Libertarian Paternalism

As of January of this year, U.S. employers can automatically enroll their employees in 401(k) plans with diversified portfolios – without fear of lawsuits and without certain regulatory burdens.  Automatic enrollment should increase participation by about one-third, and diversification should produce larger and safer returns, although employees are able to opt out of both decisions.  In the future, roughly one of every two 401(k) enrollees is likely to be so enrolled.

This opportunity was created courtesy of the Pension Protection Act of 2006, which reflected the joint efforts of the National Center for Policy Analysis (NCPA) and the Brookings Institution, including Capitol Hill briefings, publications, speeches, editorials, etc.  Yet the real intellectual groundwork came from University of Chicago professors Richard Thaler and Cass Sunstein.  They call the theory behind this effort "libertarian paternalism," and they have written a book about it called Nudge

I first discovered part of the theory on my own about a decade ago.  The NCPA created after-tax Medical Savings Accounts (MSAs) for our employees, allowing them to pay medical expenses directly and to withdraw any remaining cash balances at year-end for other purposes.  According to economic theory, this practice should have made our employees worse off.  Why?  Since there was no tax advantage to the MSA, we could have paid higher wages instead.  Employees could have established their own MSA account or exercised other options, and economics teaches that we are never worse off if we have more options.  Yet not a single employee complained.

In Nudge, Thaler and Sunstein have an explanation of this phenomenon.  True enough, they concede, in a world full of Econs, more choices are always better than less.  But in a world of Humans, things are often different.  They argue convincingly that senior citizens forced to choose among 50 different Medicare drug plans faced a decision-making nightmare and often made bad choices.  Similarly, unsophisticated employees faced with myriad portfolio choices are often poor managers of their 401(k) money.

There is a pattern here.  People tend to "make good choices in contexts in which they have experience, good information and prompt feedback," such as choosing among ice cream flavors.  They often make poor choices in contexts in which "they are inexperienced and poorly informed and in which feedback is slow or infrequent."  Choosing an investment portfolio is one example.  Choosing a drug plan is another. 

So why can't markets solve these problems?  They can and sometimes do.  But often it is more profitable to cater to peoples' frailties and exploit them.

So what can be done?  Since Thaler and Sunstein are libertarian, they are not calling for big-brother government solutions.  They are perceptive enough to realize that regulations often do more harm than the problems they are designed to correct.  But since they are paternalists, they are intensely interested in how to get people to make good choices.  Fortunately, coercion is rarely needed anyway.  Often a simple nudge will do.

With respect to 401(k) plans, far too many people fail to enroll – even when there is an employer match.  Some do not enroll even when the employer is paying 100% of the contribution and they need not invest a dime of their own money.  Once in a plan, people tend to make two more mistakes.  Either they invest in what they know (their employer's stock) or in what they think is safe (money market funds).  The first mistake puts all their investment eggs in one (very risky) basket.  The second generates an inadequate rate of return.

That's where defaults come in.  Employers can automatically enroll their employees in diversified portfolios, leaving them free to opt out of decisions if they choose.  Of course, for homo economicus, a default would matter not one whit.  Yet amazingly, ordinary humans have a very strong tendency to stay wherever the default puts them.

According to Thaler and Sunstein, a great many social problems could be solved with simple nudges.  Some examples:

• For the problem of too few organ donors, why not assume that people want to be donors – leaving them free to opt out of that presumption if they choose?
• For our wasteful, inefficient medical malpractice system, why not assume that people prefer a no-fault alternative – allowing them to pay more to secure their common law litigation rights if they prefer?
• Why not default seniors on Medicare into plans that minimize out-of-pocket costs and maximize coverage for their current drug needs – at least for chronically ill, poor seniors for whom government is paying almost the entire bill anyway?

All three of these examples are from the health care field.  Yet it is with respect to health care that the authors most disappoint.  After all, people are no better at choosing a health plan than they are at choosing an investment portfolio.  Employers could help, but their incentives are skewed by the desire to attract healthy employees and avoid the sick.  Insurers could help, but they make less money if consumers make good decisions rather than bad ones.

Ideally, one would form a committee to recommend an insurance plan toward which people could be nudged.  Trouble is, how many people do you know who are (1) knowledgeable, (2) disinterested and (3) rational about health insurance?  Out of 300 million people, I can't think of more than about five.

Cheers,
John

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