The Power and Perils of the Default Option

The psychology of the default effect can be a powerful tool in our financial arsenal. But only when we put it to the right use.

In 2012, the UK implemented reforms that required employers to do something only a handful of countries had done previously. Their aim was to increase the amount of private pension saving across the country.

The reforms required employers to automatically enrol eligible workers into a workplace pension scheme and make a minimum contribution. These requirements were phased, beginning with the largest employers – most of whom already had existing schemes – and eventually covering all businesses employing somebody by 2017.

In practice, these reforms meant that if you worked for a business, only by actively opting out could you stop yourself from investing into a private pension (provided you earned above a low salary threshold).

This change might not seem significant at first glance. After all, those that weren’t interested in investing would just opt out, right?

Wrong. By 2018, 9.9 million workers had been automatically enrolled. The opt-out rate was just 4.7%. What’s more, many of these individuals had always had the option of a pension when joining a business. They simply hadn’t enrolled when presented with the choice.

The reform has transformed many people’s long-term financial readiness, and there is simple reason why. Automatic enrolment deliberately takes account of an important cognitive bias: the default effect.

What Is the Default Effect?

The default effect shows that we tend to exhibit a preference for the default option when presented with a selection of choices. Wide-ranging experiments show that making an option a default choice significantly increases the likelihood of it being chosen.

In their book Nudge, Richard Thaler and Cass Sunstein argue that setting or changing default options can be an effective way for policymakers to nudge behaviour changes. As they demonstrate, defaults can have a striking impact on choices around a range of socio-economic issues.

These effects aren’t limited to higher pension savings. For example, countries with an opt-out policy for organ donation typically have a significantly longer list of organ donors than those on an opt-in basis.

Key Concept – Libertarian Paternalism: Nudge policymaking is based on the idea of libertarian paternalism. That is, the idea we can influence decisions to produce better policy outcomes, without taking the choice away from the individual. Default options are just one example of how this can be achieved.

Causes of the Default Effect

So why are default choices so powerful?

  1. Inertia: The first and most simple explanation is that if there is a default, we simply choose to do nothing about it. Why invest effort if the decision has been made for us?

But the truth, of course, is a little more nuanced than that. Our settling on a default option is also a fine balance of our assessments of risk, costs, and trust.

  1. Risk: The concept of loss aversion plays an important role. If we perceive that moving away from the default option involves a loss of some form, we are more likely to stick with the default option. Automatic enrolment in pensions is a prime example here.
  2. Costs: Sometimes changing our choice comes at a cost. We may need to spend time or money investigating what the other options mean and even registering our new choice. In the case of pensions, opting out often requires you to fill out a form and post it to your employer and/or pension provider. Sometimes that cost is enough to put us off deviating from the default.
  3. Trust: Depending on who is making the decision for us, default options may also be seen as helpful recommendations. Our degree of trust in that recommendation can make it more difficult to move away from the default choice.

The causes of the default effect are therefore multifaceted. But regardless of cause, they can help us optimise our decision making – but they can also be our decisions’ undoing. In the arena of personal finance, this is worth exploring in a little more detail.

The Upside: Optimising Our Personal Finances Using Defaults

Time and time again on this blog, I have extolled the virtues of automating our finances. And there is a simple reason for that.

The single most effective way of avoiding cognitive biases in financial decision making is to limit the number of decisions we take. When we take a decision and then let a machine make that decision again for us by default each month, we do precisely that.

Achieving this effect in personal finance couldn’t be more straightforward in the age of the internet. We can set up regular overpayments of debt and regular investments in a matter of seconds. And we can set these up to be taken right after our monthly pay hits our bank account, eliminating the temptation to spend the money elsewhere. (Psychologists might label this a commitment device: taking a choice in the present to restrict choices in the future.)

If our income is spread across the month, we could set up two sets of default transfers each month – one on the 1st day of the month and one on the 15th day of the month – thus reducing the window of opportunity for impulsive spending during the month as income arrives.

Setting up default choices that repeat month after month can have lasting effects on our future wealth. But this is only the case if the default choice is rationally selected in the first place.

And while defaults are an undoubtedly powerful wealth-building trick, they are not a silver bullet for your personal finances. Defaults can have downsides, too.

The Downside: Defaults Can Be Expensive

Businesses talk a lot about “paralysis by analysis”. If we invest so much time analysing every possible permutation of a decision, in the end we may fall short of taking the decision at all. In the world of defaults, we can experience a paralysis of opposite characterisation.

I like to call this “paralysis by default”. It’s the state of inertia that default choices can encourage, and it gets deeper as our time with our default choice grows longer. It can lead to the idea that because we’ve automatically done it one way for long period of time, there is no need to change it.

There are two potential problems with this approach. First, what worked before doesn’t necessarily work now. While in personal finance a steady long-term investment plan should yield fruit, there are circumstances that can change. We should therefore keep our finger on the pulse.

Second, we may be missing out. Defaulting to invest $500 per month may have been sensible two years ago, but how does that look now? If your income has grown, perhaps you are not working your money as much as you could be.

There is one overarching remedy for these two problems: we need to keep our default choices in mind, periodically reviewing them.

A simple approach to the second problem, for example, is to set a threshold for living expenses and assign the rest of your income to default transfers. As your income changed, you could then tweak your default transfers accordingly.

The bottom line is that default transfers are likely to net out favourably, but shouldn’t be immune to change. They are not an excuse to take your hands off the steering wheel.

Summary

  • The default effect shows that we tend to exhibit a preference for the default option when presented with a selection of choices.
  • This cognitive bias can be used an effective tool for managing our personal finances, by setting up default transfers to pay down debt and invest.
  • But while research shows this is an effective finance tool, if not carefully stewarded, defaults can breed inertia and complacency.

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