The dilemma of choice
Increasingly, the trend is for DC pension plan providers to offer members of DC retirement plans more investment options. Economic theorists say this must be a good thing: the more choices people are given the better off they are likely to be. But are they? Do non-professionals have the necessary asset allocation skills to make the right investment choices?
And how much risk should pension plan members take? The theory of lifecycle investing is that the people with a long time to retirement should invest in riskier assets like equities. But are equities a safe investment, even over the very long term?
Zvi Bodie, professor of finance and economics at Boston University school of management, says that people do not have the knowledge to make choices that are in their own best interests. They may even harm themselves.
He compares asset allocation skills to surgery: “No one would imagine that you or I could perform surgery to remove our own appendix after reading an explanation in a brochure published by a surgical equipment company. Yet we seem to expect people to choose an appropriate mix of equities, bonds, and cash after reading a brochure published by an investment company. As a result some people are likely to make serious mistakes.”
We wanted your views. Once again we received a thoughtful response to what seemed like a black and white issue. Most (84%) of the pension fund managers and administrators who responded to our survey agree that the man or woman in the street is unlikely to understand the principles of asset allocation. However, half feel that people are becoming more interested and better informed about asset allocation. One UK pension fund manager qualifies this: “More interested yes. Better informed, no.”
One solution to investor ignorance is to offer fewer investment choices. This gains approval from a majority (64%). A UK pension plan manager proposes “a limited number of fund options, selected by experts, where the level of potential return and risk is made clear”. The manager of a Portuguese pension fund says that “DC investment options should be centred only in plain vanilla ‘baskets’, composites of assets, and not baskets that may be presented as an asset allocation in the first stage.”
A Swiss pension fund manager suggests “not fewer but simpler choices.” A Belgian pension fund manager concurs. “KISS Keep It Simple, Stupid is certainly preferable.”
A majority (64%) of respondents agree that since members of DC pension plans bear all the investment risk they should be free to make investment choices. But there are considerable doubts among the minority. A Finnish pension fund manager says “advice about the risks should be provided to avoid mistakes and misunderstandings”. One UK pension fund manager points out that “investment choice is only real choice if people are able to understand the implications. Choice is given because of a fear of backlash if the trustees’ decision does not produce a good outcome and the members night hold them responsible”.
Another asks: “Are members really just going to blame themselves if they make an inappropriate choice and suffer because of it? The plan sponsors have a responsibility to offer products that minimise the risk of members ‘losing their shirt’, perhaps by imposing limits on the proportion of contributions that can be invested in high risk assets or insisting that a minimum proportion is invested in low risk assets.”
Choice should be exercised collectively rather than individually, a Belgian pension fund manager argues: “The unions should actively participate in the investment decision process on the general level. It is much easier and more efficient to train and inform a few union representatives instead of every single individual member.”
Since most people in DC pension plans choose to invest in the default (no choice) option, it might appear that investment choice is not working anyway; However, a slight majority of our correspondents (58%) think there is a place for the default option.
One manager suggests that choosing the default option “is a recognition that they do not have the skill or are not prepared to take the risk of making their own investment decisions. Thus the default option is an appropriate choice for many.” Another observes that “it depends on whether the choices are well communicated and whether the default option has been diligently selected as appropriate for a homogeneous membership”.
However, for some the default choice is evidence of investor ignorance. One Austrian pension fund manager states bluntly that “people should be better informed”.
A substantial majority (89%) believe there is a connection between a person’s tolerance of investment risk and the length of time they have until they retire. A Portuguese pension fund manager observes that “theories tend to strengthen this ‘utility’ function between investment risk and the length of time of the investment”. A Finnish pension fund manager points out that “people tend to have different approaches to the probability of losing money. Some are not willing to lose any money; others are able to handle more downside.”
Yet a UK pension fund manager comments acidly that “there should be a connection, but just watch the reaction of even young people if the value of their investments goes down.”
A large majority (73%) agree with the proposition that the more time people in DC plans have before they retire the more aggressively they should be invested in equities – although some are unhappy about the word ‘aggressive’.
However, one Nordic pension fund manager warns that “strategic asset allocation should reflect the expectations. Future returns for equities will not necessarily stay as high as they have been. If equities are fully valued and the upside-downside probability is limited, then why buy them?”
Most (66%) still feel that equities are a safe investment in the long run. A German pension fund manager perhaps speaks for many when he says “equities are safe if they are sufficiently diversified”.
However there are dissenting voices. One manager points out that although equities offer the best opportunities “they are not safe either in the long or the short term”. And a Swiss pension fund manager asks pointedly “what is meant by safe?”
A clear majority (73%) think that DC plans should be re-designed to reduce the risk of people making the wrong investment choice. One UK manager suggests a core-satellite model: “We need to ensure that members target an acceptable minimum pension (they decide how small) with minimal risk and then take risk with the remaining assets to provide greater returns. At present we encourage members to take equity risk with their entire pension pot, without considering if the worst caser scenario is acceptable to them.”
A Portuguese pension fund manager suggests that “DC plans should be re-designed in no way to prevent a maximum allocation in equities. People should be aware of the risks of the so-called fixed income securities.”
So should investment choice be left to the professionals (trustees, asset managers, pension plan providers) rather than to the members of a DC pension plan? A slight majority (52%) oppose this. One Irish pension fund manager says employees should have a choice “so long as proper education and advice is provided”. Many feel that they should have choice, underpinned with some protection.
The manager of a multinational company pension plan believes “there should be some guidance and some form of safety cushion,” and a UK manager says there should be “some degree of ‘paternalistic’ enforced safety for scheme members even in DC schemes”.
Finally it is worth remembering that investment choice is rarely offered for its own sake but as part of an employee benefits deal. The manager of a Swedish company pension fund should have the last word: “Leaving the risk to the employed is, from the professional’s standpoint, not a good choice, but from the standpoint of the employer, it is a must if the sentiment is that choice is good,” he says.
“We as employers do not set up pension plans for any other reason than to be perceived as a good employer or ‘first choice’ on the market. If we cannot afford DB, we offer DC at the level we have to. We naturally present this as a good thing but that has very little to do with ability to handle investment choice more to do with whether it is perceived as a good offer.”