Industry Status Quo: Accountability and Efficient Management of Retirement Funds.

Industry Status Quo: Accountability and Efficient Management of Retirement Funds

WISDOM

AGENDA• Initial thoughts• The assumption – life cycle saving and consumption• Financial literacy and why it matters• Behavioural economics

• Hyperbolic discounting• Inertia• Nominal loss aversion

• Choice architects• Libertarian paternalism• Tools you can use• Even National Treasury is doing it!• Conclusion• Questions

The background

INITIAL THOUGHTS

• Traditional economics tells us that humans are rational beings and make choices that maximise their welfare.

• However, behavioural economists say that rationality has its bounds and because of this we don’t always make the best possible choices!

• With the insights gained from behavioural economics there is a possibility of improving people’s choices.

THE ASSUMPTION – LIFE CYCLE

MORE LIFE CYCLE SAVING/CONSUMPTION

• One of the key assumptions - people behave the way the traditional economics tell us they should.

• Graph tells us the story of life cycle saving and consumption:• Consumption is stable through a person’s life. • Person knows when to save and when to consume.

• For many of us this is not the reality of our lives. Firstly, there is an assumption of lifelong employment, something that may not be true. Where this is the case we may have used some of our pension savings for other things before retirement and so break this cycle. We may have been unemployed and forced to use this money.

MORE LIFE CYCLE SAVING/CONSUMPTION

• One of the major reasons people fail to act as expected in this model is due to lack of understanding.

• Research across the globe has shown that most people irrespective of origin, culture, income, gender and educational background battle to make these life-cycle consumption and savings decisions in a rational manner to ensure that they have enough in various stages of their life.

Why intervention is needed?

FINANCIAL LITERACY

• Financial literacy has an impact on retirement planning.

• A study investigating financial literacy in Germany, the Netherlands, Sweden, Japan, Italy, New Zealand, the Russian Federation and the United States of America shows that financial literacy is an important element in achieving retirement security.

• In an environment where most pension schemes are defined contribution arrangements institutions such as employers and government are no longer responsible for making consumption decisions for workers when it comes to retirement provision. Workers are now forced to understand economic information and use this to plan for retirement, there is a need for them to become more financially literate in order to make the most appropriate consumption choices.

FINANCIAL LITERACY

• Some basic concepts have been identified which people need to be able to use in their financial decision making: • Compound interest, • Inflation; and,• Time value of money. • In addition, an understanding of the risk/return characteristics of equities and

bonds, how equity markets function, how risk is diversified and the relationship between bond prices and interest rates.

FINANCIAL LITERACY (CONTINUED)

• Financial literacy has also been found to differ by population subgroups, notably age groups.

• Financial literacy is said to follow an inverted U-shape with the lowest levels observed in the young and older groups this is said to be consistent with knowledge and increasing with experience and declining as people grow older.

• Another observation is that in many countries women are shown to have lower levels of financial literacy than men.

• An interesting observation is that many people invest little in acquiring higher levels of financial literacy.

What we have learnt

BEHAVIOURAL ECONOMICS

• The almost universal lack of adequate financial literacy makes it difficult to believe that people are able to make rational decisions to ensure that they use the resources at their disposal in the best possible way.

• Besides the lack of understanding how basic financial instruments work there is an additional psychological element to people’s relationship to money and saving. This is where behavioural economics come into play.

• The research on financial literacy levels tells us that for many people no matter how much information they have at their disposal they will still find it very difficult/impossible to understand the information and make the best possible decision based on that information.

BEHAVIOURAL ECONOMICS

• From behavioural economics we learn that people behave in certain ways that inhibit them from making the best possible choices.

• Understanding how people are likely to behave in relationship to certain decisions enables those formulating the choices to design them in such a way that the best possible outcome is achieved.

HYPERBOLIC DISCOUNTING

• Hyperbolic discounting, which refers to a discount function that “… over-values the more proximate satisfaction relative to the more distant ones”

• For example, people were asked to choose between healthy snacks (bananas) and unhealthy snacks (chocolate). When asked one week in advance, only 26 percent of subjects indicated they would choose the unhealthy snack. However, when asked immediately prior to consuming the snack, 70 percent chose the unhealthy snack.

