Australian School of Business

Navigating the Retirement Risk Zone: A Consumer Perspective

December 2013

Hazel BatemanSchool of Risk and Actuarial Studies

How well do consumers navigate the Retirement Risk Zone?

ContextIndividuals face increased risks and responsibilities for retirement saving, investment and decumulation decisions

Participation Superannuation fund/Pension provider Contribution rate Asset allocation Retirement date Retirement benefit type Financial advice/advisor

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What do Australians do? Participation decision: MANDATORY (for employees, 90-95%

coverage) Superannuation fund: < 3% (?) choose super fund (remainder

DEFAULT fund). Contribution rate: around 2/3 contribute no more than minimum

superannuation guarantee (ABS, 2009) (remainder DEFAULT at min SG, 9.25%).

Asset allocation: Around 43% assets in DEFAULT investment option, about 2/3 industry fund assets in DEFAULT option (? 60% members ?).

Retirement date: Choice NO DEFAULT Benefit choice: NO product DEFAULT. About 50% (assets) lump

sum/50% (assets) account-based pension, several hundred life annuities sold annually.

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What do Australians do? Participation decision: MANDATORY (for employees, 90-95%

coverage) Superannuation fund: < 3% (?) choose super fund (remainder

DEFAULT fund). Contribution rate: around 2/3 contribute no more than minimum

superannuation guarantee (ABS, 2009) (remainder DEFAULT at min SG, 9.25%).

Asset allocation: Around 43% assets in DEFAULT investment option, about 2/3 industry fund assets in DEFAULT option (? 60% members ?).

Retirement date: Choice NO DEFAULT Benefit choice: NO product DEFAULT. About 50% (assets) lump

sum/50% (assets) account-based pension, several hundred life annuities sold annually.

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What do Australians do? Participation decision: MANDATORY (for employees, 90-95%

coverage) Superannuation fund: < 3% (?) choose super fund (remainder

DEFAULT fund). Contribution rate: around 2/3 contribute no more than minimum

superannuation guarantee (ABS, 2009) (remainder DEFAULT at min SG, 9.25%).

Asset allocation: Around 43% assets in DEFAULT investment option, about 2/3 industry fund assets in DEFAULT option (? 60% members ?).

Retirement date: Choice NO DEFAULT Benefit choice: NO product DEFAULT. About 50% (assets) lump

sum/50% (assets) account-based pension, several hundred life annuities sold annually.

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For consumers in the retirement risk zone, retirement benefit/decumulation decisions are difficult

Involve complex financial products Interaction with publicly provided benefits Cannot navigate by ‘default’ High stakes (largest non-housing asset) Once in a lifetime decision no opportunity to learn

from experience (decision made once and generally irreversible)

Mass market DC is new little opportunity for social learning (ie, to learn from older generations)

We should not be surprised – this is what Behavioural Economists have been telling us…

• Bounded rationality – certain types of problem are too complex for individuals to solve on their own

• Bounded self control – individuals lack the willpower to execute their plans

• Bounded self interest – while individuals do seek to maximize their personal utility, they are more co-operative and altruistic than predicted by economic theory

• Swayed by behavioural factors – loss aversion , inertia, procrastination, framing, confusion, status quo bias, heuristics

(Thaler and Mullainathan, 2000)

Lessons from the academic literature?

5 year ARC Discovery Grant (2010-2014): The Paradox of Choice: Unravelling Complex Superannuation Decisions

Hazel Bateman (Risk and Actuarial, UNSW)Christine Eckert (Marketing, CenSoC, UTS)Fedor Iskhakov (CEPAR, UNSW)Jordan Louviere (CenSoC, UTS)Stephen Satchell (Cambridge UK)Susan Thorp (Finance, UTS)+ Julie Agnew (Finance and Economics, College of William and Mary, USA)

Investigated the ability of ordinary people to make complex retirement savings/investment/decumulation decisions

EVIDENCE OF INCOMPLETE AND UNREALISTIC PLANS RETIREMENT PLANNING

.

