Consumer Finance

Someone in a small Florida town has the winning ticket for the largest Powerball jackpot in history—nearly $600 million. The prize has reignited the debate over lotteries, which produce much-needed revenue for state governments by encouraging, as critics argue, a form of gambling. At ThinkProgress, Bryce Covert argues that lotteries amount to a regressive tax, as poor people are more likely to purchase tickets than wealthier citizens:

[Poor people] spend a larger percentage of their income on the lottery, and many studies of state lotteries have found that low-income Americans account for most of the sales and that sales are highest in the poorest areas. One study found that a reason for this is that “lotteries set off a vicious cycle that not only exploits low-income individuals’ desires to escape poverty but also directly prevents them from improving upon their financial situations.” The loss in income of buying tickets that provide no reward is harder to bear on a slim budget.

Covert offers the standard explanation for lottery ticket purchases among the poor -- the cost of the ticket seems to be a small price to pay for the possible chance to "escape poverty." In a chapter for our book, Insufficient Funds, however, economists Sendhil Mullainathan and Eldar Shafir suggest that the reality may be more complicated:

Calls for increasing financial literacy have grown louder recently, as the soaring costs of health care and education, high unemployment, and the effects of the Great Recession all converge to strain the budgets of governments, businesses, and individuals. Many agree that financial education benefit those who participate, but the results have been underwhelming. According to a recent column in The Economist, not only is financial literacy a major stumbling block for most people, but interest in—and success in teaching—financial education is incredibly low, regardless of age or life circumstances. Last September, the SEC released its own report on financial literacy among Americans, and its results of which were fairly discouraging. Some argue that the main problem is the ability to engage students in the material, but as we’ve written before, the problem may be more fundamental than that.

In their paper “Misunderstanding Savings Growth,” published in the RSF-funded Journal of Marketing Research, Craig McKenzie and Michael Liersch argue that the failure to begin saving early for retirement—or to reach retirement savings goals—comes down not just to a lack of financial knowledge, but also to gross misunderstandings of how savings grow over time. Conventional economic wisdom holds that people are able to “[calculate] future values and [make] trade-offs with present values.” However, through a series of experiments, McKenzie and Liersch notice that not only do people systematically underestimate how much retirement savings grow exponentially, but that understanding how compound interest works doesn’t always help to motivate them to save earlier.

In fact, what helps the most in motivating people to save is demonstrating the effects of exponential growth. Offered a graphical representation of how compound returns accumulate over time (see below), participants were markedly better able to determine whether early saving would prove beneficial over the course of a career. Not only that, but they were better able to think their way out of the fallacy that saving twice as much later might yield the same returns at the point of retirement. This finding was successful without any interventions that told participants explicitly what compound interest was or how it could be calculated. Interestingly, this approach increased motivation in participants at different stages of their careers. McKenzie and Liersch did experiments with undergraduate students as well as employees at a Fortune 100 company, and found that workers’ reactions to exponential savings growth were similar to those of the undergraduate sample. As the authors point out, this finding indicates that it isn’t an understanding of compound interest that motivates people, but demonstrations of its effects over time.

Projecting how long you think you will live is a crucial exercise in retirement planning. An estimate of life expectancy could determine, for example, your savings rate, a portfolio allocation, or whether or not you should buy an annuity. The standard theoretical model predicts that individuals make unbiased estimates of their life expectancy based on personal, relevant information, such as family history, illness, lifestyle choices, and so on. But a new paper, funded by our consumer finance working group, suggests that life expectancy estimates can be, at least in part, also affected by irrelevant context factors -- in this case, the way survey questions are worded.

For their newly published article, John W. Payne, Namika Sagara, Suzanne Shu, Kirstin C. Appelt and Eric J. Johnson conducted experiments in which they asked half of the respondents to provide probabilities of their living to a certain age, and the other half to provide probabilities of their dying by a certain age. Ostensibly, these questions are asking the same thing, but the results yielded a surprising result: Those given the "live-to" question reported significantly higher chances of being alive at ages 55 through 95 than those who answered the "die-by" question. In fact, in the first two surveys, which included nearly 2,000 respondents, the mean life expectancy was 8.68 years higher in the live-to frame than the die-by frame.

