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Rich and Co.

The Economist: Behavioral Econ and DC Pensions: Sobering

A sober overview from experience and research around the world.  Our response and comment posted to the article site is at the end.

Highlights:

  • American married couple both retire at age 65, there is a 50% chance that one of them will live to 90. But pensioners tend to underestimate how long they will live.
  • A further complication is that people’s spending profile after retirement tends to be U-shaped.
  • Employees in America do not like annuities. “People hate losing control of their money,” 
  • But South Africa also offers access to pension savings, and research that 70% of members were taking their benefits in cash before retirement.
  • Many people use the money to pay off their debts; some go on a spending spree. So they may eat up their savings and have to fall back on the state’s means-tested benefit at 65.
  • the Brookings Institution found that about half the assets in the Australian scheme were held in self-managed or retail funds, which pushed up charges to an average of around 1.25% of assets
  • …more time is needed to demonstrate that auto-enrolment actually works
  • Saving for a pension may not be the best use of an employee’s income
  • Another problem is that the amount of money going into NEST (UK DC pension scheme) may not be enough to generate a decent pension.

The Economist — A Special Report On Pensions

A Nudge And A Wink — How To Persuade Employees To Provide For Their Old Age — Apr 7th 2011

ALBERT EINSTEIN IS said to have described compound interest as the eighth wonder of the world. It should also be a boon for workers planning their retirement. Start saving early enough and a pension becomes much more affordable.

Unfortunately young people are often unable or unwilling to take advantage of this miracle.

  • Their wages are low
  • Their main priority may be to pay off their student debts or to save for a deposit on a house
  • They may find it difficult to defer gratification or, as economists like to put it, they use hyperbolic discounting
  • Most of them would much rather have money in their hands today than put it aside for a retirement which they can barely imagine. “People worry about sacrificing their liquidity by putting money in a pension.  They may have money to save now but think they might need it next year.”

But people MAY change their behaviour if the problem is explained to them in the right way.  In one academic study college-age students who were shown digitised pictures of themselves as they might look in old age allocated more than twice as much of their income to retirement savings as students who were shown contemporary photos.

Most countries use some form of tax incentive to encourage saving for pensions, usually by making contributions tax-deductible and allowing pension pots to accumulate tax-free. In a survey by the Investment Company Institute,

  • more than 80% of pension-plan members said that the tax break acted as an incentive
  • 40% said that without the 401(k) concessions they would not be saving at all.

But tax incentives are likely to be of most benefit to the rich, who have more money to save; and those on lower earnings may find the tax rules too complicated.

A survey of British savers by Aegon, an insurance company, found that few understood the concept of tax relief.   It concluded that participation in pension plans would increase if the government were described as “matching” the amount of money put aside by workers.

The Easy Option
These days the pensions industry is calling on the wiles of the behavioural school of economics.  Governments are trying to “nudge” people into doing what is good for them, as described in the eponymous book by two economists, Richard Thaler and Cass Sunstein.

  • The most popular nudge to do with pensions is auto-enrolment, which takes advantage of people’s inertia. … 
  • Under the nudge principle, workers are automatically enrolled in the scheme and actively have to opt out if they do not want to join. This has duly boosted participation.

In America auto-enrolment was approved in the Pension Protection Act of 2006 and was used by 57% of private-sector companies in 2010, with a further 15% planning to introduce it this year, according to a survey by Aon Hewitt, a consultancy

  • David John of the Brookings Institution suggests that the concept could be extended to small employers via an auto-IRA (individual retirement account), allowing businesses to offer employees a pension scheme at low cost
  • In Britain auto-enrolment is at the heart of a new national pension scheme, the National Employment Savings Trust (NEST). Due to start in 2012, it is designed to deal with the 45% of workers without a private pension plan. In future all employers will have to offer one, and NEST offers them a low-cost option if they do not want to set up their own scheme.

Economies of scale and limited investment choice will keep down charges.

However, Auto-Enrolment Raises Questions.

