Libertarian Health Paternalism
by John Goodman
Issue 110 - June 25, 2008
 As of January of this year, U.S. employers can automatically enroll
their employees in 401(k) plans with diversified portfolios - without
fear of lawsuits and without certain regulatory burdens. This automatic
enrollment should increase participation by about one-third, and
diversification should produce larger and safer returns, although
employees are able to opt out of both decisions. In the future,
roughly one of every two 401(k) enrollees is likely to be so enrolled.
This opportunity was created courtesy of the Pension Protection Act of
2006, which reflected the joint efforts of the National Center for
Policy Analysis (NCPA) and the Brookings Institution, including
Capitol Hill briefings, publications, speeches, editorials, etc.
Yet the real intellectual groundwork came from University of Chicago
professors Richard Thaler and Cass Sunstein. They call the
theory behind this effort "libertarian paternalism," and
they have written a book about it called Nudge. http://www.nudges.org/
I first discovered part of the theory on my own about a decade
ago. The NCPA created after-tax Medical Savings Accounts (MSAs)
for our employees, allowing them to pay medical expenses directly and
to withdraw any remaining cash balances at year-end for other
purposes. According to economic theory, this practice should
have made our employees worse off. Why? Since there was no
tax advantage to the MSA, we could have paid higher wages
instead. Employees could have established their own MSA account
or exercised other options, and economics teaches that we are never
worse off if we have more options. Yet not a single employee
complained.
In Nudge, Thaler and Sunstein have an explanation of this
phenomenon. True enough, they concede, in a world full of Econs,
more choices are always better than less. But in a world of
Humans, things are often different. They argue convincingly that
senior citizens forced to choose among 50 different Medicare drug
plans faced a decision-making nightmare and often made bad
choices. Similarly, unsophisticated employees faced with myriad
portfolio choices are often poor managers of their 401(k) money.
There is a pattern here. People tend to "make good choices
in contexts in which they have experience, good information and prompt
feedback," such as choosing among ice cream flavors. They
often make poor choices in contexts in which "they are
inexperienced and poorly informed and in which feedback is slow or
infrequent." Choosing an investment portfolio is one
example. Choosing a drug plan is another.
So why can't markets solve these problems? They can and
sometimes do. But often it is more profitable to cater to
peoples' frailties and exploit them.
So what can be done? Since Thaler and Sunstein are libertarian,
they are not calling for big-brother government solutions. They
are perceptive enough to realize that regulations often do more harm
than the problems they are designed to correct. But since they
are paternalists, they are intensely interested in how to get people
to make good choices. Fortunately, coercion is rarely needed
anyway. Often a simple nudge will do.
With respect to 401(k) plans, far too many people fail to enroll -
even when there is an employer match. Some do not enroll even
when the employer is paying 100% of the contribution and they need not
invest a dime of their own money. Once in a plan, people tend to
make two more mistakes. Either they invest in what they know
(their employer's stock) or in what they think is safe (money market
funds). The first mistake puts all their investment eggs in one
(very risky) basket. The second generates an inadequate rate of
return.
That's where defaults come in. Employers can automatically
enroll their employees in diversified portfolios, leaving them free to
opt out of decisions if they choose. Of course, for homo
economicus, a default would matter not one whit. Yet amazingly,
ordinary humans have a very strong tendency to stay wherever the
default puts them.
According to Thaler and Sunstein, a great many social problems could
be solved with simple nudges. Some examples:
- For the problem of too few organ donors, why not assume that
people want to be donors - leaving them free to opt out of
that presumption if they choose?
- For our wasteful, inefficient medical malpractice system, why
not assume that people prefer a no-fault alternative -
allowing them to pay more to secure their common law
litigation rights if they prefer?
- Why not default seniors on Medicare into plans that minimize
out-of-pocket costs and maximize coverage for their current
drug needs - at least for chronically ill, poor seniors for
whom government is paying almost the entire bill anyway?
All three of these examples are from the health care field. Yet
it is with respect to health care that the authors most
disappoint. After all, people are no better at choosing a health
plan than they are at choosing an investment portfolio.
Employers could help, but their incentives are skewed by the desire to
attract healthy employees and avoid the sick. Insurers could
help, but they make less money if consumers make good decisions rather
than bad ones.
Ideally, one would form a committee to recommend an insurance plan
toward which people could be nudged. Trouble is, how many people
do you know who are (1) knowledgeable, (2) disinterested and (3)
rational about health insurance? Out of 300 million people, I
can't think of more than about five.
John Goodman is President of the National Center for Policy Analysis
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