Why people tend to defer decisions about pensions
Individuals must increasingly make critical investment decisions about their retirement savings, but research from David Laibson, (pictured right) professor of economics at Harvard University in the US, shows that psychological factors often cause people to make poor choices over their pensions.
"The huge shift in the pensions industry from defined benefits, where one's employer makes savings and investment decisions, towards defined contributions, where employees have to take far more individual responsibility, has profound implications for people's future quality of life," says Laibson.
Laibson teaches an undergraduate course on psychology and economics at Harvard, and is an expert on how human psychology affects economic behaviour.
He is advising on how pensions can be structured to encourage retirement saving in diversified assets and recently undertook a roadshow in Europe to brief pension fund managers on
Laibson's academic research identifies five key psychological barriers to successful retirement savings:Passivity: individuals accept the status quo, even if status quo saving is insufficient; Present bias: individuals weight the present 50% more importantly than the future; Procrastination: when individuals do decide to save more, they delay implementing the change; Financial illiteracy: individuals know very little about financial products; Complexity avoidance: complex saving schemes lead investors to delay or avoid decision-making.
"We're gradually moving from the classical view that individuals know what's in their best interest and act on that assumption, towards realising that most people simply accept the status quo, even if that means they're not saving enough for their retirement and could face poverty in old age," Laibson told Dutch pension funds recently.
"Humans are tempted by immediate reward, weighing the present 50% more than the future, and only in the longer-term do we tend to take a more balanced view of what is in our best interests. So, given the choice of choosing between eating chocolate or fruit today, 70% will opt for chocolate, but 74% will choose fruit if it is to be consumed ‘next week'.
"Our inherent procrastination is clearly evident in our personal plans for pension savings, a study of 100 US corporate employees found. Sixty-eight people in the group reported saving too little and 24 of those planned to raise their 401(k) contribution within two months, but only three individuals actually did so within the following four months.
"We are thrilled to make plans to do the right thing in the future. So I will exercise tomorrow because there is no personal cost for me in that commitment now," Laibson said.
A study of individuals who joined gyms in the Boston area of the US found that the average cost of membership was $75 per month and that on average members went to the gym four times a month, resulting in a cost of $19 per visit.
Alternatively, they could have paid $10 a visit at the door, but people chose to overpay because they recognise that they have problems regulating themselves and if
they pay a monthly subscription believe that they might exercise more frequently.
Automatic enrolment in corporate pension plans has a big effect on employees' participation in these schemes, but unlike the gym membership analogy, people do not need to take further action to achieve the benefits.
US research found that after automatic enrolment in pension schemes, participation remained at a constant rate of about 80% of the workforce over a four-year tenure in the job.
For standard enrolment, where employees have to take the initiative to apply to join the retirement scheme, the participation rose gradually from 20% to a peak of just under 60% over a four-year tenure.
"Telling workers you must make a decision has a dramatic impact on enrolment, boosting participation by 30%. Even with determined non-savers we got a 10% increase in participation by simply sending them a postcard and telling them to check the ‘yes' or ‘no' box," Laibson said.
He said that two-thirds of people also accept the default savings contribution option, and even though US workers are sensitive to high savings rates, most will stay put in an employer's life-cycle fund.
"We can design defined contribution systems that get people to save at very high rates and we're trying to see how far we can push it. So far we've got to 10% of employees' salaries, but haven't gone beyond that and that's where the research is going next. If employers put 5% on top then you get to 15%, which with social security benefits is probably enough," he added.
Education intervention seems to have little impact on pension savings rates, even on those from highly educated backgrounds, and neither does paying people to save through employer contributions.
"Some 50% of US employees leave money on the table when it comes to taking action on employer contribution schemes and the average loss of salary is 1.6% a year," Laibson said.
Defined contribution product designers have to make constructive outcomes automatic or easy in order to encourage high savings rates and the escalation of savings.
They also have to make destructive pension choices hard - for example, non-enrolment in retirement schemes, poor diversification in investment portfolios or drawing down savings before retirement.
"We've now got all these beautifully created investment strategies, tailored to people's life cycles and circumstances and widely diversified globally over a variety of assets. Now all we've got to do is make them simple to understand and to get people to use them," Laibson said.
"This research has given us new insights about what drives investors' long-term savings decisions. The successful design of defined contribution pension schemes requires a fundamental understanding of investors' psychology, but these psychological factors have been poorly understood," adds Matteo Germano, head of Global Investment Solutions at Pioneer Investments, which hosted the roadshow.