Hugh Nolan takes a look at some of the factors that affect retirement decision making.
- Research has shown too much choice can overwhelm people
- A well-designed default can be the best solution for many people
- We need to do our best to minimise opt out rates in auto-enrolment
As an actuary, I am sometimes perplexed by the slightly illogical choices that normal human beings make – for example, not saving into a pension. Auto-enrolment has been a great success so far simply by nudging people and making it easy for them to do the best thing for themselves.
Equally, NEST has designed a great default investment strategy that foregoes the possibility of high initial returns on a small pot to minimise the risk of a fall in assets that might discourage people from future saving. Similarly 'Save More Tomorrow' in the US has boosted annual contributions by increasing them gradually, normally when the members are getting pay rises and so don't really notice.
So how do humans make decisions? My favourite research is The Jam Experiment, where 30% of supermarket shoppers who visited a display of six flavours bought some jam but only 3% bought when the range was extended to 24 flavours. The decision to buy jam seems less complicated than pensions so I'm no longer surprised that people follow the default option when DC schemes offer a choice of 749 funds.
Another interesting experiment by Rosenham and Messick took place in 1966. They showed people a pack of cards with equal numbers of smiling and frowning faces. The subjects consistently over-estimated the likelihood of a positive outcome (smiling face) termed the ‘valence effect' and there may well be a similar "optimism bias" when DC members choose equity investments or estimate how long they'll live.
Confirmation bias is the tendency to interpret information to back up your original belief, which just proves that I'm right about human beings making illogical decisions. If people believe annuities are evil, they may interpret any new information as confirming this (see also the 'irrational primary effect'). I can try to persuade people to annuitise at age 75 now but this might just reinforce their (incorrect) belief that the pension industry is always looking for a new way to rip them off.
From a basic understanding of how humans make choices, there are some obvious applications to DC pension schemes. First, keep the choices simple, limited and important. It is much more important to decide between equities or gilts than between two (or more) active equity managers.
Secondly, set up good default options. A trustee of my own scheme was distressed that many members accepted the default investment strategy so I reassured him that I am a very opinionated actuary who fancies himself as a sharp investor and had carefully considered the default strategy before deciding that it was absolutely perfect for me. There is nothing wrong with people entrusting their pension savings to a well-designed default scheme, especially when there are experts to guide them.
Let's also communicate better with people. If human beings are no good at predicting their own longevity, let's tell them how long they're likely to live after retirement and how that varies between individuals. A 65-year-old man may realise that his average life expectancy is 86, but six out of 10 will live even longer (with two out of ten surviving an extra decade or more).
While the pensions industry is more prominent on the news agenda than ever before, we remain concerned about how to make retirement saving appeal to young people. Auto-enrolment has partly been so successful because of the low initial contribution required from members and we hope the upcoming increases won't tempt too many to opt-out.
We'd like to see a similarly low entry level maintained for new entrants to the job market to minimise the chances of them opting out rather than establishing a good savings habit. Why not have a default employee contribution rate of 1% for any new hire under, say, age 22, with gradual increases each year to the standard level?
Finally, let's talk to people about a secure income for life without using the ‘A-word'. Research continues to show that retirees want a secure and regular income that will last them as long as they live – until you call it an annuity! We need a new decumulation vehicle with a new name to meet the needs of real human beings in the new environment – appealing to their rational and logical decision-making capabilities.
Hugh Nolan is chief actuary at JLT Employee Benefits
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