Stay Informed!

Remind, Automate, Disclose

Posted on 06/21/2010 @ 12:00 PM

Tags: Behavioral Economics

Genevieve Melford, Director of Research, CFED

Behavioral Economics and Microfinance

At its core, microfinance is about empowering low-income people, through access to small-scale financial products and services, to improve their financial condition. Insights from the study of behavioral economics have a lot of value to add to the practice of microfinance. They help us understand how people make decisions, and the way that the immediate context of their decisions guides financial behavior, and can even undermine the ability to meet financial goals. Armed with this knowledge, we can design products, systems, and financial regulations that meet people where they are, and therefore have the potential to support their financial success in much more significant ways.

A few weeks ago I had the pleasure of introducing and moderating a session on Behavioral Economics and Microfinance at the 2010 Microfinance USA conference. As readers of this blog likely already know, there are myriad ways that insights from the behavioral sciences can apply to everyday life, and to financial decision making. We chose to focus the session on behaviorally- informed interventions to affect savings and borrowing decisions, two of the building blocks of personal financial management and opportunity, and key areas of interest for the microfinance field.

Why Personal Financial Management Is So Hard

Standard microeconomic theory does not do a very good job of describing people’s personal financial behavior. It assumes that people always have perfect information and act rationally on that information all the time. It would suggest that we are able to effortlessly compute every step and decision along the way to reaching our life-long goals, and then take action every day in a manner consistent with those long-term plans (like saving for retirement or a home purchase or building good credit).

The reality is that almost no one does that. Our intentions, especially when related to a distant payoff, often do not translate into actions.

Personal financial management - regardless of one’s income level - includes frequent decision-making challenges about spending, saving and borrowing. It requires the ability to predict and plan for future needs, have the self-control to defer present consumption in favor of future needs and choose between sometimes complex product options (like health insurance, mortgages or retirement investment funds).

However, behavioral research suggests that people are in fact very present-oriented. A few examples of this are that:

• We discount the value of future consumption in favor of gratification in the moment (we REALLY prefer to have things now rather than save to have things in the future).
• We have trouble following through on plans when they require ongoing conscious actions (like remembering to make savings deposits or insurance payments on a regular basis), and are very likely to stick with default settings or the status quo.
• We are bad at predicting the probability of future events and risks (like unpredictable health care costs, or a future job loss, or our ability to pay back a payday loan in two weeks), or even what our preferences will be in the future.

And all of this has consequences for our financial choices and outcomes, which is why many of us automate as much as possible in our financial lives - taking advantage of direct deposit, automatic bill pay and automatic transfers into regular and tax-advantaged retirement savings accounts – to help us overcome these very human challenges.

Microfinance World: Take Note!

The trio of speakers on the panel – Margaret McConnell from Harvard, Alejandra Lopez-Fernandini from the New America Foundation and Adair Morse from the University of Chicago - presented on a number of practical and concrete ways to leverage behavioral insights to help people do three very important, and frankly difficult, things:

1. Take action today to save for the future– this includes savings reminders and account labeling;
2. Follow through on savings intentions over time – account structure (e.g., making the account very easy to open, and savings somewhat difficult to access) and automation are key; and,
3. Make a choice to borrow that’s truly well-informed – frame disclosure and options in ways that overcome predicable biases.

For readers who just want the top line takeaways from these presentations, here you go:

1. Reminders increase savings deposits, and reminders focused on specific future expenditures (like school fees) increase savings even more.
2. Savings accounts with automaticity and other features to make savings behavior “easy” and “sticky” can facilitate greater levels of saving.
3. Payday borrowers who received information on the total dollar cost of loan fees were less likely to take out another payday loan in the following two months.

For those who would like a bit more detail on the behavioral principles and mechanics of these studies, read on…

How Reminders Increase Saving

Ms. McConnell presented on joint research conducted with Dean Karlan, Sendhil Mullainathan and Jonathan Zinman. She and her co-authors wanted to explore the following observed anomalies in financial decision making:

• Many people engage in high-cost borrowing;
• People save and borrow (at high cost) at the same time; and,
• There is demand for “commitment” (restricted access) savings products.

