Whether they know it or not, millions of Britons have cause to celebrate the Nobel prize awarded this week to Professor Richard H. Thaler, the American economist.
Thaler won his Nobel Prize for Economic Sciences this week - and a $1.1million reward - for his work in behavioural economics. Notable in his studies has been “nudge” theory - the idea that ordinary people need help to make rational decisions that will be to their advantage.
It may seem obvious but this simple idea, where applied properly, has been transformative in designing systems that actually work in the real world for real people, as opposed to working only on the blackboards and spreadsheets of economists.
Behavioural economics has been around for several decades now but was slow to take root alongside more traditional theories. Thaler’s work has been instrumental in its progress.
Before behavioural economics and nudge, economic thinking was based on the assumption that people would behave in ways that were always rational. They could be relied upon to act in their own best interest, which was predictable.
The problem, as Thaler saw it, was that they didn’t. Instead, any number of biases meant that they would choose to do things that hurt them in the long run. Thaler has gently mocked the idea from traditional economics of the perfectly rational individual - he christened these fictional beings “Econs” and described them as resembling Mr Spock from Star Trek.
He has used dozens of anecdotal examples to show how we all make irrational decisions all the time. It isn’t rational to buy more food to eat on Tuesday when you are shopping on Saturday, just because you’re hungry when you do the shopping. It isn’t rational, but we’re all prone to do it.
Other examples are even more obvious. We may know perfectly well that changing to a cheaper energy supplier will cut our costs. We may know it’s easy to do and we may even complain that our bills are too high. But yet only a small minority of people bother to switch each year.
You may well be thinking “well, that’s because it’s a boring chore that won’t make enough difference to my life”. That explanation may be obvious, but traditional economics based on “Econs” precludes the possibility of such human responses.
Behavioural economics, on the other hand, takes them into account and nudge is the art of, well, nudging people to overcome them in order to make better decisions.
Nudging UK savers
So why should we in the UK be particularly thankful for Thaler’s work? The answer is that nudge theory was instrumental in the design of a seismic change to our pensions system.
Back in 2002, the Government realised that a great squeeze on retirement incomes was coming. People were living longer and the state and existing models of private pensions, if left unreformed, would leave too many people with too little to live on after they stopped working.
The existing theory, based on traditional economic thinking, was that the tax incentives for pension saving should be enough to encourage people to save, but it wasn’t working. People weren’t behaving as “Econs”.
How could the Government make people save more for their own retirement?
Over the years that followed, using Thaler’s work, an “auto-enrolment” system for pension saving was devised. The “nudge” it employed was to automatically sign workers up to their company scheme - and to make a scheme available if it wasn’t already. It wasn’t compulsory to save, but an individual would have to actively opt out not to do so.
The irrational human inertia that had prevented people saving was now put to work ensuring they stayed signed up to making pension contributions. The money they saved was helped by existing tax relief and also a contribution by their employer
The result? In 2012 when the program started to be rolled-out, the proportion of people saving into a private pension was 55%. By 2017 this had risen to 78%, according to the Pensions Regulator. Nudge has been enough to keep the vast majority of those enrolled saving and opt out levels have been lower than predicted.
Millions of future retirees will have more to live from thanks to the change.
Can you nudge yourself to do even better?
It isn’t simply by helping people to start saving that nudge can help. In a 2004 paper, Prof. Thaler laid out a plan called “Save More Tomorrow” that used nudge theory to help people save more and more over time.
This time, the saver was automatically signed up to save an increasing share of their earnings, year on year. They might save 5% this year, but this rises automatically to 6% next year. Having been automatically enrolled, their contributions were now being automatically escalated, with profound results for the sums they were able to save.
As yet there are no plans to apply this to the current auto-enrolment system in the UK, but individuals can do it for themselves by altering their pension contributions upwards each year. If timed with an annual pay rise, it can be done without fall in the cash value of their wages.