  • Saving for a pension may not always be the best use of an employee’s income. People with credit-card debts who are paying interest of 15-20% would be better off reducing their balances
  • In some countries (including Britain) means-tested benefits for low earners may be reduced in retirement if a pension is being paid.

Another problem is that the amount of money going into NEST may not be enough to generate a decent pension.

  • Total contributions will be 8%
  • of which 3% will come from the employer
  • 4% from the employeeand 
  • 1% from the government, in the form of tax relief.

But that is less than the average contribution rate of private-sector DC schemes. The danger is that employers will be tempted to “trade down” to the new levels.

Saving for a pension may not be the best use of an employee’s income — people with credit-card debts would be better off reducing their balances

“It has been relatively rare for companies not to slash their contributions when they move from DB to DC.  There is a danger that auto-enrolment may exacerbate the trend as companies realise they have to make contributions for more people.”

more time is needed to demonstrate that auto-enrolment actually works; 

  • the initial studies were based on just a small number of American companies
  • The success of New Zealand’s KiwiSaver programme, which used auto-enrolment to boost participation, may have been due to the generous tax incentives being offered
  • In particular, what will happen when workers discover they can get a short-term pay rise by opting out of the system.

In America’s corporate sector auto-enrolment is sometimes accompanied by auto-escalation. As workers earn more, their pension contribution goes up steadily. The hope is that they will barely notice the difference in take-home pay but that a higher contribution rate (perhaps 10-15% in total) will in due course allow them to earn a decent pension.

Make Them Pay
The alternative to auto-enrolment is compulsion, as practised in Australia since 1992.

  • Employers there are required to contribute 9% (set to rise to 12% in 2019) of an employee’s salary to a superannuation account
  • The system applies to all Australian workers except the very lowest-paidA report by the Brookings Institution found that about half the assets in the Australian scheme were held in self-managed or retail funds, which pushed up charges to an average of around 1.25% of assets
  • Members of the scheme are able to take all their benefits as a lump sum at age 55
  • There is no requirement to buy an annuity. Many people use the money to pay off their debts; some go on a spending spree. So they may eat up their savings and have to fall back on the state’s means-tested benefit at 65.

In theory, being able to withdraw money from a pension scheme may persuade employees to contribute to it in the first place.

But South Africa also offers access to pension savings, and research that 70% of members were taking their benefits in cash before retirement.

Problems with Annuities
Ideally savers will not take advantage of that option. One answer would be compulsory annuitisation, which is what Britain imposed for many years. Pensions are subsidised through the tax system to generate a lump sum that can be used to buy a retirement income to prevent the elderly from becoming a burden on taxpayers.

If workers in DC schemes fail to buy an annuity, they face the risk that they may outlive their savings.  Even those British workers who do buy an annuity tend to go for a flat-rate version, running the risk that inflation will erode their purchasing power.

The legal requirement to buy an annuity has been weakened in recent years. And British enthusiasm for annuities will have been dampened further by a European Court of Justice decision last month that stopped insurance companies from discriminating on the ground of gender.

Traditionally, men have received higher annuity payouts because their life expectancy is shorterIn future, annuity rates for men—the main buyers of the product—will have to be cut, perhaps by 5%, to bring them in line with rates for women. In effect, men will be underpaid.

Employees in America do not like annuities. “People hate losing control of their money,”  

If their capital is tied up, pensioners may not be able to meet sudden health-care billsthey will be exposed to the credit risk of the insurer, which the collapse of AIG in 2008 showed to be a real dangerand in some cases their heirs may get nothing.

The American insurance industry has tried to get around this problem by offering variable annuities, which they like to call a “living benefit”.  But this market still attracts only a small fraction of DC assets.

That may be because investors suffer from a condition called “money illusion”. They prefer having a lump sum to an inflation-linked income…a pension pot of $1m will buy an inflation-linked annuity of just $45,000 a year. “Retirees would go from being a millionaire to barely being in the middle class,”

This apparently low annuity rate reflects increasing life expectancy. If an American married couple both retire at age 65, there is a 50% chance that one of them will live to 90. But pensioners tend to underestimate how long they will live.

