Here’s a trivia question for your next cocktail party: What do Delta flight attendants have in common with Cravath, Swaine, & Moore lawyers?
The answer: More money in their pockets thanks to large pay raises.
Delta and Cravath both announced increases for their employees. Delta’s flight attendants, along with baggage handlers, gate agents and other hourly workers, will receive a 6% pay raise, effective April 1, 2017. Meanwhile, Cravath rewarded its associates with a huge pay raise last year; the firm resurrected the legal salary wars, increasing first year associate salaries from $160,000 to $180,000.
People can find myriad personal finance articles counseling them about what they should do with a pay raise (e.g., pay down high-interest debt, increase retirement contributions); however, there is a dearth of advice helping them translate intent into action. Individuals may resolve to put half of their raise into an emergency fund, but get distracted by a new shiny toy or simply see the money slowly drain out of their account before they get around to moving it into savings.
Regardless of what you plan to do with an influx of money, the three-step plan outlined below, based on scientific insights from behavioral economics, will help ensure that you follow through.
Step 1: Pre-Commit
The Bottom-Line: Once you find out what the size of your raise will be, decide in advance how you will use the money. Do not wait until the raise takes effect to decide how to allocate it.
The Science: Many studies illustrate the benefit of making decisions in advance, but in honor of my dessert-loving fiancé, let me share one that involves chocolate. In a classic study, “Predicting Hunger: The Effects of Appetite and Delay on Choice,” Daniel Read and Barbara van Leeuwen asked a group of participants, “If you were deciding today, would you choose fruit or chocolate for dessert next week?” When making a choice for the future, 74% chose fruit.
Read and van Leeuwen asked another group of participants a variant, “If you were deciding today, would you choose fruit or chocolate for dessert today?” Suddenly, 70% chose the chocolate!
The Why:
Participants in Read and van Leeuwen’s chocolate versus fruit experiment displayed “present bias” or “temporally inconsistent preferences,” which is science-speak for “what is gratifying now is not necessarily what is preferred for the future.”
When there is an option for instant gratification, like receiving chocolate today, people disproportionately emphasize short-term benefits and costs. But when both options are in the future and there is no immediate benefit, individuals tend to make healthier choices. Translating from food to finance, by deciding in advance how you will allocate your raise, you are more likely to choose the financial fruit. This could mean paying off debt, adding to an emergency fund, or increasing retirement contributions.
Another set of academics – Samuel McClure, David Laibson, George Loewenstein, and Jonathan Cohen – explored this phenomenon further using functional MRI scans of the brain. They analyzed brain function while subjects made choices between monetary rewards, which varied in their immediacy.
They discovered that the brain’s limbic system responds only to immediate rewards, but the fronto-parietal system responds equally to all rewards. In other words, the emotion system in the brain is impatient while the analytical brain is patient. The present bias is a result of the combined influence of those two neural systems. Because the emotional brain responds little to delayed rewards, it “engenders a taste for instant gratification.”
Pre-committing to how your raise will be allocated will help ensure that the front-parietal system tempers the limbic system. By rebuffing the need for immediate pleasure, you will make healthier financial decisions.
While pre-commitment is an important first step, its benefits are best unleashed when paired with another technique – automation.
Step 2: Automate
The Bottom-Line: Automate the allocation of your raise instead of doing it manually.
The Science: In a highly regarded study (also involving chocolate), Baba Shiv and Alexander Fedorikhin had subjects memorize a string of numbers and then move to another room where they were asked to choose between two desserts, fruit salad and chocolate cake, both of which were physically in the room.
One group of subjects had to memorize a string of seven digits, while another was asked to remember a simple, two-digit number. Shiv and Fedorikhin found that subjects who had to memorize the seven-digit number were almost 50% more likely to choose the chocolate cake over the fruit salad as compared to their two-digit peers.
In a follow-up experiment, Shiv and Fedorikhin tested whether the immediacy of the desserts made a difference. In other words, if subjects were only shown pictures of fruit salad and chocolate cake instead of having the desserts physically in the room, would the results differ? Yes! When they ran that version of the experiment, they found that the “differential between the two choices disappears.”
Insights:
All it really takes is memorizing five extra numbers for our brains to get tired and reduce our willpower. Shiv and Fedorikhin’s experiment helped show the link between cognitive load (digits memorized) and self-control (dessert choice). Cognitive load can be taxing and lead to impulsive behavior. Self-control requires cognitive effort and this becomes more difficult when our brain is engaged in other tasks. In other words, even if you have pre-committed to diverting part of your pay raise to something like an emergency fund, you may be so deluged with other decisions and tasks in your day-to-day life that, when your raise is actually paid out, your self-control becomes inhibited.
