About Nick: i am an economist based in malaysia. I write about development economics, while sneaking in a pop culture reference or two.

55, Not Out – Behavioral Finance and the EPF

Published in The Edge Malaysia, 4 - 10 May 2015, as "Behavioural Finance and the EPF".

Suppose you were offered the following options: receive either RM100,000 in two years or RM100,100 in two years and a day. Which would you choose? Repeating the same thought experiment, suppose instead you were offered receiving either RM100,000 today or RM100,100 tomorrow. Which would you choose?

If we believed as purely rational consumers – homo economicus – we would all choose either both the RM100,000 options or both the RM100,100 options. However, what is very commonly found is that most people, when presented with this scenario, often choose receiving RM100,100 in two years and a day versus RM100,000 in two years, and receiving RM100,000 today rather than RM100,100 tomorrow.

This is an example of how the assumption of homo economicus fails in practice. This particular instance of ‘irrationality’ is known as hyperbolic discounting. It refers to the tendency for people to choose a smaller but sooner reward over a larger but later reward as the delay occurs sooner rather than later in time. In other terms, it means that people avoid waiting more as the wait gets closer to the present.

In everyday use, think of the time you agreed to begin working out in a gym – as opposed to sleeping in or watching television – in two weeks. You were optimistic and excited about the prospect of leading a healthier and fitter lifestyle. However, after two weeks, when the time came to actually go to the gym, how many excuses did you come up with to go “tomorrow” or “next week” or “next month” before you eventually decided to go or perhaps even not to go? I believe that this form of example is pretty common across the population.

Hyperbolic discounting happens because we consider the future as far less salient than the present. We expect our future selves to delay gratification when our current selves often fail to do the same. Tying this to the recent Employees Provident Fund (“EPF”) is-it-55-or-60 situation, figuring out if we ourselves are hyperbolic discounters may change what we think about whether we should withdraw our money at 55 or at 60.

To be clear, a big part of the argument for maintaining the capacity to withdraw at 55 is simply about choice. Even if people would rather keep their savings till 60, they would still like to have the choice to withdraw at 55. In essence, I think this is the best argument against a withdraw-only-at-60 policy type. Since it is the hard-earned money of the individual, or at least – for the most part – the minimum-effort-to-not-be-fired earned money, it is reasonable that the individual gets to choose how the money is allocated.

Yet, this argument has a subtle weakness. If we are to maintain the withdrawal age at 55 as opposed to 60 on the basis of choice, why then should we stop at 55? What is the logic for a full withdrawal at age 55 as opposed to age 50? Or age 45? Or even a mandatory contribution in the first place? It is strange that these questions are not really put forth with regards to the future of EPF policies. If I argue that I should have the choice on the withdrawal and therefore utilization of my money, why do I say that having this choice is a must at age 55 but not necessarily so below age 55?

In truth, I am in favor of abolishing mandatory contributions and allowing employees to decide if they want to participate in the EPF or not. Companies can offer employees the opportunity to enroll, setting enrolment as the default – since most people will leave decisions to the default anyway, as argued by Richard Thaler and Cass Sunstein in their book, “Nudge.” However, if I believe that I am a savvy enough investor and a ‘rational’ person, I may rather place my funds into some other portfolio that would generate a higher return for me than the EPF. So, on the basis of choice, it is difficult to argue for mandatory contributions where withdrawal is only permitted at a set age. Is 55 really that different from 54 or 56?

However, the notion of hyperbolic discounting should alert me that I am unlikely to make the wisest intertemporal choices for my future self. I may say that I want to save more in two years, but when I reach the two year point, the desire to consume may overwhelm me and I may end up saving far less than is optimal. Hyperbolic discounting is a great argument for the need to have a credible commitment device for saving, which the EPF provides. It ensures that, at least till the age of 55, the issue of hyperbolic discounting is irrelevant for those savings allocated to the EPF.

But what happens after 55? It may seem tautological to say, but the common happens more frequently than the uncommon. And if hyperbolic discounting is a norm rather than an exception, then I should believe that I am a hyperbolic discounter as opposed to an uncommon fully-rational person. Therefore, if I am going to retire at 60 and I am a hyperbolic discounter, if I want more savings then I should try to avoid withdrawing the money till I am 60. Withdrawing at 55 would increase the likelihood of me over-consuming in the present and thus under-saving for the future.

Again, I am in favor of people being able to withdraw their own funds whenever they want, especially if enrollment is mandatory for everyone, which it is in Malaysia. What I am suggesting is that, even with the choice to spend the money as they like, people are more likely to overconsume and under-save and hence, if the goal of maximizing savings is the primary objective for a given individual, that individual should place her money in the EPF for as long as she can anyway. A critical assumption here is that life expectancy is reasonably long after 60 which may not necessarily be the case. However, with better healthcare and new insights into healthy living, this may be a fairly sound assumption.

Therefore, I think it is important to recognize that despite people’s beliefs, it is entirely possible that people may make cognitive mistakes with regards to the utilization of their money and though they may have the right to withdraw their EPF savings at 55, they may be wise to wait till they are 60. Hyperbolic discounting is a common cognitive departure from homo economicus and may well lead to overconsumption and under-saving if not checked by a credible commitment savings device, such as the EPF.

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