Late last year, the Russell Sage and Alfred P. Sloan Foundations sponsored a competition to solicit proposals for smart disclosure demonstration projects. "Smart disclosure" policies aim to improve consumer markets by providing decision-makers data about their their personal use patterns or histories. Here are some details on the winning proposals:

1. Efficient Web-Based Credit Markets

While the consumer credit market has grown dramatically in the past two decades, consumers find it difficult to systematically compare credit offers (many of which arrive in the mail). Consumers know that their credit score may be downgraded by repeated applications for credit, but a bigger challenge is sorting through lengthy contracts, complicated reward programs, and interest rates. This research project will investigate the potential of a recent policy shift in Sweden, where consumers can "shop" for credit using an online intermediary. When they submit their information -- for example, the amount of credit they seek and their credit score -- the online intermediary supplies their application to participating banks, which can decide to offer a bid to the consumer. The web intermediary standardizes all financial contracts, reduces search costs, and allows consumers to see competing bids in an accessible manner.

2. Doctor Finding Service

Finding a healthcare provider can be difficult: comprehensive information about a doctor -- that is, including malpractice history, patient feedback, outcomes -- is rarely available in one location, and websites often present data using arcane terminology and complicated designs. This research project aims to develop and test a smart disclosure service that captures information local area health care providers and provides consumers an easy to understand interface for finding and comparing health care resources.

In late 2011, Allianz Global Investors and TED organized a daylong conference on behavioral finance. Several members of the Russell Sage and Sloan Foundations' Consumer Finance Working Group discussed their research and how behavioral economics can illuminate and possibly improve consumers' decisions. You can watch videos of the lectures by clicking on the links below. You can also find other TED Talks on behavioral economics here.

Late last year, we announced the release of a special issue on consumer finance from the Journal of Marketing Research. The issue, funded by the Russell Sage and Alfred P. Sloan Foundations, features 14 articlesthat provide new insights on how to improve consumers' financial decisions. We previewed some of the articles in these blog posts, but now, we have received permission to post the entire issue for free. Browse through the links and abstracts below to download the papers.

Misunderstanding Savings Growth: Implications for Retirement Savings Behavior
Authors: Craig R.M. McKenzie and Michael J. Liersch
Abstract: People systematically underestimate exponential growth. This article illustrates this phenomenon, its implications, and some potential interventions in the context of saving for retirement, where savings grow exponentially over long periods of time. Experiment 1 shows that a majority of participants expect savings over 40 years to grow linearly rather than exponentially, leading them to grossly underestimate their account balance at retirement. Experiment 2 demonstrates that this misunderstanding leads to underestimates of the cost of waiting to save, which makes putting off saving more attractive than it should be. Finally, Experiments 3-5 show that highlighting the exponential growth of savings motivates both college students and employees to save more for retirement. Making clear to employees the exponential growth of savings before they make crucial decisions about how much to save may be a simple and effective means of increasing retirement savings.

Earmaking and Partitioning: Increasing Saving by Low-Income Households
Authors: Dilip Soman and Amar Cheema
Abstract: This research examines the effects of earmarking money on savings by low-income consumers. In particular, the authors test two interventions that are designed to enhance the effects of earmarking: a) using a visual reminder of the savings goal and b) dividing the earmarked money into two parts. Consistent with prior research which suggests that partitioning increases self-control, individuals save more when earmarked money is partitioned into two accounts versus pooled in one account. In addition, the presence of the visual reminder increases the savings rate. The authors conclude with implications for consumers’ welfare and a discussion of directions for further research.

Increasing Saving Behavior Through Age-Progressed Renderings of the Future Self
Authors: Hal E. Hershfield, Daniel G. Goldstein, William F. Sharpe, Jesse Fox, Leo Yeykelis, Laura L. Carstensen, and Jeremy N. Bailenson
Abstract: Many people fail to save what they will need for retirement. Research on excessive discounting of the future suggests that removing the lure of immediate rewards by precommitting to decisions or elaborating the value of future rewards both can make decisions more future oriented. The authors explore a third and complementary route, one that deals not with present and future rewards but with present and future selves. In line with research that shows that people may fail, because of a lack of belief or imagination, to identify with their future selves, the authors propose that allowing people to interact with age-progressed renderings of themselves will cause them to allocate more resources to the future. In four studies, participants interacted with realistic computer renderings of their future selves using immersive virtual reality hardware and interactive decision aids. In all cases, those who interacted with their virtual future selves exhibited an increased tendency to accept later monetary rewards over immediate ones.

