Everyone knows Aesop’s fable of the ant and the grasshopper: the ant worked hard all summer to provide for the winter ahead; the grasshopper did not and paid the price.
A paper by PricewaterhouseCoopers partner John Hawksworth suggests that this fable, combined with insights from recent developments in behavioural economics, can help to explain why people in the UK are not saving enough for their old age.
Put simply, the paper argues that the UK is a nation of too few ‘ants’ and too many ‘grasshoppers’. It also suggests that this has important implications for government policy on pensions and savings.
It draws on psychological research showing that, contrary to most standard economic models, people do not discount the future at a constant rate per period. Rather, the discount rate applied when comparing the current period with the next period is much higher than the discount rate applied when comparing two consecutive periods far in the future.
People are impatient in the short term, with a strong tendency to prefer instant gratification to even a short deferral of rewards. Moreover, this leads to a systematic tendency for people not to stick to their future plans: for example, they always intend to save for their retirement but never get around to doing this in practice. This is what the paper refers to as the ‘grasshopper effect’.
The paper illustrates the effects of this through a simple mathematical model where people have to choose whether to spend or save in three periods of their life: youth, middle age and old age. The analysis considers the savings behaviour in these circumstances of three types of people, who are identical in all relevant respects apart from the way in which they view the future:
- The Ant: who discounts the future at a relatively low, constant rate per period in line with standard economic theory. Based on plausible assumptions, the Ant is shown to save in both youth and middle age and consequently enjoys a comfortable retirement with money to spare for bequests to his children and others.
- The Naïve Grasshopper:who discounts the next period particularly heavily, in line with the findings of psychological research, but does not accurately predict his own future lack of resolution. Under plausible assumptions, the paper shows that the Naïve Grasshopper chooses not save in youth while intending to save later in life. But when he reaches middle age he changes his mind, not saving enough to avoid a poverty-stricken old age.
- The Self-Aware Grasshopper: who also discounts the next period particularly heavily, but has enough foresight to realise when young that he is unlikely to save enough when middle-aged to prevent poverty in old age. So he does save when young in order to at least provide a reasonable standard of living when he is older.
The paper goes on to show, with reference also to a range of other academic research in recent years, how these illustrative results can be generalised. Excessive early retirement, for example, may be the result to some degree of a similar ‘grasshopper effect’. US studies suggest that the grasshopper effect could be to reduce the household savings rate by as much as 10%. The paper then draws a number of policy conclusions:
- First, given the apparent prevalence of grasshopper-type behaviour across the population, it is unlikely that the market alone can deliver adequate pensions. There will always be an important role for the government in providing an adequate basic state pension and in creating the right regulatory and fiscal environment to promote private savings.
- Second, however, it is important that the state pension system does not itself create adverse incentives. Unfortunately, while the means-tested pension credit has had beneficial effects in reducing pensioner poverty in the short term, its long run effects could be detrimental to the government’s other objectives of getting people to save more and retire later in response to higher life expectancy. This suggests that there is an argument for reforming the state pension regime in order to reduce the reliance on means-testing in the long run and provide a better basic state pension.
- Third, to the extent that we wish people at least to be Self-Aware rather than Naïve Grasshoppers, even if it is too much to expect most to be Ants, there is a need for better financial education and clearer communication from pension providers, employers and government of the arguments for saving. Following the recommendations of the Sandler report, this needs to be combined with a regulatory regime that promotes long-term saving.
- Fourth, while full compulsion may be undesirable in totally over-riding individual preferences, there is a good argument for introducing a presumption that people will join and contribute at some minimum rate to either an occupational or a stakeholder pension scheme unless they actively choose to opt out. Inertia can then be a positive force offsetting the grasshopper effect, particularly for Self-Aware Grasshoppers who may be most inclined to take the opportunities to save under a presumption regime.