Faculty Research: Failure to Appreciate Exponential Growth Leads to Underestimation of Retirement Savings and Decreased Motivation to Save
A recent study by professor Craig McKenzie reveals that many employees have a fundamental misunderstanding of savings growth, which negatively affects their ability to plan for retirement. In a paper titled "Misunderstanding Savings Growth: Implications for Retirement Savings Behavior," published in the November 2011 edition of Journal of Marketing Research, McKenzie and coauthor Michael Liersch suggest that employees' failure to appreciate how savings grow over time leads them to grossly underestimate how much money they could have at retirement and encourages them to put off saving.
In a series of experiments, McKenzie and Liersch demonstrate that the majority of participants believe that savings grow linearly, rather than exponentially, and therefore massively underestimate their account balance at the time of retirement. Among undergraduates - those soon to be on the job market and making crucial decisions regarding retirement savings - 90 percent substantially underestimated their future account balance. For example, when asked to estimate how much money would be in their account after 40 years if they deposited $400 each month and earned 10 percent annual compound interest, the majority of undergraduates gave a response of just more than $200,000. The correct response is more than $2.3 million. Misunderstanding savings growth, as illustrated, makes putting off saving more attractive than it ought to be; participants think it is easier than it really is to make up for lost time by saving more later. However, after seeing the exponential growth when presented with their estimated account balance 30 to 40 years down the road, participants began to understand the benefits of saving early, which motivated both undergraduates and employees at a Fortune 100 company to save more now. "Appreciating exponential growth is key," said McKenzie. "When employees understand the extent to which saving a small amount now translates into much more decades from now, they are motivated to save more...now."
McKenzie and Liersch's study further suggests that making clear to employees the exponential growth of savings - moments before they make crucial decisions about how much to save - is a simple and effective means of increasing retirement savings. By removing complicated calculations and instead simply highlighting the exponential growth via their own retirement savings account, employees are better able to handle the responsibilities and challenges associated with personally managing their financial futures.