Do We Need to Be Forced Into Saving for Retirement?

Most Americans are not saving enough for retirement
By Kim Clark, CNN Money

Meir Statman, a finance professor at Santa Clara University, is one of the most influential experts in behavioral finance -- the study of how your emotions and beliefs affect your decisions surrounding money.

Research in this field has led to a growing number of practices, such as automatic enrollment in 401(k) plans, intended to gently steer you toward smarter choices.
Ultimate Guide to Retirement

In presentations to financial advisers, and in his 2011 book What Investors Really Want, Statman explores how people try to balance the conflicting goals they have for their investments -- for example, earning top returns while reducing risk.

Statman, 65, has now started to question some of the behavioral finance dogma that has been the focus of his work. In a new paper, he argues that improving Americans' retirement security may require something stronger than a polite nudge.

His conversation with MONEY senior writer Kim Clark has been edited.

You've studied behavioral finance for more than 30 years, and you've seen many efforts to nudge people in the right directions. Do they work?

Nudging is very useful. Lots of people were nudged into saving for retirement by making it automatic and adding automatic escalation of savings.

Fifteen years ago, I might have said that would do the job. I doubt it now, because I see almost two populations: one that can be nudged into retirement savings, and another that is resistant. For them, we need to go beyond nudge into shove, and make retirement savings mandatory. I'm reluctant to shove people. But I think half of us, maybe more, are in a crisis.

So what's your plan?

It's similar to a 401(k) except that it is mandatory instead of voluntary. Employers would administer it. For self-employed people, there would be something like the insurance exchanges in the new health care law.

How much would people be required to save?

We should set a relatively low minimum, say 8% of one's income, satisfying pressing retirement needs. Ideally the level would be closer to 15%. That's the range in other countries that have created mandatory savings plans, such as Israel and Australia.

This is on top of Social Security?

Precisely. You might ask, "Why not just expand Social Security?" but that is not likely to fly politically, and enacting my proposal would require a new federal law.

Social Security is an insurance plan more than a retirement savings plan. It is fair for us to insure one another against dire poverty and disability. It is unfair, however, to ask us to assure others of a comfortable retirement.

Your plan seems very paternalistic.

People would resent it today, but be grateful later on. God knows, we all can tell stories about stuff our mothers forced us to do that we resented then, but for which we are grateful now.

When my dad was young and had young children, he wanted to take money from his pension fund to build another room to our house so there would be more room for the kids. He was turned down. In retirement, he was very grateful that he had been turned down, because it meant that he had more income and could live more comfortably.

We all face dilemmas between consumption now and later. A mandatory savings program prevents you from succumbing to temptation, even to one that is quite reasonable.

If I'm a person who saves already, why should I support your plan? Why should you be permitted to meddle in my life?

Savers should be indifferent to a requirement to save, because they do it anyway.

A resistance to mandates, of course, is part of American culture. I just hope that it can be overcome.

Think about spendthrift parents who arrive at retirement with nothing. And think about their adult kids who are savers. Those children might resent supporting their parents, but they are not likely to abandon them.

If you don't make the nonsavers save, one way or another they are going to fall on the shoulders of the savers.

Let's move on to other financial behavior. What are some big errors people make when investing?

One is applying wrong analogies from other parts of their lives. People think that experience will make them more competent investors, just as surgeons become more competent by performing more surgeries. Well, the analogy does not necessarily apply to investing, because the human body is not trying to fool the surgeon by moving the heart from one place to another.

In investing, the person on the other side of the trade will try to fool you. It might be an insider. It might be someone with special knowledge. People have to be disabused of the notion that investing is like surgery and realize that it's more like a tennis game where your opponent may look weak but, in truth, is much better than you.

What else?

Hindsight. If you kept a diary in 2007, it would likely say something like, "I think that the market is high. I'll wait a bit, and then decide." It would be wishy-washy. But we all look back at 2007 and we say, "Wasn't it clear that the market was going to go down?"

That kind of hindsight gives you the confidence that you can tell the future as well as you can the past.

Later on you might be tempted to sell your stocks because you are sure that their prices will fall -- only to find, three years later, that stock prices doubled while your cash was in a money-market fund.

So whenever I feel like saying, "I just knew it," I tap myself on the forehead and remind myself that I didn't. We are intelligent beings. We can identify cognitive errors and set a defense against them.

You point out that people often overlook the emotional reasons behind their investing. Can you give me an example of that?

I hope that people who trade heavily can admit to themselves that they do it not just to make more money, but because it is fun. Trading, of course, loses people money on average, but it can be fun the same way that playing videogames is fun.