To avoid temptation to divert your funds towards something impulsive, automate the process. Once you’ve pre-committed, change your direct deposit if you have it, or adjust the settings in your savings or investment account. As my favorite “As Seen On TV” inventor, Ron Popeil, used to say, you need to “set it, and forget it!”
This is especially important if you are set to receive a large raise, like after a promotion perhaps. Seeing a sizable amount in one’s bank account is like having the chocolate cake physically in the room: If you can eat it or spend it right away, you’ll probably be tempted to do so. However, if you pre-commit what to do with the sum and automate it, you are taking control of the situation in advance. Suddenly there’s just a picture of some hypothetical chocolate cake you can’t touch, smell, or taste, and you’re much less likely to stray from your plan.
Step 3: Strategically Coordinate When Changes Take Effect
The Bottom Line: Set up direct deposit or other changes to take effect right when your raise kicks in, not before.
The Science:
An experiment from two of the founding fathers of behavioral economics, Daniel Kahneman and Amos Tversky, helps illustrate the importance of timing. Sadly, neither received the “use chocolate in experiments” memo.
Instead, Kahneman and Tversky asked a set of people to imagine that the U.S. was readying for the outbreak of a rare disease, which was expected to kill 600 people. They presented two programs to combat the outbreak along with exact scientific estimates of the consequences and asked the participants which program they favored:
- Program A: If adopted, 200 people will be saved
- Program B: If adopted, there is a 1/3 probability that 600 people will be saved, and 2/3 probability that no people will be saved.
When presented with these two options, 72% of people selected Program A.
Kahneman and Tversky polled another group and changed how the two programs were described. For this variation they asked participants which program they favored:
- Program C: If adopted 400 people will die
- Program D: If adopted, there is a 1/3 probability that nobody will die, and 2/3 probability that 600 people will die.
Suddenly, 78% of people selected Program D.
Insights:
To start, take note of how the two groups were given options with the same outcomes, just framed differently. Program C has exactly the same outcome as Program A (in both cases, 200 people will be saved and 400 people will die) and Program B has exactly the same outcome as Program D.
The different responses stem from the asymmetry in people’s minds between gains and losses. Experiment after experiment demonstrates that losses have a disproportionately larger impact on people than similarly-sized gains, a tendency Kahneman and Tversky labeled as “loss aversion.” The result is that choices involving gains are often risk averse while choices involving losses are often risk taking.
Going back to the initial experiment, when choosing between Program A and Program B, participants were being asked to choose between two gains. Loss aversion explains why 72% chose Program A, which was the safe bet of saving 200 people, while 78% in the follow-up chose Program D, which was a gamble trying to prevent more people from dying. Simply put, most people would rather take a risk to avoid a certain loss, but they would rather take a sure gain than gamble for more.
Loss aversion relates to your pay raise because most people use their disposable income as the main reference point for earnings and because there is often a lag between when you are informed of a salary increase and when the increase will actually take effect. For example, Delta flight attendants were informed in November, 2016 of their 6% increase; however, that increase will only kick in April 1, 2017.
If you augment your savings too quickly – before your raise takes effect – you will have a short time period where your disposable income actually drops. This may lead to the feeling of loss aversion and cause you to go into your accounts manually and undo your initial decision.
By aligning your allocation changes to take effect only when your raise kicks in, you mitigate loss-aversion. Your disposable income actually never drops, which avoids the perception of a loss. Strategic timing, therefore, increases the likelihood that you won’t go into your accounts and make a change to undo the initial decisions you made.
Putting It All Together
Augmenting retirement contributions is one classic way to apply these three strategies to personal finance – pre-commitment, automation, timing. Richard Thaler and Shlomo Benartzi, two other behavioral economics’ heavyweights, proposed the creation of the “Save More Tomorrow” (nicknamed “SMarT”) program to help employees save more. They suggested giving employees the option to pre-commit to a gradual, automatic increase in their retirement savings rate, anytime they get a raise.
The results, tested with real 401(k) plan participants and not just in a lab, were staggering: 78% of participants who had refused to increase their retirement savings immediately by 3% were willing to commit to the increase if implemented automatically a year later. As Thaler and Benartzi note, “more important, the majority of these participants did not change their mind once the savings increases took place.”
After four years, those who followed SMarT boosted their savings rate from 3.5% to 13.6%, a higher amount and larger increase than other control groups.
SMarT provided strong evidence of the power of making decisions in advance, automating the process, and strategically timing the implementation. The same principles can and should be applied to non-retirement savings as well, such as building an emergency fund or saving for a child’s college fund.
Conclusion
Whenever I bring dessert home, the only way to ensure that some remains the next day is to hide and literally put it out of reach for my 5’2 fiancé. Similarly, you can use behavioral economic techniques to put your pay raise out of immediate reach and increase the chances of following through on your financial intentions.
Note: This article was originally published on Forbes on March 1, 2017. It was selected as a Forbes Editor's Pick.
