enrollment is really worthwhile. Sure, it gooses retirement plan participation, which might please some policy wonks. But are individuals really better off if the default over-emphasizes retirement saving at the expense of other necessary and intermediate saving projects?  

Auto-enrollment is a well-intentioned concept, one that is partly responsible for Richard Thaler being awarded the Nobel Prize in Economic Sciences last year. But the application is perhaps a bit heavy-handed, because the assumption is that retirement should be the highest saving priority for all employees. You need to ask yourself, “Do I want to be nudged into a 401(k) right now? Or should my saving be allocated elsewhere?”