If you are sitting in a packed cinema enjoying a romantic movie with your partner and someone suddenly yells “fire” and runs out, the chances are other individuals may perceive this as a signal to also leave the cinema, even if they have not seen or confirmed the existence of a fire. This behavior can create a panic, leading to a stampede that will, needless to say, ruin your romantic evening. The scenario described is an example of herd behavior where individuals who are uncertain about the appropriate course of action, may follow the actions of others. Does this remind you of something that is just happening in some of the US banks facing a bank run after the collapse of the Silicon Valley Bank (SVB)?
Herd behavior is a natural human tendency that has evolved over the course of our evolution as a survival mechanism. In early human societies, living in groups provided protection and increased the chances of our survival. To put it in simple terms, Individuals who followed the behavior of the group had a better chance of survival than those who acted independently. This behavior has been reinforced over time through socialization and cultural learning. As individuals interact with others in their social groups, they learn to conform to group norms and follow the behavior of their peers. Additionally, herd behavior can be amplified by cognitive biases, such as the availability heuristic, where individuals make decisions based on easily available information, rather than considering all available evidence. In situations where information is scarce, individuals may follow the actions of others as a way to reduce the cognitive effort required to make a decision.
So herd behavior can be a rational response to uncertainty or incomplete information. In situations where individuals are unsure about the best course of action and swift decisions are required – like a fire in the cinema or a bank collapse, they may choose to follow the actions of a larger group, as they perceive it to be a more reliable signal of what the best course of action is. This is exactly what just happened in the collapse of the SVB bank that followed the media storm leading to a customer race against each other to pull money from the bank with more than $40 billion withdrawn suddenly in a classic bank run no one expected to see in 2023. A bank run occurs when large groups of depositors withdraw their money from a bank at the same time on fears that the bank will become insolvent. With more people withdrawing money, the bank uses up its cash reserves and ultimately ends up defaulting.
All fine until here, but while following the actions of others in a dangerous situation may seem like a rational response to uncertainty, herd behavior also has its downsides. It is one of the main drivers behind stock market bubbles, where investors follow the trend of buying a particular stock or asset, even if its price is significantly higher than its fundamental value. This behavior can lead to a price bubble, which eventually bursts, causing a significant market correction. We all know when your hairdresser or the mechanic tips you to buy a certain stock or an asset class, it’s about time you get out of it. In many Initial Public Offerings (IPOs) herd behavior is also present, where investors tend to invest in a newly listed stock simply because other investors are investing in it, without considering the fundamentals of the company. And let’s not forget the real estate market, where buyers tend to follow the trend of buying properties in a particular area, like a condo in MIami, leading to a surge in prices, which form bubbles that sooner or later burst.
Herd behavior and retirement saving
Herd behavior can also be observed in retirement saving decisions. For example, when individuals follow the investment decisions of their peers or the default investment option offered by their employer-sponsored plan, without considering their personal financial goals and risk tolerance. This can result in suboptimal investment decisions and may lead to individuals not achieving their retirement savings goals. That is why it’s essential for individuals to understand their personal financial goals and risk tolerance and make investment decisions that align with these factors. The same goes for contribution levels as the default rate is not optimal for all plan participants and similar can be said about ways of drawing down your savings. This is why it is important for employers to provide educational resources and tools that help workers make informed retirement saving decisions, rather than simply following the actions of others. Also taking independent financial advice can help us to better understand our unique financial situation and select an appropriate set of products and services to come to a desired result.
So it’s good to keep in mind, herd behavior is not always a rational behavior, as it can lead to suboptimal outcomes for individuals and society as a whole. In some cases, herd behavior can be a result of individuals following the actions of others without considering the available information and their own preferences or needs. As Charles MacKay nicely put it: “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.”
The lack of self-control is one of the main reasons many fail to save for retirement or a rainy day. We get our paycheck and on our way home from work we stroll by our favourite mall and treat ourselves just a bit – this is at least what we tell ourselves. Some buy those new AirPods, some buy a new perfume or a pair of sneakers, … sounds familiar. Then we buy groceries, pay our bills and mortgage, go to the movies and dinner with our friends and pretty soon our paycheck is gone and the money we intended to put aside and save is gone.
