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1 Nudges and Networks: How to use behavioural economics to improve the life cycle savings-consumption balance Professor David Blake Director Pensions Institute.

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Presentation on theme: "1 Nudges and Networks: How to use behavioural economics to improve the life cycle savings-consumption balance Professor David Blake Director Pensions Institute."— Presentation transcript:

1 1 Nudges and Networks: How to use behavioural economics to improve the life cycle savings-consumption balance Professor David Blake Director Pensions Institute May 2012

2 2 Agenda n Most people are not rational life cycle financial planners n Identifying behavioural barriers n How behavioural economics can help overcome barriers n Speedometer Plans n How networks can help n How to implement: A life-cycle fund + corporate platform

3 3 Most people are not rational life cycle financial planners

4 4 n This would require people to accurately forecast: u Total career income u Total available retirement resources u Asset returns u Interest rates u Tax rates u Inflation u Longevity u Medical and health costs n It would also require people to have the commitment to start and maintain a very long-term savings and investment programme

5 5 Identifying behavioural barriers

6 6 What needs to be recognised n In reality, individual decisions subject to: u Bounded rationality: F Certain types of problems are too complex for individuals to solve on their own F Many people have a poor sense of the ‘time dimension’ of their lives u Bounded self-control: F Individuals lack willpower to execute plans n In view of these limits on optimising behaviour, we need to change our understanding of individual economic decision making: u Especially long-term savings decisions F Such as those involved in accumulating and decumulating assets in a pension plan

7 7 Pre-retirement behavioural barriers

8 8 Starting to save n Procrastination and inertia are bad for saving: u Employees fail to join pension plans where they are required to opt in n Retirement saving means reducing consumption now in order to have a comfortable income in future: u Requires self-control - not always easy F Similar to losing weight or giving up smoking

9 9 How much to save n It is difficult to know how much to save for retirement n Members may be anchored by irrelevant information u Default saving rate is 5% - that must be the right rate? n Cognitive polyphasia: u People can think about the same issue in contradictory terms in different situations u ‘I know I should be saving 15% of my income if I want a good pension’ u ‘I think I will be able to live on much less when I retire, so I do not need to save as much as I thought, which means I can spend more today’

10 10 What to invest in n Most DC members don’t want to choose funds u 90% take-up of default funds n There are many behavioural biases relevant to investment: u Regret u Loss aversion u Mental accounting: F How people keep track of financial activities u Framing F ‘You are aware equities are risky’ Leads to ‘reckless conservatism’ F ‘You are aware that equities tend to generate higher returns in the long run, despite short-term volatility’

11 11 What to invest in n There are many behavioural biases relevant to investment: u Choice overload/anxiety (problem of complexity): F Too many investment funds means no decision at all F When faced with difficult choices, individuals often employ simplifying heuristics (simple rules of thumb) E.g., choose default option on grounds that someone else must have thought that it was good idea F Herding – follow the herd u Weak investment preferences (problem of complexity): F Individuals can easily be led F Evidence suggests menu design influences fund choice

12 12 When to retire n Time inconsistency: u When you are young, you believe that you will be able and willing to work longer if necessary to compensate for inadequate pension savings: F Even if someone tells you that you will probably not feel like that when you are older u When you are old, you regret not saving enough, because you do in fact want to retire earlier u Another example of the poor understanding of the time dimension of people’s lives

13 13 At-retirement behavioural barriers

14 14 What retirement income strategy n Effective retirement saving needs an optimal decumulation strategy as well as optimal accumulation n Need to deal with: n Human spenders u Spend too quickly in retirement n Human hoarders or squirrels u Spend too slowly in retirement u Wish to guarantee inheritance for their children n Properly designed retirement income strategy can help both