A further complication is that people’s spending profile after retirement tends to be U-shaped.

When they first leave work, they are still active and keen to travel and spend moneyAs they reach their mid-70s they stay at home more and spend lessIn their 80s their costs may rise again because of higher health-care bills or because they have moved to a nursing home.

If workers are not required to use all of their pension pot to buy an annuity, it seems sensible to ensure they make provision for their basic needs. In a report on retirement design, Mercer suggests dividing the pension pot into three:

one from which to draw income for the first 15 years after retirement, aiming at a 50% replacement ratioa second to be set aside to meet the higher costs of advanced ageand the rest for discretionary spending.

But this will be possible only if workers learn to regard their DC plans as the basis for an income stream. According to Geoff Manville, head of government relations at Mercer, the Obama administration is looking into a policy change that would require DC sponsors to give members a rough idea of the level of annuity they might expect. That could be another nudge in the right direction.

 

(This is our comment posted to the original article site.) It is well to take any and all of the behavioral ideas and theories with great critical thinking and skeptcism.   It’s appropriate to ask hard basic questions.  “Where is the evidence?” is one.

Behavioral theories and ideas are largely a pop media phenomena.  There is very little (if any) hard, peer-reviewed, double-blind study evidence for even the preliminary theories let alone practical applications.  BTW, there was no “Nobel” prize for these ideas —- there is, in fact, no Noble Prize for economics. A bank in Sweden gives out a prize in economics which they “spin” and is mislabed as a “Noble Prize” in economics.

The idea that some of the most pervasive, self-harming and intractable problems of human behavior and policy can be solved by simple “nudges” is sadly silly and simple.  But silly and simple ideas are always hugely popular.

In fact, the British government has made a serious investment in these ideas and found them a dead end.  British ministers, it turns out, are sensible and properly skeptical of fashionable ideas of the moment.

Here is some evidence contra BE –

“Demographic Time Bomb”
This is a massive and increasingly complex and accelerating global problem – how to fund extended lifespans with increasing health care costs, for hundreds of millions of adults – living for extended decades after their work lives?  Yikes!!

There seem to be a few determining factors in this “wicked problem:”

  • Historically unprecedented lifespans – longer for women.
  • No historical precedents or models for coping – in any domains.  We effectively have to get out and repaird the “airplane” “in-flight.”
  • Increasing realization of the serious limits in the human brain’s, and therefore policy, groups and institutions, to cope with problems that are inevitable but in the future.  

 

We have been studying and posting on this primacy of hyperbolic discounting or soel focus on the “moods of the moment” in driving behaviors.  There are additional age and life –stage complexities,  For example, younger people are more impulsive and focused on “dating and mating” priorities; older adults suffer from brain capacity declines – especially men.

Finally, there simply is no money to pay for even basic living and health expenses for the vast numbers of people entering retirement.  The retirees don’t have the money, employers and companies don’t, governments don’t.  Add in health care which is inflating at 5% a year….it’s serious.

There are historical precedents for periods when population growth has exceeded the current “carrying capacity” of the “local ecologies” (economies).  These are often accompanied by the serious challenges to the social fabric and warfare.  It is said Hitler was helped to power by the German government’s inability to pay WWI vets pension guarantees — leading to hyper-inflation.

Our hope would be that any solutions be expert-advised, evidence-based and experimented with before being enacted.  Realistically, there will need to be much trial and error – with the majority of the ideas failing.

However, predictably, our brains won’t “stand still” for problem analysis or problem-solving.  They will treat with disgust any careful or thoughtful processes and policies and just “grab” at whatever our moods of the moment demand.  Thus, it has always been so.

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Written by Rich and Co.

April 10, 2011 at 1:26 pm

Posted in Uncategorized

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