We swear to ourselves that next month is gonna be different, but in most cases the cycle repeats and 30 years fly by and we have next to nothing saved for retirement. Reading The Odyssey just the other day with my kids made me think, what lessons can we learn from the legendary hero Odysseus (or Ulysses), to help us save for retirement or a rainy day. I know, it’s just a typical question one gets when reading The Odyssey, right?
So let’s remember what Odysseus was all about. He is a legendary hero in Greek mythology and the central character of Homer’s epic poem “The Odyssey.” He is known even to this day for his intelligence and resourcefulness. He devised the Trojan Horse used to win the epic siege of Troy and after the fall of Troy he embarked on his now legendary ten-year journey home to Ithaca, a small island kingdom in the Aegean Sea, where his wife Penelope and son Telemachus await. In the middle of his journey on an island between Scylla and Charybdis Odysseus and his crew encountered the Sirens, creatures who sang a irresistibly beautiful song that lured sailors to their deaths on the rocky coast. Odysseus being Odysseus still wanted to hear their beautiful song and thought out an ingenious plan on how to hear their song and at the same time survive it. To avoid being lured by the Sirens’ song, Odysseus had his crew tie him to the mast of his ship and fill their ears with wax so they could not hear the song. As they sailed past the island of the Sirens, Odysseus begged his men to untie him, but they refused and sailed past safely. So what’s all of this got to do with retirement saving and investing?
Odysseus had him tied to the ship’s mast and used it as a “commitment device” in order to resist the temptation of the Sirens’ song. In this way he was effectively committing himself to not giving in to the temptation to steer the ship towards the rocks, even if he wanted to. This helped him to resist the sirens’ song. Commitment devices are a type of self-binding strategy used to help people stick to a course of action they have chosen in advance, despite the temptation to do otherwise. They are used to prevent future self from acting against the present self’s better judgement. In this case, the mast acted as a physical “commitment device” that prevented Odysseus from steering the ship toward the rocks and ensured the survival of Odysseus and his crew.
A commitment device is a tool or strategy that individuals or groups use to lock themselves into a course of action in order to achieve a specific goal or overcome a particular obstacle. It is designed to make it difficult or impossible for the person to change their mind or behaviour once they have committed to a particular plan of action.These mechanisms are used to overcome cognitive biases and self-control problems that might otherwise cause an individual to procrastinate or abandon their goals.
Commitment devices can be very helpful in achieving our financial goals, as they can make it easier to stick to a budget, save money, and invest for the future. Some of the best examples of commitment devices used in finance are savings plans with automatic payroll deduction of contributions. These programs automatically transfer a set amount of money directly from your paycheck to your savings or retirement account each month. By setting up the automatic payroll deduction, you are committing yourself to saving a certain amount of money each month and this makes sure your contributions to the retirement account are made before you have the time to buy those new AirPods. Even more, most countries offer special tax incentives for employee contributions to retirement plans, like 401(k) plans in the US where employees can make pre-tax contributions to their plans each year up to a certain limit and in this way you are reducing your taxes at the same time. We have a similar favourable tax treatment of employee contributions to retirement plans in my home country Slovenia.
401(k)s have another feature that could be considered as a commitment device and those come in the form of investment “lock-ins”. These kinds of accounts have a penalty for withdrawing money before a certain age and this “helps” us keep the money invested for the long-term. In Slovenia, if you save in a collective retirement account financed by your employer, you can only start to draw down your savings at retirement and many countries have similar “lock-ins” for retirement accounts.
In recent years many saving Apps came on the market that can help us to track our spending and budgeting. These tools can also be considered as a commitment device as they hold individuals accountable for their spending and make it super easy to make special saving rules that automatically set aside a certain amount of money each time you buy a cup of coffee at Starbucks, for example. mBills app developed in Slovenia enables me to put away €1 each time I use the app to pay for my lunch and the savings go to a special sub account intended for my daughter’s new bike. There are many similar apps, like Acorns and Qapital, which are gaining in popularity.
