Delaying gratification

Individuals' tendency to opt for immediate rewards at the expense of longer term benefits has been implicated in everything from the pensions crisis to the growing problem of obesity in the Western world. A new report out today explores how policymakers can use our latest understanding of human behaviour to inform how best to encourage people to save more for retirement, lead healthier lifestyles, and make long-term financially responsible decisions.

The Parliamentary Office of Science and Technology (POST) report, entitled 'Delaying Gratification', was written by Laura Haynes, a University of Cambridge PhD candidate in Behavioural Economics at the Behavioural and Clinical Neuroscience Institute, while undertaking a research fellowship at POST (funded by the British Psychological Society).

Classical economic theory assumes that people are "rational" and that their preferences will not change over time. However, recent research has found that more often than not individuals will sacrifice positive long-term outcomes for immediate rewards (for example, accepting £50 today rather than £100 in six months). Such 'time inconsistency', the tendency to plan to be patient in the future but to then succumb to the temptation of immediate rewards, is evident in decisions that affect everything from our finances to our health.

Time inconsistency leads individuals to have a difficult time overcoming 'present bias', the tendency to place a greater importance on immediate outcomes. This phenomenon is cited as one of the contributing factors to the current credit crisis. Many sub-prime borrowers were offered mortgages with very low 'teaser' interest rates. It is believed that present bias may have 'led them to underestimate the difficulty they would experience paying off their loan once the interest rate increased'. Present bias is also relevant to bonus structures at financial institutions which rewarded short-term gains without regard for the long-term risk to the institution's solvency.

Interestingly, some groups are more likely to be vulnerable to present bias than others. They include people of low socioeconomic status, people with drug abuse problems (including smoking) and individuals with mental health problems (such as Attention Deficit Hyperactivity Disorder).

Time inconsistency and present bias have a tremendous affect on how we make decisions. But what can policymakers do to help overcome these innate biases? The report highlights several policy tools that could assist individuals in making decisions in their long-term interest. It states, "Social marketing and public information campaigns are useful tools to educate the public and change certain attitudes, but some issues demand a greater degree of intervention to effect widespread behaviour change."

Policy approaches discussed in the report include using immediate incentives to encourage behaviours that otherwise produce largely long-term rewards (for example, in the health domain), committing to future decisions in advance (for example, in the case of pension contributions), and measures to protect vulnerable consumers (for example, in the alternative credit market).

Author Laura Haynes stated: "There is a growing appreciation that policy is more likely to be successful if it is designed to take account of an understanding of people and their behavioural biases."

One of the examples cited in the report was the issue of 'saving for retirement'. With the ratio of working age individuals per pensioner expected to plummet from 3.4 people in 2002 to 2.5 in 2030 and the fact that seven million people of working age are estimated to be under-saving for retirement, people are justifiably concerned.

The scheme Save More Tomorrow (SMarT) was cited as an example which attempts to overcome individuals' tendency to under save for their retirement. It is designed to capitalise on individuals' long-term financial preferences to encourage them to increase their pension contributions. Employees are given the option to allocate a percentage of future salary increase towards their retirement savings. The scheme attempts to overcome individuals 'present bias' and has proven very successful as a result.

Additional case studies explored in the report include 'responsible lending' and 'incentives and health'.