Economics of Savings

Achieve Financial Goals? Spend less than you receive. Two ways: Receive more  Spend less

S: What is Saving? Economists define “saving” as: –S = Income minus spending Or, more complete, if there are taxes, then: –S = Income – taxes – spending –Thus, saving = net (after tax) income that is NOT spent E 2 + S + I 2 = F 2

S: Why Do People Save? To provide for future wants –Intermediate & long-term goals This is the BENEFIT of saving E 2 + S + I 2 = F 2

Every Choice Has a Cost! Opportunity cost of saving? –What you give up to get something –If save, cannot spend now give up present consumption

Economics: a Study of Choice In choosing, we weigh: –BENEFIT of future consumption versus –COST of less consumption now B(X)C(X)

Why Do So Many Save So Little? C(X): sacrifice immediate gratification B(X): –Expected future consumption or bequest to children For many, the C(X) > B(X)... and the data...

Immediate Gratification! Many people seem “hardwired” for now consumption Experiments: –Choice: $100 today or $120 in three days »many people choose $100 today! »forego annualized 2,400% rate of return

Savings Assessment 10% save too much 30% save about right amount 60% save too little David Laibson, Harvard University

Why Do Many Save Too Little? Response to incentives: –Great Moderation Falling inflation Stable society reduces future uncertainty –Strong safety net – health & retirement –Easy and low cost of credit –Rise of stock and home prices

Why Do Many Save Too Little Response to incentives: –Great Moderation Falling inflation Stable society reduces future uncertainty –Strong safety net – health & retirement –Easy and low cost of credit –Rise of stock and home prices May explain why U.S. savings rate less than many other countries

Why Do Many Save Too Little Response to incentives: –Great Moderation Falling inflation Stable society reduces future uncertainty –Strong safety net – health & retirement –Rise of stock and home prices –Easy and low cost of credit  Time inconsistency (hyperbolic discounting)  Status Quo Bias

Instant Gratification …people are not always rational. I, for example, occasionally take a third helping of spaghetti when a careful calculation of my own long- run interests would lead me to abstain… Having discovered bowls of potato chips located within arm’s reach empty themselves mysteriously. David Friedman, Law’s Order, Ch. 1

Theory of Moral Sentiments (Adam Smith, 1759) “The pleasure which we are to enjoy ten years hence, interests us so little in comparison with that which we are to enjoy today… [However,] the spectator [cognitive self] does not feel the solicitations of our present appetites. To him the pleasure which we are to enjoy a week hence, or a year hence, is just as interesting as that which we are to enjoy this moment.”

Choosing Fruit vs. Chocolate Time Choosing TodayEating Next Week If you were deciding today, would you choose fruit or chocolate for next week?

Patient Choices for the Future Time Choosing TodayEating Next Week Today, subjects typically choose fruit for next week. 74% choose fruit

Instant Gratification Time Choosing and Eating Simultaneously If you were deciding today, would you choose fruit or chocolate for today?

Time Inconsistent Preferences Time Choosing and Eating Simultaneously 70% choose chocolate Today, subjects typically choose chocolate for today.

Some People Do Save & Invest Growing Number of Millionaires [although declined during Great Recession]

The Millionaire Next Door 9M 2010

“Emerging Affluent” Household NW between $100,000 - $500,000 –excluding primary residences 24.5 million emerging affluent HH in 2005 Average age head of HH: 50 –average total income reported:$64,600 –average salaries or professional fees: $45,000

It Can Be Done! Invest difference at 8% interest –Save $5 per week redeeming coupons (age ) $85,692 –Save $1.50 per day on junk food, alcohol, tobacco, etc. (age ) $290,363 –Not spending $200 per year on lottery tickets (age ) $106,068 4

How Much to Save? 10% save too much 30% save about right amount 60% save too little David Laibson, Harvard University What’s right amount? Most financial advisors recommend saving ≈ 10% of gross income –6% + 3% employer “match” is just about right

Techniques of Budgeting and Saving

Chest of Savings Drawers 1. Emergency drawer –“top drawer” –first priority –Needs to cover: Few months of crucial expenses –Rent or mortgage –Bills –Groceries Advisors suggest – 3 – 6 months of spending

Chest of Drawer Savings 2. Retirement drawer –If company pension, good start –get full employer match –consider supplementing

Third Savings Drawer 3. College savings drawer 529 plans: state-sponsored college savings plans established by the federal government in Section 529 of the Internal Revenue Code encourage families to save for college. offer state & federal tax benefits

College Savings CollegeInvest: –only 529 program that qualifies for a Colorado state tax deduction –Colorado resident: every dollar contribute to 529 plans can deduct from Colorado state taxable income do pay federal income tax on contributions Savings grow tax-free –Earnings used for qualified higher education expenses are federal &Colorado state income tax-free

The Other Savings Drawer –Vacation –Long-term care –Home down-payment –Car purchase