The main feature of payroll deduction is that it can help an individual to save money and invest for the future by making it automatic and constant, reducing the temptation to spend that money on something else. After it is set it also requires no work from us (set and forget) and then our natural tendency to procrastinate and save our cognitive energy starts to work in our favour. Payroll deduction also has the advantage that it can be set-up easily and usually with low transaction costs. You can read more about using payroll deduction to achieve financial wellbeing in the workplace in this great post from the Money and Pension Service.
So the next time you are trying to resist the temptations to spend your paycheck remember Odysseus and the Sirens. There is a smarter way of ensuring you can socket away some money before it lands in your checking account and this is with the help of payroll deduction.
Further reading:
Elster, John (1984). Ulysses and the Sirens: Studies in Rationality and Irrationality. Cambridge University Press; 1st edition (January 1, 1979).
Ashraf, N., Karlan, D. & YinTying, W. (2006). Tying Odysseus to the Mast: Evidence From a Commitment Savings Product in the Philippines. The Quarterly Journal of Economics, Volume 121, Issue 2, May 2006, Pages 635–672. Available at: https://doi.org/10.1162/qjec.2006.121.2.635
Let’s be honest, most of us make New Year’s resolutions and most of us terribly fail at them and by february we would rather forget all about them. But it doesn’t have to be this way and behavioral experts can offer us much help on how to make them work and actually change our behavior for the better. Starting to save for one’s retirement or starting to build some emergency savings are on the wish list of many, so let’s look at some behaviorally informed advice on how to make the first steps this January that will stick.
Why do we fail at resolutions?
In the beginning it’s good to look at the most common reasons people fail at New Year’s resolutions. Many set unrealistic goals for themselves, which can be difficult or impossible to achieve. If you have never even saved for retirement, the goal of saving $10.000 by July is a tad bit overly optimistic. Another reason is that they may lack the motivation or discipline to consistently work towards their goals. Additionally, people may fail because they do not have a clear plan or strategy in place to help them stay on the right track. Just saying I will start saving for my retirement in 2023 doesn’t quite cut it, you have to get much more specific. Finally, life events or unexpected circumstances can sometimes interfere with a person’s ability to follow through on their resolutions. We have seen many unexpected scenarios in the last years, from the Covid-19 pandemic, to the outbreak of war in Ukraine.
What can we do?
To follow through on our New Year’s resolutions we should:
Set specific and achievable goals – be concrete and realistic and instead of setting broad or vague goals, be as specific as possible about what you want to achieve. This will make it easier to track your progress and stay motivated. For example, I will open a retirement savings account and contribute $200 monthly and by year’s end I expect to have approximately $2.400 in my account give or take fees and yields.
Make a plan: Break your goal down into smaller, more manageable steps and create a plan for how you will achieve each one. This will help you stay on track and avoid feeling overwhelmed by the daunting task, like how to start saving for retirement. Break it down into parts, decide on the optimum product like a 401(k) plan or a savings app like Acorns or Qapital, as a first step also check with your employer if they already offer a company retirement plan in which you can join, maybe there is also an employer match option by which the employer will match your contributions up to a certain amount. Decide on the level of monthly contributions you will make, … and your are already closer to your goals,
Keep a record: Writing down your goals and tracking your progress can help you stay focused and motivated. You could use a journal, a spreadsheet, or a planner to record your progress. Tracking progress will give you positive feedback you need to stay on the right path and you will also know what needs to be done next to get to the next stage. Most retirement plans nowadays have online accounts where you can monitor your balance and smart saving apps, like Acorns or Qapital, can give you even more positive feedback on your saving goals.
Find an accountability partner: Having someone who you can check in with and who will hold you accountable can be a great way to stay on track. If you plan to quit smoking, share this with your co-workers or roommates. This will serve as extra motivation, as it’s much easier to disappoint ourselves, then to disappoint the whole office. We also want to present ourselves to others in the best possible way, so keeping up with our New Year’s resolutions is for sure a great way to do this. If you can’t find anybody to share your resolutions with, there is a growing online commitment platform called StickK where you can post your goals and the whole online community will check in on you and hold you accountable. Maybe you will also find there are many people with similar goals and that you are not alone. Goal setters on the platform can interact, offer support, and share best practices.
