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August 18, 2013

Why don't people save their own money?

There is a proposal being discussed in California and other states that would effectively force citizens to hand over a certain percentage of their salary to the government so that it can be saved. The rationale for this plan -- called the “Ghilarducci plan” after its most vocal proponent -- is that left to their own devices, too few people save enough of their own money for their old age. This means that citizens must lean more heavily on welfare programs on their dotage, which in turn puts extreme pressure on these government programs. The thinking goes that if citizens are forced to save at least some portion of their salary during their working years, then this will both reduce the pressure on government welfare programs and provide the citizen with another source of guaranteed income after retirement.

I’m not going into any detail on these public pension proposals: they are authoritarian, badly flawed in design, and paternalistic in the worst sense of the word. I could devote a book-length treatment to the subject of why these public pension plans are silly, but right now that’s not the question that interests me.

The interesting question is: why aren’t people saving enough of their own money for retirement? It’s not a phenomenon restricted to poor people, either; even comparatively well-off middle-class people go into retirement with hardly any money saved. What gives?


We must start by understanding the difference between saving and investing. They are not the same thing. When you invest money, you are putting your money at risk in an enterprise in the hopes of gaining a return on your principal capital. When you save money, there’s no expectation of capital appreciation; you’re simply storing your money for use later. This is a vital distinction, but one that is increasingly muddied these days.

So the problem is not with inadequate investment; the problem is with inadequate saving. Americans simply are not storing enough of their income for use later.

Part of the problem is the confusion between investment and saving that I mentioned. Too many people (and cities, and states, and nations) assume that they can contribute less of their own money if the investment return is high enough to make up the difference. This sometimes works in a high-growth economy, but the flaw in this thinking becomes glaringly apparent during downturns and periods of slow growth. Investment means risk, and too few people appreciate how much risk they are undertaking in investment scenarios. The real risk is not that you might make 5% instead of 10% return; it is rather than you might make zero return, or even lose money on the deal. Now with a smaller stack of principal, even better performing future investments will still leave you short of where you need to be.

Something economists call “opportunity cost” is another part of the problem. If you decide to save $100 a month, that $100 dollars can no longer be used for something else. Putting away that money means not going out to dinner with the wife, or leaving the dish-washer unfixed, or no new shoes for the kid. It makes more sense to many people to spend the money on short-term needs and pleasures; to them, it is an eminently rational choice.

Everybody has to perform the mental calculus to determine if the opportunity cost of saving money is worth it...and this process is made more complex by our inability to tell the future. Human beings are hard-wired with the “bird in the hand is worth two in the bush” mentality -- better to take the short-term sure thing than the long-term bet with the higher potential payoff. Risk, in other words. Human beings seek to take the path with the lowest risk but the highest reward. But in the modern age many people simply don’t have the mental tools to perform accurate calculations of this kind. They cannot accurately assess risk.

Human beings evolved with short time preferences. It’s a survival trait. Longer time preferences really didn't start paying off until the invention of agriculture, which happened pretty recently as ages of the earth go. If you wanted to be successful at growing things, you had to think ahead -- in terms of seasons and years, not days. And because agriculture fixed you in one place, as opposed to the footloose life of a roaming hunter-gatherer, you had to start thinking about legacy: what would happen to your farm if you died or became injured?

The history of civilization is partly the history of human beings learning to have longer time preferences, of learning to calculate risk and opportunity over longer periods of time. However, this trait still does not come naturally to us as a species. The people who learn to have longer time preferences tend to be more successful because they have learned how to do this mental calculation of risk versus reward.

There is risk even in saving your money. Banks can (and do) fail; inflation can cause the saved amount to evaporate like a puddle under a hot sun; the money itself can be rendered worthless. Even if you put your gold coins in a strongbox and bury it in your yard, there’s always the chance that a thief will find it and take it. Even if no one finds the strongbox, you may die of a sudden malady or injury, and that money will be lost to history. All the foregone pleasures now seem to have been missed to no good point or purpose.

To many people, these risks tend to amplify their existing predilection towards a short time preference. The choice to forgo saving is, to them, rational. They simply find the imponderables and risks associated with saving money to be intolerable.

All of which means this: you cannot force a free people to save their own money. Given a choice in the matter, many people will simply do what humans are prone to do and prefer the short-term over the long-term. They will regret it when they are old, like as not, but regret is the bill everyone has to pay for poor decisions.

Of course this raises the dilemma with what society is to do with people (whether elderly or not) whose poor decisions have left them destitute. We have evolved a generous welfare state to deal with this problem, but it turns out that this welfare state is unsustainable. It actually incentivizes the kind of short time preference behavior that leads to the problem in the first place. If people won’t save of their own accord and can’t be forced to save without turning the state into an authoritarian nightmare, what options are left?

My own answer is: you’re asking the wrong question. The world will always have rich people and poor people and people in between. It always has; it always will. But in America in this age of the world, “poor” is relative. It’s certainly nothing that a beggar in Bangladesh would recognize as poor. We’ve managed to take away the biggest incentives for people to escape poverty: starvation, disease, exposure. Our poor are well-fed, well-housed, and well-entertained. They have access to medical care that even kings of old could not have had at any price.

In short, there are few incentives in America for people to develop longer time preferences. Saving money is a behavior, not an action, and people who develop that behavior tend to have other traits as well: responsibility, intelligence, a concern for legacy, a strong work ethic, and so on. These proposed government programs, as usual, try to instill a behavior by mandating a policy...which never works, because the incentives are all wrong.

Many people see saving as a bad choice, a bad use of their limited resources. In some cases, they’re absolutely correct to think so. Saving money is not, always and everywhere, a good thing. It is, rather, a generally good behavior for a society to have. And it’s a behavior that cannot be enforced by government fiat.

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posted by Monty at 01:14 PM

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