If employees are automatically enrolled in (and given the option to opt
out of) a 401(k)-type savings plan, they will set aside more money than if
the plan defaults to a zero contribution and requires active enrollment.
Merely changing the plan’s default nudges people to save more for retirement.
ment of traditional baseball scouts at selecting top players. In
baseball, the market for talent had been inefficient in large part
because it was dominated by intuition-based decision-making.
Similarly, my experience and that of my colleagues in helping
insurers build and implement predictive models have demonstrated that the often subjective methods used by underwriters
to select and price risks can be improved through the judicious
use of predictive models. That these predictive models provide
improved accuracy, consistency, and segmentation power is—in
retrospect—unsurprising given that underwriters are, like the
rest of us, Homo sapiens, not Homo economicus.
Using predictive models to improve insurance underwriting
decisions is therefore, like Moneyball, a case study in behavioral
Fraught Choices and Better Choice Architecture—Nudge is
more than a popularization of behavioral economics. Discussions of behavioral economics often dwell on the ways in which
people make suboptimal or irrational decisions. Thaler and
Sunstein take the conversation to the next level—they suggest
that the findings of behavioral science can be strategically employed to prompt people to make better decisions. Put simply, if
we know that people tend to select the default when presented
with a long list of confusing options, then let us set the default
with their best interest in mind.
A motivating example is the line at a cafeteria. People tend to
stock up on items at the beginning of the line and select fewer
items at the end of the line because their trays are already full. So
a cafeteria manager who wants to promote public health would
take care to put more healthful items at the beginning of the line
and less healthful items at the end. Thaler and Sunstein call their
idea “libertarian paternalism”—it is libertarian because people
remain “free to choose” (to borrow Milton Friedman’s famous
phrase) whatever items they want, regardless of how they are
presented. But it is simultaneously paternalistic in the sense that
the cafeteria manager uses good choice architecture. He or she
strategically uses knowledge of people’s behavior to present the
choices in a way that promotes sound decisions.
The idea of choice architecture is particularly relevant to
insurance. Good choice architecture is especially needed in domains where people must make complex, infrequent choices that
have long-term implications. To illustrate, it is easy to walk into
an ice cream store and quickly choose a flavor from dozens of alternatives. The choice is not complex, you’ve done it many times
before, and the feedback from your choice (does it taste good?)
is always immediate and unambiguous. In contrast, consider the
decisions involved in choosing among financial products like
mutual funds, annuities, stock/bond allocations, various types
of mortgages, and menus of employee-benefit options.
Purchasing insurance and other long-term financial decisions are examples of what Thaler and Sunstein call “fraught
choices.” They have the opposite character of the ice cream
purchase. Fraught choices are complex decisions that often require specialist knowledge, are made infrequently, and whose
good or bad effects are felt only in the (distant) future. Here especially would people benefit from careful choice architecture
that nudges them toward better decisions.
Thaler and Sunstein cite the recent Medicare Part D prescription drug benefit program as a notorious example of poor choice
architecture. Seniors were given a large menu of choices with
no guidance to help them make a sensible decision. For some,
the default option was non-enrollment, and for others, the default was randomly assigned! The result was mass confusion. To
borrow another of Thaler and Sunstein’s culinary analogies, this
presented seniors (and their equally confused doctors) with a
decision problem similar to that of studying an extensive menu in
a foreign country. Just as a set tourist menu would help at the restaurant, judiciously selected Medicare Part D defaults, perhaps
tailored to the individual using relevant data, would have helped
the seniors avoid decision paralysis or random guessing.
Their most famous example of successful choice architecture involves retirement savings plans. It has been demonstrated that if employees are automatically enrolled in (and given
the option to opt out of ) a 401(k)-type savings plan, they will
set aside more money than if the plan defaults to a zero contribution and requires active enrollment. People are given the
same choices either way. But merely changing the plan’s default
nudges them to save more for retirement. Another example is
Thaler’s “Save more tomorrow” idea in which employees in
advance can elect to allocate a portion of future pay increases
to savings. When this has been implemented, it has resulted in
significant increases in savings rates.