Super important –don’t be too hard on yourself: It’s important to be realistic and understand that setbacks and challenges are a normal part of the process and life. So don’t get discouraged if you have a tough day or week – just pick yourself up and keep going. Review again your written plan in steps and keep grinding.
Last but not least, celebrate your successes. It’s important to celebrate your achievements along the way and give yourself a pat on the back, no matter how small they may seem. This will help you stay motivated and motivated to keep going.
In the end always keep in mind, as with any behavior change, it’s super important to keep on the right track and not slip back into the old ways. One of the best tools, when it comes to saving money, is automatic payroll deduction of contributions. This way each month contributions are taken from your paycheck immediately and you don’t have to do any thinking about it. This way you are staying on the right track even if you have totally forgotten about it and at the end of the year you will be positively surprised by how much assets you have accumulated. Can’t stress enough the power of automatic payroll deduction and you should definitely harness it to help you build retirement and emergency savings.
The New Year represents a fresh start and is often seen as a time of renewal and a chance to leave behind any negative behaviors or habits that may have been holding one back. So, let’s muscle up all the fresh start energy and start saving towards a more financially secure future now.
“There’s a boy I know, he’s the one I dream of” are the first lines of Whitney Houston’s hit single “How will I know” from her debut album launched in 1985. The song became Houston’s second number-one single on the US Billboard chart and together with the accompanying music video you can still watch on the link launched Whitney into super stardom. The song is today considered one of the classic hits of the 90s and listening to it just the other day I noticed a very subtle line in the pre-chorus uncovering some great behavioral lessons that can be applied not only to romantic relationships, but also to – you guessed it – retirement planning. Let’s look at the song’s lyrics.
The song starts with …
There’s a boy I know, he’s the one I dream of
Looks into my eyes, takes me to the clouds above
Ooh, I lose control, can’t seem to get enough
When I wake from dreaming, tell me, is it really love?
… and now pay attention to the pre-chorus
Ooh, how will I know? (Don’t trust your feelings)
How will I know?
How will I know? (Love can be deceiving)
How will I know?
And right there and then you have it – Don’t trust your feelings. We are not getting into the romance department in this blog, but if there is one area where you definitely don’t want to trust your feelings is retirement planning and investing your money. Here what may feel right in most cases turns out to be wrong, very wrong. Let’s look at some classic examples related to retirement planning.
Saving for retirement in company stocks and home bias – What can be safer to invest in than the company I work for? For sure I would know if something is not OK, are just some classic lines many tell themselves when thinking about where to invest their 401(k), but they couldn’t be more wrong. Nobel laureate Robert Shiller was one of the first to study investor behavior called “anchoring” and one of the things he found out was that besides the so-called quantitative anchoring, which is related to numerical values (f.e. anchoring on purchase prices of stocks), we are also influenced by moral anchors which is the influence of intuition and emotions [1]. A nice example of moral anchoring is investing your retirement savings in shares of the company where you work and used to be very common in the US.
This occurs because we feel a false sense of security, as we feel we know the company where we work more than others and because of this, we perceive it as a safer investment. A plant worker at Ford will perceive Ford shares to be much safer than for example BMW shares, or even a diversified equity portfolio. This way employees take on too much risk, as if something goes wrong with the company where they work, they will not only lose their job, but also their savings. And we all know the old saying “don’t keep all your eggs in one basket”. Luckily after the Enron fiasco in 2001 where both the company and it’s retirement plan tanked (in 2000 62% of the assets held in Enron’s 401(k) retirement plan consisted of Enron shares, yes, you read it correctly) less and less retirement plans offered company stocks and most plan sponsors started to discourage concentrated stock positions. If you are interested in this topic there is some nice research from Vanguard written by John Lamancusa and Jean Young [2]. Similar is home bias that means we perceive investments in for example our home country to be more familiar and also safer than investments in other countries. To most investing in 5 local companies feels much safer than investing in a diversified global equity portfolio. The reality is just the other way around.