They wondered if people fail to save enough for future and emergency needs, resulting in high rates of expensive borrowing, because people are only able to plan for expenditures that are closer to the “top of the mind.” That is, they simply are not accurately predicting their future expenditure needs (in psychology this is called the “planning fallacy”). As Ms. McConnell pointed out in her presentation,

“When a shock [unexpected expense] occurs, debt is your friend, ready to be there, right when your attention is on your ‘shock.’ Savings, on the other hand, is not…it had to be planned.”

To find out if lack of attention paid to future expenditure needs does in fact reduce savings in the present, researchers randomly assigned new savings accountholders in three countries (Peru, Bolivia and the Philippines) to receive generic reminders to save, as well as reminders focused on a particular savings goal / specific future expenditure. They found that reminders increase savings deposits, and that reminders focused on specific future expenditures (like school fees) increase savings even more, supporting the hypothesis that simply failing to think about future expenditures may explain at least some portion of people’s failure to save enough, and therefore to resort to expensive borrowing.

Interestingly, the authors conclude that their findings “suggest that reminders or other attention shocks may be most (cost-)effective when they focus on inducing a one-time change with ‘sticky’ consequences (e.g., 401(k) enrollment, fertilizer prepayment or automatic payment of annual car registration fees).” That is, rather than sending people reminders to save every month, it would be better to use an attention shock technique to get people to sign up for a savings account that would have money automatically deposited from a paycheck or checking account each month.

Automation and Other Account Features Can Also Increase Saving

The need for “sticky” consequences, or a financial product structured to reduce the need for conscious follow through, is a key element of the New America Foundation’s AutoSave pilot. The program is designed to offer employees the opportunity for automated, regular savings via their employer’s existing payroll infrastructure. Working with CFED’s own Innovator-in-Residence Mindy Hernandez, Ms. Lopez-Fernandini and her colleagues designed the AutoSave product and enrollment process to leverage multiple behavioral principles to increase savings.

Mindy and Ms. Lopez-Fernandini wrote an excellent post on AutoSave, describing its features and rationale, for this blog just a few months ago, so I will skip to some of the key findings here:

• The anchoring effect of a suggested savings level was very strong: 51% of participants chose the recommended savings dollar amount pre-checked on the enrollment form.
• Many participants liked the fact that the AutoSave account is not linked to a transaction account, making it more difficult to access the savings (this supports the observation of demand for “commitment” savings products referenced by McConnell in her presentation). People know that they will face temptation to spend rather than save, and like having that temptation lessoned or made easier to resist through savings product design features.
• Ease of enrollment appears related to take up of the product, as does apparent strong support and follow up from employers, though the size of these effects are difficult to quantify.

The Way Costs are Disclosed Can Reduce Payday Borrowing

The third panelist, Adair Morse, presented on a fascinating research project conducted with her colleague, Marianne Bertrand. In the one presentation to focus directly on use of credit, Ms. Morse spoke about her project to determine if high-cost payday borrowing may be an irrational decision, resulting from the inability of most people to do complex math in their heads. If it is indeed a decision that consumers are making without fully understanding the costs, then Morse argues one policy remedy may be to mandate disclosure of costs in such a way as to “debias” the consumer by “exposing the population at risk of mistake with site-relevant information at moment of a possible mistake (e.g., at point of payday loan or mortgage).”

In order to study the effect of different methods of presenting the cost of payday loans, Morse and Bertrand randomly assigned borrowers at 77 payday lending branch locations in 11 states to receive their loaned cash in one of four different envelopes. The “control” envelope, the standard one provided by the lender, was simply printed with a calendar and the date on which the loan was due.

The other three “treatment” envelopes presented the cost of payday borrowing in three different ways:

• As an APR, compared to the APRs of other types of loans,

• Total dollar cost of loan fees into the future, compared to the dollar cost of borrowing on a credit card, and

• Information on the typical number of refinancings of a payday loan.

I encourage people to read more of the details of this fascinating study, but in a nutshell the finding was this: Borrowers who received information on the total dollar cost of loan fees were 10% less likely to take out another payday loan in the following two months.

Interestingly, researchers working on a different project on “confused” mortgage borrowers recommend the same form of disclosure - total dollar cost – as a method by which consumers can realistically make a well-informed choice between different mortgage options and brokers.