I say, "Well, you know, everything in moderation." Just don't overdo it.

What's another way that emotions can affect investing?

When people are feeling poor, they are willing to take more risks.

You can have two people each earning $100,000 a year. One of them says, "This is plenty." The other feels behind. That one is more willing to risk losses in the hopes of reaching his or her aspirations.

Are there ways in which our emotions and biases actually improve our investment returns?

Whenever you trade stocks, you expose yourself to the possibility of regret. You might find out later on that you would have been better off doing something else.

I think that the anticipation of regret prevents many people from doing something stupid, such as selling all their stocks in March of 2009.

So to the extent that our aversion to regret causes us to buy and hold rather than time the market -- because any action opens a door to regret -- that is a cognitive error that helps us.

Have you seen any evidence over time that people are getting smarter about investing?

You know, I thought that I would be blue in the face before people were going to believe the logic and empirical evidence that index funds do better, on average, than actively managed funds. But it seems that people are learning and getting smarter.

There has been an increase in the proportion of investors' money that is going into index funds and exchange-traded funds. And I'm not blue in the face!

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Gallery: 10 Most Tax-Friendly States for Retirees

10 Most Tax-Friendly States for Retirees
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Do We Need to Be Forced Into Saving for Retirement?

State Income Tax: Flat rate of 3.07%

State Sales Tax: 6%

Estate Tax/Inheritance Tax: No/Yes

Pennsylvania is one of only two states (Mississippi is the other) that exempts all retirement income -- including public and private pensions, IRAs and 401(k) distributions -- from its state income tax. Non-retirement income is taxed at a low, flat rate of 3.07%. Food, clothing and medicine are exempt from state sales taxes. But property taxes can be high in the Keystone State, especially near larger cities. One caveat for the wealthy: Your heirs won't get off so easily. Pennsylvania is one of a handful of states to have an inheritance tax, paid by the heirs.

Photo: Nicholas A. Tonelli, Wikipedia

State Income Tax: 2.2% to 6.75%

State Sales Tax: None

Estate Tax/Inheritance Tax: Yes/No

The First State is number one with many retirees, thanks to low real estate taxes, modest income taxes and no sales taxes. In fact, its highway billboards welcome visitors to the "home of tax-free shopping." Social Security benefits are exempt from income taxes, and residents 60 and older can exclude $12,500 per person of qualified pension benefits and investment income, including dividends, interest and capital gains, from income taxes. Income tax rates on remaining income range from 2.2% to 6.75%, with the top rate kicking in for both individuals and married couples when income reaches $60,000. Residents 65 and older who do not itemize their deductions are eligible for an additional standard deduction of $2,500. Real estate taxes vary by county but are generally low, and homeowners 65 and older qualify for a credit against school taxes of up to $500.

State Income Tax: 2% to 6%

State Sales Tax: 4%

Estate Tax/Inheritance Tax: No/No

For retirees, every day is like Mardi Gras in Louisiana. Social Security and military, civil service, and state and local government pensions are exempt from state income taxes, plus up to $6,000 per person of pension and annuity income. Personal income tax rates max out at 6% on taxable income over $50,000. Property taxes are among the lowest in the nation, according to the Tax Foundation. Assessments are based on 10% of the fair market value. Homeowners receive a homestead exemption of $7,500 of their home's assessed value, and homeowners 65 and older may qualify for a freeze on the value of their home. But sales taxes can be steep. The statewide sales tax is 4%, and local parishes and jurisdictions within those parishes can add their own sales taxes. Louisiana's average combined sales tax rate of 8.86% ranks third-highest in the nation, according to the Tax Foundation. But food and drugs are exempt from sales taxes throughout the state.

State Income Tax: 3% to 7%

State Sales Tax: 6%

Estate Tax/Inheritance Tax: No/No

South Carolina extends its Southern hospitality to retirees. The Palmetto State exempts Social Security benefits from state income taxes, and it allows residents who are 65 and older to deduct up to $15,000 per person ($30,000 per couple) of retirement income, regardless of the source. Younger retirees can deduct up to $3,000 of retirement income, including public and private pensions and IRA distributions, from their taxable income. Property taxes are very low. Taxes are based on 4% of the market value of a home, and homeowners 65 and older qualify for a $50,000 homestead exemption. Senior homeowners are also exempt from school taxes on their properties. But sales taxes can be high. The statewide rate is 6%, plus localities can levy an additional tax of up to 3%. Prescription drugs are exempt, but food is not.

