Home / Opinion / Manage the source to manage the destination

A previous article, “Rich Keralite, poor Kerala conundrum", provided a behavioural explanation for why emigrants from Kerala splurge their hard-earned income on building palatial houses in the state.

Over the years, governments, financial institutions and investment advisers have taken many initiatives to inculcate a saving habit among individuals. Their strategies mostly revolved around guiding one’s hard-earned income to appropriate savings destinations. Financial products with varying levels of returns, liquidity, tax benefits, etc., have been developed to attract investments from individuals.

The financial services industry took learnings from behavioural sciences to motivate individuals to invest in various savings instruments. This was done by linking the future life goals of investors to a particular investment product. Investors with the goal of providing good education to their children are advised to invest in a certain product while those with the aggressive goal of owing a luxury car are advised to invest in a different type of investment product.

But the strategies to build robust saving behaviour in the country are still a work in progress. We are far from claiming any spectacular success on this front. Most individuals continue their evolutionary habit of using their hard-earned income to eat, drink and live just for the day.

What can be done to improve the saving behaviour of individuals? Can behavioural sciences come up with new strategies that can mitigate the behavioural tendency to expend all our income for today’s pleasure?

Recently, two projects were undertaken to study the behaviour of Indian investors. One of them was conducted among those who had opened new bank accounts under the Pradhan Mantri Jan-Dhan Yojana (PMJDY) and the other was conducted among existing and potential investors of mutual funds. Both these studies threw up an extremely powerful insight about financial behaviour: where the money gets spent depends on where the money comes from.

Can we develop a new savings strategy by focusing on where the money came from? The fundamental assumption of this new strategy is that if we can orchestrate the perception of where the money comes from, we can better manage where the money will go to.

According to Richard Thaler of The University of Chicago Booth School of Business, who put forward the theory of mental accounting, “the primary insight is that people treat various mental buckets of money as non-fungible, meaning that there are implicit rules against taking money from one account—the children’s savings account—and expending it on something else like a new TV". The corollary of this insight is that money that is marked as “bonus" will be spent differently from money that is labelled as “salary".

The most significant takeaway from Thaler’s work on mental accounting is that when it comes to the safe upkeep of money, mental accounts could be safer places to keep one’s hard-earned money than the metal lockers in the bank strong- room.

The new savings strategy uses the power of mental accounts and focuses on compartmentalizing the source of income into various mental accounts. This strategy can be implemented easily among employees of organizations. So far the incomes of employees have been compartmentalized at best as salary, bonuses and reimbursements. The new strategy involves compartmentalizing salary into mental accounts like routine expenses, entertainment expenses, healthcare expenses, savings for children’s higher education, retirement savings, etc. Lest the organization is seen as too paternalistic, the individual could be given an option to choose the mental accounts he wants his salary to be split into.

Once compartmentalization happens at the income level, the power of mental accounts will set in. Now there will be a reduced tendency to move money from one mental account to another. So there will be less chance of money that is in the mental account for children’s education moving into the entertainment account involved in the purchase of alcohol.

At the same time, it will become easier to transfer the funds from income mental accounts to mental accounts at the spending level. So if there is a mental account for retirement savings at the income level, it will be easier for that money to move into the retirement savings product on the spending side. This new savings strategy complements the large efforts being undertaken by government and financial institutions to build mental-account-based investment products on the spending end.

Organizations use their compensation strategies to improve the motivation level of their employees. The initiative to create mental accounts on the income side will help organizations ensure that the salaries that are paid to employees are utilized in an effective way. This will further improve the motivation levels within the organization.

Creating appropriate mental accounts on the income side has learnings for policymakers who are involved in developing the direct benefit transfer programme. If the source of funds in the direct benefit transfer programme could be compartmentalized into appropriate mental buckets, it will help in moulding an ideal spending pattern among the beneficiaries of the programme.

So to build a saving behaviour across the country, managing the source of income may be more important than choosing the right destination for one’s income.

Biju Dominic is the chief executive officer of Final Mile Consulting, a behaviour architecture firm.

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