Why do so many Americans receive such a big tax refund? Every year, the IRS sends a check of around $3,000 to Americans who paid more taxes than they should. The excess withholding is a puzzle: why do consumers prefer to give the U.S. government an interest-free loan? Wouldn't a quick trip to the payroll administrator be worth the effort if it meant a bigger paycheck? Michael Barr, an editor of the RSF volume Insufficient Funds, spoke to the Wall Street Journal last week about his research on the problem:

"People want to have a ready way to save," says Michael Barr, a University of Michigan law professor and a former Obama and Clinton Treasury official. "For some families, tax time is a good time to do so."

In the mid-2000s, Mr. Barr and colleagues surveyed about 650 low- and moderate-income families in the Detroit area who had filed tax returns in 2003 or 2004. About 82% received refunds—either because they had overpaid or because they qualified for the federal Earned Income Credit, a federal cash bonus to low-wage workers that is paid through the IRS. [...]

In fact, Mr. Barr and co-author Jane Dokko of the Federal Reserve Board, found these folks don't want smaller tax refunds. In the survey, researchers offered them choices: Withhold $100 a month more and get a bigger refund (an option favored by 35%), withhold the same amount and get the same refund (46%) or withhold less and get a smaller refund (only 19%.) This and other survey findings appear in a coming Brookings Institution book, "No Slack: The Financial Lives of Low-Income Americans."

Late last year, we posted TED Talk videos from Daniel Kahneman, Sendhil Mullainathan and Dan Ariely, three scholars involved with RSF efforts to study consumer finance. The talks offer an excellent introduction to the methods and insights of behavioral economics, which the Foundation has supported since the early 1980s.

This month, economist Shlomo Benartzi gave his own TED lecture in New York on how to improve money management among consumers. Benartzi, a member of RSF's Behavioral Economics and Consumer Finance Working Group, discusses research from the field of behavioral finance, which he says is a "combination of psychology and economics trying to understand the money mistakes people make." Watch the video below:

In his latest column in the New Yorker, financial writer James Surowiecki reports the return of a retail phenomenon not seen since the Great Depression: the layaway purchase. Before the financial crash, the default payment mode for consumers was the credit card. Buy now, pay later. Now, as the financial crunch continues to pinch pockets, more stores are offering layaways. Here's how they work:

You pick out the product you want, make a down payment, pay a service fee (typically five dollars), and then make regularly scheduled payments over a period of time until you’ve paid off the full price. There are no interest payments, and if you don’t make all the payments you get your money back, minus a cancellation fee. It’s the exact opposite of installment credit, where you get the product, and then pay for it.

According to standard economic theories, Surowiecki explains, rational consumers would not choose the layaway. Why not simply save enough money in a bank account and then head to the store? Or why not use your credit card and pay the balance in a sustainable manner? But Surowiecki cites RSF-funded research in the field of behavioral economics to explain the appeal of layaways:

More on Consumer Finance
• Study: Misunderstanding Savings Growth: Implications for Retirement Savings Behavior
• RSF Review: Special Issue on Consumer Finance
• Behavioral Economics and Consumer Finance Working Group

Why don't Americans save more for retirement? Earlier this month, I discussed a study that hypothesized that people are not invested in their "future selves"; for many, the pain of stashing away part of the weekly paycheck outweighs the benefits of bigger savings 40 years down the road. But another article, which also appeared in the RSF-funded issue of the Journal of Marketing Research, examines another problem: do people underestimate the power of compound interest?

Here's the question the researchers ask: Imagine you deposit $1,000 at the start of each of three years and earn 7 percent interest, compounded annually. At the end of those three years, how much money would you have? The correct answer is $3,440, almost 15 percent (not 7 percent) more than than the total amount deposited, as interest is earned annually on the previous interest earned. The authors of the article—Craig McKenzie and Michael Liersch—explain why these calculations matter:

Due to compound interest, savings grow exponentially over time, but most undergraduate students believe that savings grow linearly, and the therefore grossly underestimate how much money can accumulate over the span of a typical career...Because they believe that savings grow linearly, they also underestimate the cost of waiting to save, which makes the decision to put off saving more appealing than it ought to be. However, we show that increasing students' and real employees' awareness of the exponential growth of savings over time, even subtly, helps them appreciate the benefits of saving and motivates them to save for retirement.