Social Norms, Rules of Thumb, and Retirement: Evidence for Rationality in Retirement Planning

Center on Social and Economic Dynamics Working Paper No. 37

43 Pages Posted: 9 Nov 2007

See all articles by Gary Burtless

Gary Burtless

Brookings Institution; Boston College - Retirement Research Center

Date Written: November 2004

Abstract

Most economists assume economic agents are well informed, far sighted, and rational. By “rational” they mean that agents use sound logic when deciding on a course of action. Rational agents combine all the information at their disposal, including knowledge of their own references and long-term interests, to make logical choices that maximize their well-being given the constraints facing them. This essay considers empirical evidence on whether this model explains saving for retirement or the timing of retirement. Many observers are skeptical that workers make retirement decisions in the far sighted and logical manner just described. Unlike other economic choices, which are repeated many times over the course of one's life, the decision of when to retire is made only once. Workers are not given the opportunity to improve on decision making through constant repetition. As an alternative to fully rational decision making, agents might imitate the behavior of others who are presumed to be better informed or to have superior skills in planning. Alternatively, workers may adopt and follow simple rules of thumb, which can produce decisions that depart significantly from a financially optimal choice.

The evidence on the financial soundness of workers' retirement choices is mixed. When polled about their preparations for retirement, large minorities of Americans acknowledge they have given no thought to the subject, have saved little or nothing in pension and other retirement accounts, and lack confidence they will be able to afford retirement. Many workers near retirement age are ignorant of the rules that will determine their pension benefits. Economists and financial planners report alarming evidence that middle-aged and older workers face large saving shortfalls compared with the nest eggs needed to retire at the typical retirement age. Extensive evidence shows that a substantial minority of workers experiences big drops in consumption after they retire, which appears to violate a basic implication of the life-cycle model.

On the other hand, recent analysis of the best survey evidence on workers' earnings, pension accumulations, Social Security entitlements, and non-pension saving reveals that very few workers have nest eggs that obviously and substantially fall short of what is “optimal” under some conceivably rational plan. Many workers who have little or no retirement saving can all back on Social Security or public assistance to support minimal onsumption in old age. The drop in consumption that occurs after retirement could be explained by declines in workers' consumption requirements after they leave work. Alternatively, it could be the unwelcome byproduct of a plant closing or the onset of serious disease, events that force workers to leave work early. Even if the possibility of a plant closing or poor health were fully anticipated in a far-sighted plan, the worker may have rationally intended to accept a big cut in consumption if his or her career came to a premature end. This means we cannot rule out rational foresight when workers enter retirement with little savings or when they experience big drops in consumption over the course of their retirement. Bad outcomes may have been fully anticipated – and accepted – in a far-sighted and rational retirement plan.

Recent research findings on worker savings and retiree consumption do not prove that retirement and saving decisions are made in a fully rational and far-sighted way. The evidence only shows it is hard to rule out rationality and far-sightedness using available information on households' consumption and savings. What older workers actually tell us about their saving behavior, retirement plans, and knowledge of pension rules suggests that relatively few make big investments in learning or thinking about the financial trade-offs that are relevant to retirement. Many workers probably consider the payoffs from such investments to be uncertain and small. Compared with the happiness that retired workers could obtain if they followed a rational and far-sighted retirement plan, the loss in happiness they actually experience using a simpler decision-making rule may be minor.

Suggested Citation

Burtless, Gary T, Social Norms, Rules of Thumb, and Retirement: Evidence for Rationality in Retirement Planning (November 2004). Center on Social and Economic Dynamics Working Paper No. 37, Available at SSRN: https://ssrn.com/abstract=1028068 or http://dx.doi.org/10.2139/ssrn.1028068

Gary T Burtless (Contact Author)

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