State Income Tax: 2% to 5%

State Sales Tax: 4%

Estate Tax/Inheritance Tax: No/No

Alabama is a tax haven for retirees. Social Security benefits, as well as military, public and private pensions, are excluded from state income taxes (but IRAs and distributions from 401(k)s and similar defined-contribution retirement plans are not exempt). Remaining income is taxed as high as 5%, the maximum rate that kicks in when taxable income tops $3,000. Alabama also has some of the lowest property taxes in the U.S. Homeowners 65 and older are exempt from state property taxes, but some cities assess their own property taxes. The only downside is sales taxes. The statewide rate is just 4%, but cities and counties in the Yellowhammer State can impose their own levies. Together, the combined sales tax can add up to a whopping 10% -- among the highest in the nation. Food is taxed, but prescription drugs are not.

State Income Tax: 1% to 6%

State Sales Tax: 4%

Estate Tax/Inheritance Tax: No/No

Georgia is doing its part to attract retirees to the Peach State with a sizable exemption for income taxes on retirement income. Taxpayers ages 62 to 64 can exclude up to $35,000 per person from state income taxes for a total of $70,000 per couple. Georgia residents who are 65 and older can exclude up to $65,000 of retirement income (or $130,000 per couple) from state income taxes in 2012. Retirement income is broadly defined as interest, dividends, capital gains, net income from rental property, pensions, annuities and up to $4,000 of earned income. Non-retirement income is taxed at a rate as high as 6%. The statewide sales tax is 4%, but local jurisdictions can add up to 4% of their own taxes. Food and prescription drugs are exempt. Property-tax rates are close to the national average, but higher than in many neighboring southern states.

State Income Tax: 3% to 5%

State Sales Tax: 7%

Estate Tax/Inheritance Tax: No/No

Mississippi turns on its Southern charm for retirees. It not only exempts Social Security benefits from state income taxes, but it is one of only two states that excludes all qualified retirement income -- including pensions, annuities, IRAs and 401(k) distributions -- from state income taxes. Non-retirement income is taxed at a maximum 5%. Property taxes in the low-cost Magnolia State are below the national average, according to the annual 50-state property-tax comparison study conducted by the Minnesota Taxpayers Association. Single-family homes are taxed at just 10% of assessed value, and statewide, property taxes average about $1,070 per $100,000 of a home's market value, according to Kiplinger's calculations. In addition, for residents 65 and older, the first $75,000 of property value is exempt from taxes.

Photo by Natalie Maynor,

State Income Tax: None

State Sales Tax: 4%

Estate Tax/Inheritance Tax: No/No

Thanks to the abundant revenues Wyoming collects from oil and mineral companies, residents of the Equality State don't have to fork over much of their income to taxes. There is no state income tax, so you'll pay nothing on your Social Security benefits, pension or IRA distributions. The state sales tax is 4%, and counties can add up to 2% in additional levies. Still, Wyoming has one of the lowest combined sales tax rates in the U.S., and prescription drugs and groceries are exempt. For most residential property, only 9.5% of market value is subject to tax. With a top property-tax rate of 80 cents per $100 in most cities and towns in Wyoming, annual property tax is just $760 per $100,000 of a home's market value.

State Income Tax: None

State Sales Tax: 6.85%

Estate Tax/Inheritance Tax: No/No

Nevada is a good bet for retirees because it shifts much of its tax burden to out-of-state tourists and gamblers. The Silver State has no income tax, so your Social Security benefits, pension, IRA distributions and even income from a part-time job won't be taxed. Property taxes, which are assessed on 35% of a home's appraised value, are reasonable and typically run about $1,050 per year for a $100,000 house. But sales taxes, which can top 8% in some areas, are higher than average. Overall, Nevada has the second-lowest combined state and local tax burden in the nation, according to the Tax Foundation.

State Income Tax: None

State Sales Tax: None

Estate Tax/Inheritance Tax: No/No

Alaska is a true tax haven for retirees -- if you don't mind the cold weather and you enjoy rugged outdoor beauty. In addition to enjoying no state income tax, Alaska residents benefit from the cold, hard cash of an annual dividend ($1,174 for 2011) from the state's oil reserves that is distributed to every permanent resident who has lived there for at least one year. There is no statewide sales tax. But some localities impose a sales tax, at an average of less than 2%. Alaska real estate taxes and home prices can be high, but homeowners 65 and older are exempt from municipal taxes on the first $150,000 of the assessed value of their home. "Alaskans are consistently the least taxed residents in the nation," according to the Tax Foundation.

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