How to counter hyperbolic discounting vis-a-vis investments

Recently, the government has notified a few changes to the management of funds to the EPFO (Employee Provident Fund Organisation). While the changes ranged from liberalised partial withdrawal options to waiting periods for final withdrawals to formalisation to ease of access and to simplified administration.

The changes tried to bring balance between the short-term needs and the long-term benefits. While these changes might reflect the evolving dynamics of the current needs, providing ‘too much’ liquidity could compromise the long-term welfare. This is well illustrated in a research -“Golden Eggs and Hyperbolic Discounting” by David Laibson (1997).

Investors are not time-consistent optimisers. This systematically leads to chronic under-saving unless constrained. The paper illustrated that individuals overvalue the present relative to the future, described as hyperbolic discounting. Traditional economic models use exponential discounting i.e., places consistent weight on future outcomes. It’s understood that preferences are time-consistent and so if one plans to save tomorrow, they will.

In hyperbolic discounting, people give much higher value to the present rewards than future ones and that this valuation declines the further into the future as we go.

The consequence is that people exhibit dynamic inconsistency i.e., they plan to save in the future but repeatedly change their minds as immediate temptations arise. This means, they remain patient about the distant future but impatient now. Thus, plans made for the future are abandoned when the future becomes ‘now’.

Rational agents therefore seek constraints on themselves. The paper shows people value commitment mechanisms because those tools help solve their own self-control problems. Hyperbolic discounters change preferences over time. They may desire tools that commit them to future actions that go against their own short-term impulses.

Examples include illiquid retirement accounts, automatic savings programs, or pre-commitment contracts that make it harder to consume savings prematurely. These inconsistencies bring forth that ‘tomorrow-me’ is disciplined while ‘today-me’ is impulsive, with each version of the person disagreeing with the other.

The classic view is that illiquidity is a cost, but Laibson’s insight describes illiquidity can be a feature, not a bug. Modern finance worships liquidity. Faster access, instant redemption, frictionless exits — these are sold as unambiguous improvements.

Yet household balance sheets across the world tell a different story. This helps explain why many households hold wealth in hard-to-access forms despite needing more liquid funds. Different assets have different marginal propensities to consume, not because of risk/return, but because of accessibility. It’s intentional self-commitment.

This model predicts people will spend some assets more readily than others. People systematically lock their wealth into illiquid assets — pensions, real estate, insurance, even gold—as self-imposed commitment tools because they are difficult to access immediately. These’re hard to raid impulsively and protect long-term plans from the short-term temptations. Hence, the metaphor: don’t eat the goose that lays golden eggs.

The paper predicts that people consume liquid assets aggressively and preserve illiquid wealth. So, a coexistence of debt and long-term assets is a puzzle under rational model, is perfectly normal under hyperbolic discounting. More liquidity doesn’t translate to better outcomes; it can destroy long-term compounding.

This is well illustrated with the innovations like ATM (Automated Teller Machine), Credit cards, BNPL (Buy Now Pay Later) and instant loan apps. Also, open-ended liquidity is overrated as it increases panic-selling, encourages market timing and destroys compounding. They rescind commitment.

Financial innovation is increasing liquidity. For instance, new easy-access financial instruments and platforms might paradoxically reduce household savings and welfare because it undermines people’s ability to commit to long-term goals. It could reduce welfare even as it expands choice.

Good policy should encourage default lock-ins, at least, rolling lock-ins and exit hurdles instead of hard bans, also tiered liquidity windows. Also, use automatic enrollments (like auto-SIP & auto step-ups), penalize early withdrawals to reduce the temptation at the margin. Policymakers and financial product manufacturers should, hence, consider how choice architecture, not just incentives that affects people’s ability to act in their long-term interests.

This research is highly relevant to PF/NPS (Provident Fund/National Pension Scheme) and insurance lock-ins. Lock-ins are not paternalistic, they’re welfare enhancing.Indians particularly are wired to invest in hard assets as history put us through bouts of inflation and currency debasement resulting in larger allocations to gold and real estate.

This ‘inefficient’ asset-bias is a self-regulated framework evolved socially and institutionally for optimal self-control. People don’t fail to save because they’re irrational, but they fail because they’re human. The smartest systems protect people from their future selves.

A smart financial plan doesn’t assume investors are strong-willed but assume investors are human and build accordingly. This paper has been influential in behavioral economics and has shaped research and thinking about time inconsistent preferences, personal savings behavior, financial self-control strategies and design of commitment devices and regulations.

It bridges psychology and economics by showing that real human behavior deviates from classical models of rational planning and it gives a formal framework to analyze that departure.

(The author is a partner with “Wealocity Analytics”, a SEBI registered Research Analyst and could be reached at [email protected])