• This form of present-biased preferences is characterised by the discount rate increasing as consumption gets closer.

HYPERBOLIC DISCOUNTING

• Hyperbolic discounting and present-biased preferences could explain why many of us engage in suboptimal behaviour such as excessive eating, lack of exercise and excessive spending. Yet, at the same time, many of us envision we would eat less, exercise more and save more in the not-too-distant future. Hyperbolic agents believe (often wrongly) that doing the right things would be easier in the future, as the temptation to eat too much would be moderated.

INERTIA

• Hyperbolic agents tend to procrastinate because they think that whatever they will be doing later will not be as important as what they are doing now.

• Procrastination, in turn, produces a strong tendency toward inertia.

NOMINAL LOSS AVERSION

• Nominal loss-aversion refers to the fact that the pain associated with losses is about twice the pleasure that is associated with similar magnitude gains.

CHOICE ARCHITECTS

• Behavioural economics teaches us that all people who design choices or questions are choice architects.

• Trustees developing benefit options with employers or labour organisations are choice architects.

• Choice architecture seeks to affect outcomes through the manner in which the person or organization presents the choice to the decision-maker.

• For example, nations that require citizens to opt-out of organ donation have a significantly higher organ-donor rate than nations where the citizens must affirmatively choose to take part (opt-in).

CHOICE ARCHITECTS

• Another technique suggested is laying out various outcomes of a decision in a way that is easy for the choice-maker to understand.

• Choice architecture builds a framework to distinguish between two types of tools that choice architects can use: those that structure a choice in a certain way, and tools that make use of how options are presented to decision-makers.

• To illustrate, the use of a default, where the default option will lead to a more socially desirable outcome, is an example of structuring choices. The way in which options are categorised and then presented to a decision-maker is an example of presenting options in a way that influences choice.

LIBERTARIAN PATERNALISM

• The term libertarian paternalism was coined by behavioural economist Richard Thaler and legal scholar Cass Sunstein.

• They propose that libertarian paternalism is paternalism in the sense that “it tries to influence choices in a way that will make choosers better off, as judged by themselves"

• It is libertarian in the sense that it aims to ensure that “people should be free to opt out of specified arrangements if they choose to do so.”

LIBERTARIAN PATERNALISM

• The possibility to opt out is said to “preserve freedom of choice”.

• Libertarian paternalism refers to policies designed to help people who behave irrationally and so are not advancing their own interests, while interfering only minimally with people who behave rationally. Such policies should be acceptable both to those who believe that people behave rationally and to those who believe that people often behave irrationally.

What can be done?

TOOLS YOU CAN USE

• Libertarian paternalism provides the philosophical frame work for creating appropriate defaults • Investments – many trustees already do this.• Default preservation option – soon this will be law.• Default annuity option – soon it will be law.

• Using the structure-a-choice choice architecture tool opt-out defaults can be created.

• Default preservation and annuity options will allow the choice architects to counter behavioural issues such as hyperbolic discounting (reason most members choose a cash option at withdrawal and retirement).

TOOLS YOU CAN USE

• Using inertia - once defaulted members are unlikely to initiate a request to change the status quo.

• Due to inertia the choice architect will also be able to counter the member’s nominal loss aversion by designing the most appropriate investment strategy, even if the potential risk is higher than the member would have accepted had she preserved or annuitised.

Understand this now!

EVEN NATIONAL TREASURY IS DOING IT!

• Many of the things we discussed in this presentation form the basis for much of the proposed reform National Treasury has put forward.

• For example, default preservation and annuitisation and even compulsory enrolment for all formally employed workers.

• A further example is the phasing out of provident benefits which makes it law for all members to have an annuity. There is however a phase-in period.

• This is not unique to South Africa as many of the initiatives that have been launched in recent times internationally have also relied on the work done by behavioural economists.

• An example, the 2012 introduction of auto-enrolment for all formally employed workers in the UK. There is also a team of behavioural economists who do research on how best to design and present UK government benefits and programmes.

Industry Status Quo: Accountability and Efficient Management of Retirement Funds.

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