Another example, where you don’t want to trust your feelings, is about when you are planning to retire and how much costs you will be facing. Many plan to work beyond the standard retirement age when they can first claim social security and by doing this, they plan to increase both their public pension (most countries offer incentives for working longer) and also their private pension. The gap between the age when workers plan to retire and the age when they actually do is revealed in Prudential’s study where 51% of retirees in reality retired earlier than planned. Only 23% retired earlier than planned voluntarily, meaning they had enough money saved to retire, or were just tired of working. The majority of those who retired earlier than expected did so involuntarily – 46% because of health problems, 30% were laid off or offered an early retirement package, and 11% left work to take care of a loved one [3].
Retiring early has a considerable negative impact on retirement income – lower social security and lower private savings and retiring just 5 years early can reduce income in retirement by an estimated 36%. The last few years are especially important as they are on average also our top-earning years and losing just one will reduce our retirement income substantially. Similar over-optimistic outlook is revealed regarding expected costs we will face in retirement. 37% of retirees say their overall cost estimates turned out to be low. Healthcare costs seem to be the most underestimated, as 44% said they faced higher-than-expected costs.
Who is to blame for our overly optimistic outlooks? The answer is “optimism bias”, which is considered to be one of the most prevalent and robust cognitive biases in behavioral science. Tali Sharot, one of the leading neuroscientists in this field, describes it as a cognitive illusion which developed in humans during our evolution to help us deal with a unique ability that we have and that is conscious foresight. This simply means we can imagine things and events in the future (animals can’t do this) and among other things we are also aware that someday in the future death and other bad things await us. Without developing positive biases during our evolution and looking at the future with the “glass half full” mentality, we could not function normally every day knowing death is around the corner, it would be just too damn depressing [4].
Optimism bias is also very dangerous when it comes to investing our money as we mostly just feel things on the market will only get better, but those are just our feelings and nothing more. After every bull market there is a “correction” or a bear market and if every stock would just rise and rise, investing successfully in the long term would not be so hard, as it is in reality. If we are investing for our retirement for 40+ years, we need to expect both bull and bear markets in between and diversify our portfolio appropriately.
Because of similar reasons we also tend to take on too much debt when purchasing our ars and homes, as we overestimate our future income. Why worry about paying the mortgage, as surely in the future we will get that promotion at work and our salary will increase. But we know in reality some get that promotion, some get the boot. More details and cases of the negative effects optimism bias can have on retirement planning in my article for The Decision Lab [5].
Estimating how much money you will actually need to generate a sufficient lifetime income in retirement is also something we tend to be very bad at and our feelings can quickly deceive us. I see this first hand from talking to members of our pension fund and many believe €50.000 is quite enough to be able to buy a decent life annuity and are shocked when I tell them that this only gives them roughly 160 euros per month (assuming today’s annuity rates and that they retire at 65) and in reality, they should be aiming to have at least €500.000 saved up. Most retirement plans nowadays offer online calculators that can show members what kind of income they can expect based on their current saving rates and how they can improve this by increasing contributions. Financial advisers can also provide their clients with different ways one can convert their savings into an income stream, as at the end of the day that is the point of saving for retirement – to receive income.
Connected with this is also how much people contribute to their pension plans and many anchor themselves on contributions that are too low. If the employer match is 3% many anchor on this and falsely think this is “the right” amount, as surely the employer knows best. By doing this they can save for their entire working period with a total contribution rate of 6%, which is by most estimates far from enough, as they should be saving with at least 10% of their salary.
Similarly our feelings can trick us into saving too conservatively given the long time horizon of retirement saving and younger members of pension plans should invest in funds with more equity exposure and transition to bonds only in the years prior to retirement, instead especially in Europe many still save for their entire working periods in guaranteed funds with majority bond allocation. It just feels safer, but what they are forgetting is that the yields will also be lower resulting in suboptimal amounts of assets at retirement and as a consequence lower retirement income.
I could go on and on, as there are so many ways our feelings can trick us to make bad choices when it comes to retirement planning, so I would encourage all to listen to Whitney’s song once again and count on our feelings only when making decisions about relationships, not retirement planning.
References:
[1] Shiller, J. Robert. Irrational exuberance (2015). Princeton, NJ: Princeton University Press.
