Finance

What is reverse pressure and how does it affect your financial planning?

To be sure, I almost just coined the term “reverse nudge.” But here is the definition:

Reverse pressure is a threshold, limit, or similar policy feature of a governmental body, educational institution, employer, or similar entity that has the unintended effect of directing individuals toward behavior that is unreasonable for their particular circumstances.

It’s a bit of a mouthful and a bit clumsy. But let’s start by explaining “ordinary” nudging, a concept from behavioral economics popularized by Richard Thaler and Cass Sunstein in their book by that name and defined as follows (on Wikipedia):

“Cutting, as we will use the term, is any aspect of choice architecture that changes people’s behavior in predictable ways without forbidding any option or significantly changing their economic incentives.” To count as mere nudging, the intervention must be easy and cheap to avoid. Pushing is not a mandate. Placing the fruit at eye level counts as a push. Banning junk food doesn’t mean.”

A “classic” incentive is the use of automatic enrollment and automatic escalation in pension plans; “auto-enrollment” means that when an employee is first hired by a new company, they are automatically enrolled in the company’s 401(k) plan at a modest contribution rate and age-adjusted investment portfolio, but informed that they can opt out at any time and will not be given contributes if you unsubscribe soon enough. “Auto-escalation” means that each year the contribution percentage increases, usually by one percentage point, until it reaches a higher level such as 10%. Again, there is no limit and employees can reduce their contributions, but this increase ideally occurs at the same time as raises are given, so that the employee does not “feel” the cost of the increase in contributions. Both of these automated mechanisms aim to overcome the inertia that otherwise prevents saving for retirement, compared to individuals having to fill out forms or open an account online.

So far so good. Auto-enrolment and auto-escalation have become popular and, indeed, are now mandatory for new retirement savings plans under the new Secure 2.0 legislation.

But pushes can have unintended consequences. I raised the issue in my previous article about the RMD age threshold being a potential “inducement” that leads retirees to believe they should avoid spending their savings, even when it makes more financial sense to do so, especially to delay the start of Social Security Benefits . The actual RMD amount each year certainly also acts as an incentive, causing some to be more conservative and others more aggressive in spending than is appropriate for their personal financial situation.

Even with auto-enrollment, while it’s true that researchers have shown that adding auto-enrollment increases the savings rate when a company makes the switch, at the same time we know that there are other savers who would hypothetically save more than the default amounts. But as far as I know, this is hard to quantify, and we don’t know how much savings are “lost” due to the reverse push effect even if the amount of increase in push-based savings is greater.

There are certainly other “reverse pushes” if you extend the idea to thresholds, thresholds, and design features that were never intentionally designed that way. When requalifying a potential buyer, the mortgage lender will calculate the maximum available mortgage amount. How many people are conversely driven to spend more on their homes than they otherwise would have, even if, in their personal circumstances, it would be financially wiser to borrow less?

Or consider something as simple as university admission requirements, for example at Illinois’ flagship, the University of Illinois at Urbana-Champaign (since I’m writing from Illinois, after all). Although four years of math, social studies, laboratory science, and a foreign language are recommended, the actual requests are lower: 3 or 3.5 years (depending on the intended major) of mathematics and only 2 years of social sciences, laboratory sciences and a foreign language. How many high school students who would otherwise take each of these courses each year actually test the entry requirements and are conversely forced to take fewer?

All this being said, when we as individuals deal with our financial planning or other decision-making, it is important to be aware of whether a nudge or reverse nudge is part of the picture, and to be careful to consider our particular circumstances. Consult a financial planner or use a good planning modeler and look at your own budget, not rules that may not apply to you. This might seem obvious, and financially savvy readers will already know to be wary of marketing gimmicks of various kinds, but the reverse push may be harder to spot because they come from “official” sources and intend to do good, for a segment of the population that would otherwise spent too much or not enough of them.

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