Survey of financial knowledge, plans and values

• Fielded in May 2011• Online panel provided by Pureprofile

– 920 people– Ages 50-74– Even genders– 60% had some post-school education– 37% already retired

Uneven planning and expectations

Around 30% still employed had not thought about the financial aspects of their retirement and a further 20% had just started to think about it

Only around 45% of those 50+ had tried to work out how much money they would need for retirement (2012 Financial Literacy survey)

Uneven planning and expectations

Optimistic lifestyle expectations of pre retirees (travel/leisure) vs post retirees (carers/return to work)

Fewer than one in five discussed retirement with friends and co-workers

Fewer than one in four had attended a retirement seminar

Estate planning is more common than financial or workplace planning

60% of surveyed had made a will 70% had thought about leaving a financial or

material bequest

Pessimism about length of retirement Typical respondent was

– Pessimistic about near-term survival (75-85)– Optimistic about survival at older ages (90 onwards)

Men in their 50s– Underestimated lifetime by 6 years on average

Men in their 60s– Close to improved life table expectations

Women in their 50s– Underestimated lifetime by 7 years on average

Women in their 60s– Underestimated lifetime by 5 years on average

EVIDENCE OF POOR FINANCIAL LITERACY, SYSTEM AND PRODUCT KNOWLEDGE

.

Survey fielded in June 2012 – Australian extension to Financial Literacy around the World (FLaT) study

Online survey using PureProfile Web Panel (600,000+ Australians)

1,024 respondents Nationally representative sample Age ranges from 18 to 84 742 respondents aged 25-65 and non-retired

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Measuring financial literacy in Australia

(1) Interest rates: Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?

– More than $102 -Do not know– Exactly $102 -Refuse to answer– Less than $102

(2) Inflation: Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account?

– More than today -Do not know– Exactly the same -Refuse to answer– Less than today

(3) Diversification: Buying shares in a single company usually provides a safer return than buying units in a managed share fund.

– True -Do not know– False -Refuse to answer

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3 Key Financial Literacy Questions

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Only 42% respondents answered 3 key questions correctly

Russia

Sweden

New Zealand

Italy

Japan

US

Australia

Netherlands

Germany

0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00%

Percent Answer All Questions Correctly

The same survey indicated somewhat poor super knowledge

% incorrect/do not know

What is the mandatory employer contribution under the SG

33%

Does superannuation receive tax concessions? 38%If you have any superannuation you will not receive an Age Pension

29%

Do you know the minimum age at which you can access your superannuation account?

48%

Only 14% of those who said ‘yes’ were correct

Of concern: If your superannuation account is invested in a ‘balanced’ investment option, this means that it is invested exclusively in safe assets such as savings accounts, cash management accounts and term deposits

.

TRUE FALSE DO NOT KNOW0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

28%

40%

32%

A related study revealed mixed awareness of products to provide income in retirement Have you heard of this product? Yes

Term deposit 98%Unit trust 45%Bonds 67%Cash management trust 63%Shares 88%Reverse mortgage 59%Retirement savings account 54%Lifetime annuity 37%Allocated/account based pension 48%

Survey of 920 superannuation fund members, 50-75 years old, May 2012

In particular, retirement income products are not well understood

Lifetime annuity Yes

Have you heard of this product? 37%- Offers lifetime income? 22%- Offers guaranteed income level? 8%Allocated (account-based) PensionHave you heard of this product? 48%- Offers choice of income subject to regulated minimum?

25%

- Withdrawal of capital is possible? 20%

Survey of 920 superannuation fund members, 50-75 years old, May 2012.

CONSUMERS ARE SWAYED BY BEHAVIOURAL FACTORS

.

Consumers making retirement benefit decisions likely influenced by

Mental accounting (narrow framing) Loss aversion (eg, focus on impact of dying young) Misleading heuristics (insurance is for bad events) Illusion of control (wealth vs income) Hyperbolic discounting Framing (consumption vs investment frame) Complexity

=> Use defaults or other decision rules

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FRAMING: Brown et al (2008) Why don’t people insure late life consumption? American Economic Review

Life annuity of $650 per month OR

Consumption frame (spend, payment)(% prefer life annuity)

Investment frame(account, earn, invest)(% prefer life annuity)

Savings account bearing 4% pa interest

72% 21%

Term annuity for 20 years paying $650 per month

77% 48%

Term annuity for 35 years paying $500 per month

76% 40%

Console bond paying $400 forever

71% 27%

Benefits calculated to be actuarially equivalent.Weak bequest motive

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FRAMING: Brown et al (2008) Why don’t people insure late life consumption? American Economic Review