Psychological inertia is best described as a general tendency towards inaction and because actions are always associated with some mental or physical effort, we prefer to avoid it and maintain the status-quo. Inertia is just one of the behavioral reasons millions all across the globe are still not saving for retirement and for the ones who are already saving it can have a big influence on their contribution rates and investment allocation, and the purpose of this article is to share one bit of novel research regarding the influence of defaults on investment allocation of pension plan members.
Luckily behavioral scientists like Brigitte Madrian, James Choi, David Laibson, Shlomo Benartzi and Richard Thaler, just to name a few, found a way to use inertia in a positive way to help people save for retirement by the use of “automatic enrollment”. Under automatic enrollment all employees of a certain company are enrolled in the pension plan and given an option to opt-out if they do not wish to participate. You can read more about the success of automatic enrollment and its evolution in my article from last december. What is also an integral part of any auto-enrollment is the default contribution rate and investment policy, which is in most cases set by the employer or it can also be set by the government depending on a particular policy. Because of defaults the employee doest have to make any choices regarding how much he or she will contribute and where the contributions will be invested. There has been quite a lot of research and lately also meta-analysis on how and where defaults influence decisions and you can find some of them in the references at the end of the article.
In 2016 pension funds in Slovenia could start offering life cycle funds and members now had a choice between three investment funds which were limited by age (before members had no choice and were enrolled in guaranteed funds). The younger members could start saving in high equity exposure funds, when they reach “middle age” they are automatically switched to medium equity exposure funds and before retirement they are again switched to the more conservative guaranteed funds with majority bond allocation and principal protection. By law each provider had to designate the maximum age limits when members must be switched from more dynamic to more conservative funds. This also means in practice that younger members have a choice between 3 funds, middle aged between 2 funds and older members have no investment choice and can only invest in the guaranteed fund. The legislation also prescribed how new members are enrolled in the funds, and all new members to the pension plans have to receive by registered mail a formal notice one month prior to their first contribution. The notice has to explain in plain language that they will be enrolled in the plan by their employer and give them the basic conditions of the plan. Members also have to receive a special investment fund selection form by which they select one of the three life cycle funds from their provider. What is also pointed out to members is, that if they do not send back the investment fund selection form within 10 days from receiving it, they will be enrolled in the fund according to their age. So what does the data tell us and how many members stick with the default?
The data below is based on two years of data from members that joined the Pokojninska družba A, Inc. collective life cycle pension plan. The data contains only investment allocation of new members that joined in the years 2016 and 2017 (N = 5.953). In this particular pension plan the age limits for the funds are as follows: Equity fund is for members up to and including 42 years of age, Balanced fund is for members older than 42 years up to and including 55 years, and the Guaranteed fund is for members above 55 years. Members can also select a more conservative fund, meaning a member age 40 can go directly in the Balanced or Guaranteed fund. If all new members in 2016 (3.594) would stick with the default fund according to their age 64,4 % would be in the Equity fund, 26,9 % in the Balanced fund and only 8,8 % would be in the Guaranteed fund (marked blue on the chart).
So what was the actual fund selection of newly joined members in 2016 – 52,9 % joined the equity fund, 28,9 % the Balanced fund and 18,1 % the Guaranteed fund (marked orange on the chart). The data tells us the majority of members stuck with the default fund (chart below), but what we can also see is that 11,4 % of the members that would by age fall in the equity fund made an active choice and choose deliberately a more conservative fund with some of them choosing the Balanced fund and even more choosing the Guaranteed fund. This is why the actual membership in the guaranteed fund was at the end of 2016 18,1 % of all new members, if all would stick with the default the share would be 8,8 %.
The data for new members in 2017 tells a similar story and again from all new members (2.359) the majority stuck with the default and 15,9 % made an active choice and chose a more conservative fund, which is evident from the chart below, again most of them going to the guaranteed fund.
Given all the literature I read on defaults in asset allocation of retirement plan members the results came as no surprise, as the majority of studies find strong evidence they work in similar circumstances. Members of pension plans who are automatically enrolled in the plans also have notoriously low levels of engagement and investment funds and wealth management are subjects not listed highly to be of much interest to the average employee.