15 15 Source: 100% PNMA00 medium cohort 2007 Age 25% Life expectancy = 86.6 Most likely age at death = 90 % deaths at each age Random Variation Risk Expected distribution of deaths: male 65 Idiosyncratic risk % deaths at each age Expected distribution of deaths: male 85 Life expectancy = 91.6 Most likely age at death = Age 1 in 3 will reach 93 and 5% will reach 100 People have a poor understanding of longevity risk Idiosyncratic risk

16 16 What retirement income strategy n Many scheme members dislike the idea of buying an annuity: u Annuities are perceived as poor value u This may be because members underestimate how long they (and their spouse) are likely to live n There are many behavioural biases relevant to decumulation: u Illusion of control: F People like to feel in control of their capital but annuitisation leads to a ‘loss of control’ u Framing: F Expressed using a ‘consumption’ frame, annuities are desirable F Expressed using an ‘investment’ frame, annuities are risky

17 17 What retirement income strategy n There are many behavioural biases relevant to decumulation: u Regret/loss aversion rather than risk aversion: F ‘Annuities are a gamble’ F Probability of dying very soon after purchasing annuity is very low, but this probability is likely to be overestimated: So ‘loss’ perceived to be high Dying AND losing all your capital too! F Conversely the significant probability of out-living one’s resources if one doesn’t annuitise is underestimated: So ‘gain’ perceived to be low F Hence ‘gain’ to annuitising will give small utility benefit, while ‘loss’ of dying early may have large utility loss

18 18 How behavioural economics can help overcome barriers

19 19 Behavioural economics n Combines economics, finance, psychology and sociology n Recognises: u Individuals do try to maximise personal welfare u But limits to the extent they can do this u Individuals are Humans not Econs and need nudging towards optimal solutions n Recognises: u Importance of social norm groups and social networks in helping individuals improve outcomes: F ‘People like us’ n Comes out of the US, so needs to be adapted to other countries

20 20 Overcoming pre-retirement barriers

21 21 Starting to save n Behavioural traits have been exploited to design pension schemes that increase long-term pension savings. n Classic example is Save More Tomorrow (SMT or SmarT) plan: u Thaler and Benartzi (2004) n Scheme member agrees to start or increase savings on regular basis: u Not now but on future significant date F E.g., date of next pay rise

22 22 Starting to save n SMT plans deal with a number of behavioural traits: u Accept individuals have self-control problems: F And benefit from using pre-commitment devices: Auto-enrolment with payroll deduction Auto-escalation Withdrawal restrictions: –creating psychological and financial barrier to accessing funds u Utilise inertia: F Since, once signed up, workers typically do not cancel payroll deduction facility u Uses herding behaviour constructively: F A worker will join if other workers are joining

23 23 How much to save n Importance of an appropriate default contribution rate n Contribution matching by employers provides a powerful incentive n Once enrolled, members tend not to alter contribution rate u Unless automatic annual increases are in place u Again exploits inertia positively

24 24 Impact of pre-commitment devices and inertia: Savings rates in SMT plans

25 25 What to invest in n To deal with choice overload/anxiety (problem of complexity): u Have only a small number of investment funds to cover the range of risk tolerances u Individuals want to know what a fund does, not what its asset mix is n To deal with simplifying heuristics: u Have a well-designed and low cost default fund n To deal with inertia: u Use lifestyle investment strategies: F De-risking near retirement is automatic

26 26 Overcoming at-retirement barriers

27 27 What retirement income strategy n Overcoming the illusion of control: u ‘All-or-nothing’ annuitisation likely to be suboptimal as well as undesirable u Gradually purchasing annuities over time might be better F Deals with: Interest rate risk – hedges interest rate cycle Possibility that investment returns might be higher in future Possibility that mortality rates might be higher in future Possibly long period of retirement and not wanting to be locked into a low-yielding bond-like investment

28 28 n Overcoming regret/loss aversion: u Any pooling of mortality needs to be perceived to be fair by the public F Currently, this is not true! F At younger ages annuity mortality cross-subsidy or survivor credit gives poor value to those dying early u Solutions: F Money-back or capital-protected annuity F Impaired life annuity What retirement income strategy

