By Jyoti Madhusoodanan
We all know that we should be saving for retirement. But for many, it’s a challenge. We’d rather spend that money on day-to-day needs. Or we just can’t find the time to fill out the forms and enroll in the 401(k).
In the last 15 years, inspired in part by pioneering research by Yale SOM’s James Choi, many companies have begun to automatically enroll employees in retirement savings plans. Automatic enrollment in 401(k) and other long-term savings plans has been shown to increase the amount people save for retirement. But that means that paychecks are a little smaller each week. So where does the savings come from?
We know that balances in retirement accounts increase when employers implement automatic enrollment, Choi explains. But “all the previous research had only looked at what happens inside a 401(k) plan,” he says. “We didn’t know how automatic enrollment affects the rest of a household’s balance sheet.”
In an ideal scenario, people would spend less on a daily basis in order to compensate for the dip in monthly income. But is that what happens? What if they are borrowing money on credit cards or through personal loans to meet their needs? If people don’t change their spending habits, funneling dollars into retirement accounts may actually cause them to take on more debt—resulting in less economic security in their later years.
Understanding that question has been challenging because it requires researchers to link information on retirement savings with an individual’s personal credit history. Choi and his co-authors took advantage of a natural experiment to obtain this data. In August 2010, the U.S. Army introduced automatic enrollment in a retirement savings plan for its civilian employees. New hires were automatically enrolled in the Thrift Savings Plan (TSP), but not existing employees.
The researchers collected anonymized data on individual employees’ retirement account balances as well as personal credit history. They tracked different kinds of debt, such as mortgages and auto loans, as well as measures of financial distress, such as a dip in credit score or a debt being sold to third party collectors.
They found that at the end of four years, employees who were automatically enrolled in the TSP had saved more for retirement—approximately 5.8% of their income in additional savings—than those who were not auto-enrolled.
Automatic enrollment didn’t seem to hurt people’s personal credit: the new hires who were subject to it did not have more unsecured personal loans such as credit card debt, poorer credit scores, or debt with collection agencies. However, it increased participants’ auto loans by 2.0% of their income, and their first mortgages by approximately 7.4% of their income. The larger mortgages may be, in part, because employees who made automatic retirement contributions had larger balances in their TSP accounts—and thus, could obtain larger mortgage loans by using a loan from the TSP to finance a larger down payment.
“The worst-case scenario of an increase in credit card debt doesn’t seem to happen, so that’s good news,” Choi says. “But if you thought that all the extra dollars in retirement savings were being funded by reduced spending, that’s not the case either.”
Since mortgages and auto-loans are secured loans used to purchase assets, they don’t necessarily have a negative short-term impact on net worth, Choi explains. However, cars depreciate quickly, and the net worth impact of a larger mortgage depends on whether a house appreciates in value in the future. So in the long run, these forms of debt may or may not be beneficial.
More work is needed to understand why people who rely on automatic enrollment accrue greater debt on their first mortgages, and how that influences their household finances over time.
“What this study tells us is that there’s this grey area we need to acknowledge,” Choi says. “On balance, I think automatic enrollment is still a reasonable idea and people shouldn’t stop doing it. But they need to be aware that there could be these kinds of consequences.”