A popular way to help people with their finances is by gently prodding them to make better decisions.
There are automatic payments on credit cards and auto-enrollment in 401(k) plans. Some companies even automatically up retirement plan contributions every year for their employees.
These nudges appear to work at first, but a handful of recent studies show that some aren’t nearly as effective as promised in the long term, while others lead to more harmful outcomes.
The findings underscore the limits of changing people’s financial situation one nudge at a time but also provide a window into how to make these policies work better in the long run, so people can achieve financial security.
“Nudges are not a panacea,” Jialan Wang, an associate professor of finance at the University of Illinois Urbana-Champaign, told Yahoo Finance. “But that doesn’t mean that a smartly designed nudge can’t help people on average.”
“They can be absolutely a very powerful tool in our tool kit.”
Wang came to this insight after more than a decade of research on how Americans pay down their credit cards. In a recent study of hers focused on credit card autopay, cardholders were given the opportunity to enroll in autopay for the minimum amount or full balance every month when they opened an account.
Autopay more than doubled the share of cardholders making the minimum payment, Wang found, and reduced charge-offs, crucial to helping a person’s credit score and avoiding late payment fees. Autopay for the minimum was also very sticky — people stuck with that option for 10 months after the account opening rather than paying more.
“It has a convenience feature and does prevent you from being late,” she said. “But that leads to another stream of potential negative effects such as racking up more debt, paying higher interest costs, etc.”
Wang theorized that maybe if more autopay options were available, that could prevent people from getting stuck in the minimum payment loop.
If only it were that easy. Just ask Benedict Guttman-Kenney, an assistant professor of finance at Rice University.
Read more: The best ways to pay off credit card debt
Guttman-Kenney and his colleagues designed a study in the UK that nudged cardholders to choose a different automatic payment option than the minimum.
When cardholders were presented with autopay options, one subset could choose among three: the minimum, a fixed amount, or the entire balance. The other subset could only choose between the fixed amount and the full amount.
At the outset, the results seemed promising. More people signed up for the automatic fixed amount payment if they were not offered a minimum payment option. But after seven months, it became clear that the fixed-amount crowd didn’t fare much better.
Their debt remained unchanged because they often chose a fixed amount that was so low — just above the minimum payment — that after months of spending on their card and adding to their balance, their fixed amount didn’t even equal the minimum payment.
“It was a disappointing finding overall,” Guttman-Kenney said.
Read more: What happens if I only pay the minimum payment on my credit card?
Of course, not all financial nudges backfire. Some just turn out to be meh. Let’s look at retirement savings.
In 2006, Congress passed the Pension Protection Act that encouraged companies to automatically enroll workers into 401(k) plans, a heralded effort to boost participation and increase savings.
The legislation followed research similar to that of James Choi, a professor of finance at the Yale School of Management. In 2002, he and his colleagues published one of the first papers showing that auto-enrollment had a big effect on 401(k) participation rates and contribution rates. This year, Choi and his co-authors revisited those findings.
“The spirit of the scholar should be trying to be the toughest critic of your own work and really trying to see what are the limits of that result?” Choi said.
Choi also wanted to examine the auto-escalation of contribution rates, which the recently passed Secure 2.0 Act requires employers to do starting next year.
What Choi and his colleagues found was that — again, after time passed — the benefits of auto-enrollment and escalation eroded quite a bit, given that people often change jobs. When they do, many of them cash out some or all of their 401(k)s, commonly referred to as leakage.
Turnover also leads to less-than-impressive outcomes for auto-escalation because the hike in contribution rates usually occurs once a year. If a worker leaves after a year and a half, their contribution rate doesn’t increase that much. Once they’re at a new employer, their auto-contribution rate is likely set at a lower starting rate.
“You’re gonna start off back at square one,” Choi said. “It is a big part of the story of why auto-escalation in the job environment that Americans live in [is] not having as big of an effect as we thought initially.”
And then there’s the stickiness of auto-escalations overall. Previous research put the participation rate in auto-escalation at 85%, Choi said, but his research found that just 40% of workers who were defaulted into auto-escalation actually accepted the first escalation. Many opted out, followed by more as time went on.
“A lot more people opt out of the auto-escalation default than had previously been understood,” he said. “So that was a surprise.”
Another recent working paper from Taha Choukhmane, an assistant professor of Finance at the MIT Sloan School of Management, and his colleague found that with any additional income put toward retirement savings, people cut back their spending — a good outcome. But they also reduced their net savings in the bank and shrunk their credit card payments — not so good.
And among folks with substantial savings in a bank account, an increase in retirement contributions didn’t prompt them to reduce spending at all and didn’t lead to a real increase in overall savings.
“Any sort of nudges for savings may not have that big of an effect for high-income people,” Choukhmane said, “because all they’re going to do is shift money from one account to the other rather than really change their spending patterns.”
So why don’t financial nudges work as intended? It’s not like people want to stay in debt or not save for retirement.
In some cases, nudges don’t take into account people’s actual circumstances.
“If they haven’t got the money, they haven’t got the money,” said Guttman-Kenney, who found that credit cardholders with limited money in the bank chose lower payments. “It’s going to be hard to use these soft nudging approaches to get people to repay more.”
These nudges also often work in isolation. They don’t take into account what’s happening with other aspects of a person’s finances. Again, take auto-enrollment and escalation.
“The goal cannot be just retirement preparedness. It has to be retirement preparedness that also is financial resilience, having the money to pay for your car if it breaks down,” Choukhmane said.
“That’s one of the things I think is interesting about these financial nudges because they are addressing probably one piece of that puzzle, but what is the effect on the rest of the puzzle pieces?”
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This doesn’t mean we should throw out nudges with the bathwater. But we need to be smarter about designing financial nudges and stay diligent about testing them, especially over the long term.
Otherwise, consumers will be faced with a bunch of ineffective nudges, leading to what Wang called “nudge overload.”
“They’re just going to tune out everything.”
Policy is also expensive to implement, so any new nudges shouldn’t be slapdash.
The CARD Act of 2009 in the US mandated credit card issuers to show the effects of paying just the minimum on monthly billing statements to change payment behavior. But studies later showed it didn’t, said Guttman-Kenney, who did a similar study on disclosures in the UK, which also wasn’t successful.
“In this case, we were able to work out that this didn’t work,” he said of his latest study. “So it didn’t make sense for the regulator to make policy.”
“That was a good policy outcome — at least.”
Janna Herron is a Senior Columnist at Yahoo Finance. Follow her on X @JannaHerron.
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