29 It is not a question of IF but WHEN pensioners should annuitize Age Survivor credit % Limited value from annuitization – Death benefit seen as more valuable. Annuitization essential to provide income for life Investment split - Equities : Bonds/Annuities Equities Bonds / Annuities Level of survivor credits Source: Own analysis; 100% PNMA plus improvements in-line with CMI_2009_M [1.00%]; Survivor credit = q x / (1 - q x ) 29

30 Death benefits under a money-back annuity On death any excess of the original purchase price over the gross annuity payments already received is returned to the annuitant’s estate Age at death ACCUMULATED INCOMEDEATH BENEFIT Accumulated gross payments £ Purchase price Source: Own calculations 100% PNMA plus improvements in-line with CMI_2009_M [1.00%]

31 31 What retirement income strategy n To deal with framing: u Pose problem in a way that generates the optimal outcome for most people F Talk about the income stream ‘generated’ by the annuity rather than the ‘loss’ of the lump sum F Explain the annuity in a ‘consumption frame’ (which makes an annuity look safe) rather than an ‘investment frame’ (which makes an annuity look risky) u Emphasize risk of living in poverty in old age, rather than giving up the lump sum F Studies show people with annuities are happier: they can spend their annuity payments knowing they have full longevity risk protection show series of photos of decreasing bundles of goods that can be purchased due to inflation

32 32 Speedometer Plans

33 Spend More Today Safely: Using Behavioural Economics to Improve Retirement Expenditure Decisions David Blake & Tom Boardman February 2012 (

34 SPEEDOMETER retirement expenditure plan n Spending Optimally Throughout Retirement: u First, make a plan u Second, secure 'essential' income u Third, have insurance and a 'rainy day' fund to cover contingencies u Fourth, secure 'adequate' income u Fifth, achieve a 'desired' standard of living and make bequests n A universal plan for all retirees 34

35 First, make a plan n Either... by using an on-line or telephone-based service providing generic financial advice n Or... if wealth permits, involving a financial adviser whose role is to assist with making and implementing the plan and conducting annual reviews 35

36 Second, secure 'essential' income n Plan manages all assets and income sources holistically to secure essential income n Defined as the minimum, core inflation-protected income sufficient to meet the retiree’s ‘essential’ needs for the remainder of their (and their spouse’s) life. 36

37 Third, have insurance and a 'rainy day' fund to cover contingencies n Use insurance solutions, when available and cost effective, to cover contingencies, n Where appropriate, rely on state support n Where possible, maintain flexibility by holding sufficient assets to meet uninsurable shocks (i.e., a ‘rainy day’ fund) 37

38 Fourth, secure 'adequate' income n Secure an ‘adequate’ level of life-long income above the minimum if there is sufficient wealth n ‘Adequate’ income defined as that needed to achieve the minimum lifestyle to which the pensioner aspires in retirement. 38

39 Fifth, achieve a 'desired' standard of living and make bequests n The plan uses a simplified choice architecture for managing any residual wealth n Aim of achieving a ‘desired’ standard of living in retirement, while allowing part of the remaining wealth to be bequested at a time of the retiree’s choosing. 39

40 How a SPEEDOMETER plan deals with behavioural traits n Use of commitment devices and inertia n Use of defaults n The plan NOT the member deals with complexity of decumulation n Use of money-back annuities n Use of phasing n Positive norming via effective communication n The slogan ‘spend more today safely’ to reinforce the idea that ‘buying an annuity is a smart thing to do’. 40

41 The SPEEDOMETER plan involves just four key behavioural nudges: n First, make a plan n Automatic phasing of annuitization n Capital protection in the form of ‘money-back’ annuities n The slogan ‘spend more today safely’ to reinforce that ‘buying an annuity is a smart thing to do’. 41