Life annuity of $650 per month OR

Consumption frame (spend, payment)(% prefer life annuity)

Investment frame(account, earn, invest)(% prefer life annuity)

Savings account bearing 4% pa interest

72% 21%

Term annuity for 20 years paying $650 per month

77% 48%

Term annuity for 35 years paying $500 per month

76% 40%

Console bond paying $400 forever

71% 27%

Benefits calculated to be actuarially equivalent.Weak bequest motive

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FRAMING: Brown et al (2008) Why don’t people insure late life consumption? American Economic Review

Life annuity of $650 per month OR

Consumption frame (spend, payment)(% prefer life annuity)

Investment frame(account, earn, invest)(% prefer life annuity)

Savings account bearing 4% pa interest

72% 21%

Term annuity for 20 years paying $650 per month

77% 48%

Term annuity for 35 years paying $500 per month

76% 40%

Console bond paying $400 forever

71% 27%

Benefits calculated to be actuarially equivalent.Weak bequest motive

Discrete choice experiment of retirement benefit decisions• September 2011 (repeated Sept 2012)• Initial - online web panel of 854 participants with a

superannuation account (ages 50-64, not retired)

Survey instrument included:• TASK: Hypothetical allocation of ‘retirement

accumulation’ between life annuity and investment account

• Longevity expectations, health expectations• Product knowledge/Financial literacy• Demographics/personal information.

Income stream choice task

Annuity, guaranteeInvestment account, flexibility,risk of account depletion,

4 levels of risk of running out of funds

Two-stage model of decision making: first understand the products then make the choices

1. Who is involved? Test for who recalls the features of the products correctly:• People who understand the decision• People who are paying attention in ‘real time’

2. Who is risk aware? Test for who chooses to reduce the chance of low income as the risk (of running out of funds) rises

Who understand the products and is ‘involved’ with the decision?

Numeracy +Basic financial literacy +Sophisticated financial literacy +Knowledge of existing retirement income product attributes +Subjective understanding of finance -Planning of financial aspects of retirement (Higher = more advanced planning)

+

Quality of Life (Higher= better quality of life) -Subjective survival expectations (Higher = more optimistic) +Gender (female = 0, male = 1) FWealth sector ($50K, $125K, $250K, $1000K) -Intention to retire before age 65 +

Risk-aware choices depend on understanding the products and ‘real time’ interest.Dependent variable (irrational) = 1 if subject decreased annuity % when risk increased or did not move the slider at all

Numeracy +Basic financial literacySophisticated financial literacy

Knowledge of existing retirement income product attributes

Subjective understanding of financePlanning of financial aspects of retirement (Higher = more advanced planning)

Quality of Life (Higher= better quality of life)Subjective survival expectations (Higher = more optimistic)

Gender (female = 0, male = 1)

Wealth sector ($50K, $125K, $250K, $1000K)Intention to retire before age 65

Involvement score +

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Benefit choices experiment: conclusions People with higher financial capability pay more attention

(more ‘involved’) More numerate and more attentive people are better risk

managers Detailed understanding of specific products is critical to

risk-perception

Repeat experiment identified use of heuristics (decision rules) diversification (1/n) heuristic (50/50 allocation) default (stay with initial allocation) Extremes (100% annuity, 0% annuity)

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What have we learnt about navigating the retirement risk zone?

Incomplete plans, unrealistic expectations

Poor financial skills, system/product knowledge

Numeracy, financial competence and system/product knowledge enhances interest/involvement

‘Involvement’ and numerical ability facilitates risk awareness (and better decisions)

Role of decision heuristics (1/n diversification, defaults)

Navigating the retirement risk zone – is this the consumer perspective???

Thank you

Relevant papers

Papers 1. Economic rationality, risk presentation and retirement portfolio choice

(CenSoc and UNSW Working Paper) 2. Financial competence, risk presentation and retirement portfolio

preferences (Journal of Pension Economics and Finance, forthcoming).3. Financial competence and expectations formation: evidence from

Australia (Economic Record 2012).4. Superannuation knowledge and plan behaviour JASSA, 2013. 5. Work, money, lifestyle: Plans of Australian retirees JASSA, 2013.6. Financial literacy and retirement planning in Australia (Numeracy, 2013). 7. Involvement: A partial solution to the annuity puzzle (CenSoC and UNSW

Working Paper)