Professors from Harvard, Yale, Cambridge and the University of Chicago have just brought out a paper that shows the best way to solve the savings dilemma is to limit a client’s ability to withdraw funds from their retirement accounts.
Say what you will about DSC funds but ultimately the sliding-scale withdrawal charges are higher in the first two or three years to ensure a client keeps their funds invested with a fund company over the long haul. It’s a disincentive to move their money.
The six professors’ findings suggest the idea of limiting choice could actually be a good thing for clients, and by extension, advisors.
“This paper studies the demand for commitment devices [such as DSC early withdrawal] in the form of illiquid financial accounts,” state authors of the academic research paper Self Control and Commitment:
“When the commitment account and the liquid account have the same interest rate, commitment account allocations are increasing based on the commitment account’s degree of illiquidity.”
Essentially, when there is a serious disincentive for a client to move money from one savings account (DSC) to another as a result of a tax or withdrawal penalty, the study has found that clients are far more likely to remain invested in the savings product in question.
The authors also point out that U.S. retirement vehicles such as the 401(k) and IRA provide only minimal disincentive to pull money from the account – a 10% tax penalty for funds withdrawn before age 59.5 -- but that the level of commitment would increase with a higher penalty not unlike those of DSCs.
“Among participants offered only one liquid account and one commitment account, those whose commitment account has an early withdrawal penalty equal to 10% of the withdrawal allocate less to it than those whose commitment account has a 20% early withdrawal penalty,” write the researchers. In turn, those investors allocate less than those whose commitment account completely prohibits early withdrawals.”
So, by making the DSC withdrawal charges as high as possible, combined with the tax consequences of a client withdrawing funds from an RRSP, the authors maintain that the disincentives for doing so, help, not hinder, a client’s ability to save.