42 42 How networks can help

43 43 How networks can help n Now beginning to be recognised that nudging is more effective in networks: n Employment-based networks are most effective for: u Encouraging pension savings u Helping to pay-off debt via pay-roll deduction with payments used to create positive savings once debt paid off n Social networks: u Family, friends and neighbours n Internet-based networks u Daily Dollar - Daily Budgeting Facebook App ( u “brings to life the notion that small lifestyle changes can add up to big savings.” u publish the results on your profile

44 44 Age-based networks Age range Description Baby Boomers (1946 – 64) Gilt Edge Lifestyles Mid Life Affluence Modest Mid Years Advancing Status Ageing Workers Generation X (1965 – 81) Successful Starts Happy Housemates Surviving Singles On The Breadline Flourishing Families Generation Y (1982 – 95) Happy Housemates Surviving Singles On the Breadline

45 45 Networks based on personality types Personality type in retirementDescription Empowered Reinventors (19%)Can easily adapt to change – welcome adventure and new challenges Carefree Contents (19%)Optimistic about coping with change – but do not seek adventure or new challenges Uncertain Searchers (22%)Recognise change could be fulfilling and satisfying, but still trying to make sense of change Worried Strugglers (40%)Worried, bored or saddened after the change. Lack of planning and preparation play a role here Source: The New Retirement Mindscape (Ameriprise Financial, January 2006)

46 46 How to implement: A life cycle fund + corporate platform

47 47 First, get ‘em young n Savings is a habit that needs to be engendered from a very early age n Four boxes for pocket money Immediate spending (Instant gratification) Charity: Spending on other than self (Feel good) Short-term saving for specific item (Deferred gratification) Saving for an unspecified purpose (Precautionary and long-term savings) When grown up, this becomes the rainy day fund and the pension fund

48 48 Life-cycle fund n Manages savings and loans around key life events: u Paying off student loans and future debt management u Tax-efficient short/medium term savings: F ISA (individual savings account) F Share incentive plans u House purchase u Marriage u Children & school fees u Holidays u Retirement u Inheritance and tax planning u Long-term care Life/health assurance

49 49 Implemented using (corporate) wealth management platforms/wraps n Employer as facilitator: u Exploiting one of the most effective networks n But how much choice and flexibility should be offered? n Econs like lots of choice and flexibility: u Many people, especially the young, claim to like choice and flexibility F Especially the flexibility to delay starting a long-term pensions savings programme! u So provide lots of self-selection? n Humans do not really like that much choice and flexibility: u They like well-designed defaults u So provide segmented information and products? F Based on effective client profiling

50 50 Conclusions

51 51 Lessons from behavioural economics n Assume nothing (or very little) n Design products and marketing strategies with abilities of less sophisticated, less experienced population in mind: u guiding choice, choice-editing … n Wherever possible, work with human biases – not against n Nudging will help if the product design is good n Networks can help support and reinforce good individual behaviour

52 52 Well-designed pension plans recognise… n Need to help both Human Spenders and Human Hoarders n People need reassurance that it pays to save n Pension death benefits need to be as generous for annuities as they are for income drawdown n Phasing into annuitisation may be more acceptable n Annuity products with equity linking might be valuable for those who are sufficiently risk tolerant

53 53 Better communication and education alone will not work n Need good design of default option: u “Education no substitute for good default” F David Laibson, Harvard University F Pioneer Investment’s European Colloquia 2007 n Because vast majority of individuals will not be able to design their own retirement income programme: u Who wants to go into a car show room and be offered a choice of car kits to self assemble?

54 54 Thank you!

55 55 References n Mitchell, O, and Utkus, S. (2004) Pension Design & Structure: New Lessons from Behavioral Finance, Oxford University Press, Oxford n Thaler, R, and Benartzi, S (2004) Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving, Journal of Political Economy, 112, S164-S187 n Thaler, R, and Sunstein, C (2008) Nudge: Improving Decisions about Health, Wealth & Happiness, Yale University Press, New Haven & London

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