How to achieve savings discipline when it comes to retirement
Savings discipline is the willingness to forgo spending now in order to accumulate the funds needed to meet a valued objective in the future. The objective is critical because it must outweigh the costs of the discipline required.
The objective of homeownership, for example, is a very powerful motivator. It is the reason why the equal payment, fully amortizing mortgage is a highly effective instrument for promoting savings discipline. In less developed countries that don't have modern mortgage systems, prospective homeowners must find other ways to discipline themselves.
Liberia, for example, does not have a mortgage system, though when I was there some years ago I saw many instances of savings discipline directed toward homeownership. The method used, however, was one I had never seen before. They used their savings to purchase cinder blocks, which they piled up on their land until they had enough to start building. This was a costly type of savings discipline.
The cost was not only the loss of interest that would have been earned had their savings been deposited in a bank (Liberia had branches of two U.S. banks at the time), but in addition a prolonged delay would result in the cinder blocks deteriorating. Nonetheless, the purchase of cinder blocks protected them against any sudden impulse to spend their savings.
Nest egg as the objective: Another objective of savings discipline is the accumulation of a nest egg, which may or may not be targeted at any specific use. A good illustration of this is a deliberate, over-withholding of income taxes, which is aimed at getting a refund at the end of the year. The practice is particularly widespread in the U.S. military. Most over-withholders realize they are giving an interest-free loan to the government, but they accept that as the price of savings discipline.
The nest egg objective is even more widespread in less developed countries, and the costs incurred may be significantly higher. In many African countries, people can join informal associations called EKUB or SUSU. Members commit themselves to contribute a certain amount every month, the total of which goes to one of them, usually chosen by lottery. If there are 12 members contributing $100, for example, each member receives a $1,200 nest egg at some point during the year. The cost, in addition to interest foregone, is the risk that those who get theirs early will decide to get lost.
Costly consumer goods as the objective: Aside from homeownership, the most important objective of savings discipline in the U.S. is acquisition of costly consumer items. The mechanisms that cater to this need include layaway plans and deferred interest loan plans.
On layaway plans, people without the means to purchase a desired item on the spot put down a deposit equal to some percent of the sale price, in exchange for which the merchant puts the object aside. Buyers have a specified period of time within which to pay the remaining balance, at which point the item is released to them. The cost may include a service fee, a cancellation fee if they cannot pay the balance within the prescribed period, and possibly a higher price placed by the merchant on an item sold under the layaway.
Deferred interest loan plans, which have become very popular recently, are similar but consumers receive the product at the outset and pay for it within a prescribed period. Failure to repay within that period will trigger the interest charges that the buyer hoped to avoid.
The U.S. is rich in mechanisms that provide savings discipline where the objective is acquisition of costly consumer items within a short period of time. The opposite is true when the objective is poorly defined and the time period is long and uncertain, as is the case with retirement.
Everyone wants a comfortable retirement, but a very large segment of the population never develops the savings discipline required to achieve it.
Earlier this year, I wrote several articles on two valuable tools for protecting retirees: longevity annuities and HECM reverse mortgages. The first is sold in a cash-on-the-barrelhead market and has no features that provide savings discipline. The second does have a savings discipline feature in that the amount a senior can draw on a HECM depends on the owner's equity in the property, which in turn depends on whether or not there is an existing mortgage balance.
The problem is very few homeowners connect the repayment of their forward mortgage to the amount that will be available to them under a reverse mortgage after they retire. In future articles I will be offering some ideas on how to provide or strengthen savings discipline in connection with both longevity annuities and reverse mortgages.
• Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Contact him via his website at mtgprofessor.com.
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