Shlomo Benartzi, professor emeritus at the University of California, Los Angeles (UCLA) Anderson School of Management and senior academic adviser at Voya Financial, has published a new white paper examining the interplay of financial wellness and behavioral economics.

As Benartzi writes, American workers’ financial lives have become increasingly complicated in the 21st century. It’s a familiar story: Instead of relying on an employer pension, most workers now save on their own. In addition, workers have to effectively allocate these savings across different financial products and accounts.

In practical terms, this means workers have to make decisions on questions such as: Should they fund their 401(k) account or emergency savings account? Should they choose a high-deductible health plan (HDHP) and put their savings in a health savings account (HSA)? Should they pay off their student debt, or start saving in a 529 education account?

“Given the complexity of the alternatives, making the right choice requires workers to see the big picture,” Benartzi writes. “Unfortunately, many people exhibit a behavioral tendency known as ‘narrow framing,’ which can lead people to focus on just a narrow slice of the overall picture. In the context of financial wellness, narrow framing can lead people to allocate their savings to the wrong accounts, choose the wrong health insurance plans and fail to prepare for unexpected financial shocks.”

The paper outlines what Benartzi calls a new approach, informed by behavioral economics, that minimizes the problem of narrow framing. For instance, it explains how workers can be nudged to save for emergencies, thus helping them avoid cashing out their retirement savings during a financial shock. It also outlines sample interventions that can be used to help people reduce health care costs.

Understanding Narrow Framing

To explain the concept of narrow framing, Benartzi points to an example developed by Nobel Laureate Paul Samuelson. As part of a research project, Samuelson asked a colleague whether he would accept a bet in which he would win $200 if a coin landed on heads and lose $100 if it landed on tails. As Benartzi recalls the story, Samuelson’s colleague declined this bet because, like many people, he felt that the potential pain of losing money wasn’t worth the pleasure of the bigger gain.

“But here’s a follow-up question,” Benartzi writes. “Do you want to play this same bet twice? When Nobel Laureate Richard Thaler and I tested a similar gamble with undergraduates and coffee shop customers, most people found the offer of multiple gambles even less appealing.”

Specifically, the percentage of people accepting the wager dropped by 23 percentage points.

“Since they didn’t really like the single bet, why would they want to play it several times?” Benartzi asks.

However, he explains, when one pauses and reviews the actual odds at stake here, that question is turned on its head. The gambler playing twice actually has a 25% chance of winning $400, a 50% chance of winning $100 and a 25% chance of losing $200. In short, narrow framing is the mental construct that prevents people from realizing playing two games is actually far more appealing than playing one.

What It Means for Retirement Plans

In Benartzi’s view, the financial marketplace has been organized in a way that promotes narrow framing.

“This is because financial institutions have traditionally been specialists, focused on providing a single type of financial account to consumers,” he explains. “While this allows financial firms to use specialization to deliver best-in-class products, it can also make it harder for people to have a holistic view of their financial lives. The end result is a failure to effectively allocate income, which can leave workers unprepared for various financial scenarios, whether it’s a financial shock, unexpected health expense or an extended retirement.”

Narrow framing can significantly impact participants’ savings decisions, Benartzi explains, and given the need for the typical worker to maintain multiple savings accounts, from emergency funds to retirement accounts to HSAs, it is extremely hard for people to know which account is most in need of their next dollar. Simply put, the retirement plan services industry must put more time, attention and resources into supporting customers in this decisionmaking process.

“Given the negative impact of emergency expenses, why do so many people fail to save for them?” Benartzi asks. “The answer returns us to narrow framing, which causes people to engage in the ‘one future’ fallacy, as they focus on a short list of possible future outcomes. When it comes to household financial planning, the ‘one future’ fallacy often leads people to focus on predictable and recurring expenses, such as rent and the monthly phone bill. Unfortunately, this means they overlook the full range of possible futures.”

On the other hand, if they saw the big picture, they would think about all the unexpected financial expenses that could happen. The paper goes on to make similar points about the health care savings landscape, demonstrating how narrow framing causes people to often choose health care plans that are in fact not their best financial option.

“Given the difficulty of saving for emergencies, we need to design interventions that make it easy to consider emergency savings and act upon it,” Benartzi concludes. “One nudge that Voya has recently begun testing involves using the 401(k) system to help workers build an emergency account. The advantage of this approach is that it allows participants to see the big picture of their savings, as it shows all of their different accounts on a single screen. This makes it far easier for people to effectively allocate their income across accounts.”

The full paper is available here.