One driver reinforcing the default in this case is also, that the default fund selection can in this context be perceived as being endorsed as the “right” option by the designers of the system – in this case the pension fund and also the Ministry of labour which was responsible for the legislation or even the employer that selected the pension plan provider. According to The Behavioural Insights Team report this effect is stronger where the trust in the system designer is higher, so if people trust the government or their employer or the pension plan, surely they must think that they have all thoroughly studied the issue of fund selection and their default setting according to the age of the member must be optimal, so why go against it. This effect is even more relevant in cases where individuals have limited knowledge on the matter, which fits this particular case again nicely.
What would be perfect of course would be, to have another collective pension plan with the same investment choices but no default fund allocation, as this would enable us to make a direct comparison and really establish the power of defaults in the case of investment fund selection. Here in my opinion, how the fund selection options would be framed would have a big influence on the end decisions – for example Balanced fund (appropriate for members up to and including 55 years of age), or Balanced fund (suitable for members aged 42 to 55 years), etc. – and also what other data would be presented to members on the selection form, like the last five annual yields of each fund, in this case the actual yields would influence members decisions even though as the old saying goes, past performance is no guarantee of future performance. You can read more about the dangers of anchoring when it comes to retirement saving in my article from 2020.
Defaults can have a big influence on where pension plan members invest their contributions, so this is why it is super important to get them right, meaning members should be defaulted in carefully selected investment options, whether it be life cycle or target date funds, balanced funds, managed accounts, … with proper asset mix, low transparent fees and good governance. Because defaults work that good the people designing them must pay extra attention, so the outcomes are in the end really beneficial to the members. There is also an increasing debate about defaults when it comes to decumulating retirement assets and some also propose alternatives to the investment phase defaults, which are for the time being dominated by target date funds, but this is a topic for a different post. For the time being, when it comes to defaults of investment options in pension plans, they seem to work in the presented context, so we better get them right.
[2] John Beshears, James J. Choi, David Laibson, and Brigitte C. Madrian (2006). The Importance of Default Options for Retirement Savings Outcomes: Evidence from the United States. NBER Working Paper No. 12009. January 2006, Revised March 2007. Retrieved from: https://www.nber.org/system/files/working_papers/w12009/w12009.pdf
[3] JACHIMOWICZ, J., DUNCAN, S., WEBER, E., & JOHNSON, E. (2019). When and why defaults influence decisions: A meta-analysis of default effects. Behavioural Public Policy, 3(2), 159-186. doi:10.1017/bpp.2018.43
[4] ZHAO Ning, LIU Xin, LI Shu, ZHENG Rui (2022). Nudging effect of default options: A meta-analysis[J]. Advances in Psychological Science, 2022, 30(6): 1230-1241. Retrieved from: https://journal.psych.ac.cn/xlkxjz/EN/Y2022/V30/I6/1230
[5] Pablo Antolin, Stéphanie Payet, and Juan Yermo (2010). Assessing default investment strategies in defined contribution pension plans. OECD working paper on finance, insurance and private pensions. Retrieved from: https://www.oecd.org/finance/private-pensions/45390367.pdf
According to the article in July’s issue of The Journal of Superannuation Management, you needed a tertiary level education* to understand or accurately interpret documentation related to your retirement plan. Guess how many Australians have a tertiary level education? Only 1,2 % of adults, hence the title of the article, Houston, we have a problem.
The background to the article above is, the company Ethos CRS reviewed the documentation comprising of product disclosure statements, financial services guides, annual reports and company policies of the 20 largest Australian superannuation funds (10 largest industry funds and 10 largest retail funds) and checked their documentation using their readability benchmarks comprising of the usage of active voice, average sentence length, readability score and grade level benchmarks (more details on this in the article) [1]. This gave them a quantifiable measure of the clarity and quality of each document and by doing this they could rank individual documents and also assess what kind of education level a person would need in order to understand or accurately interpret them. So to sum it up, you need to be pretty educated to understand all of the documents from your pension plan and I dare to speculate the needed education would be the same to understand documentation from Slovene or US pension plans.
Given the importance of retirement saving to the quality of an individual’s life in retirement, decisions about it – where to invest, how much to contribute, how to draw it down, are very important and one would ideally think that one of the things improving people’s decisions when it come to retirement planning would also be, how easily it is to read what funds put to members in writing online and offline. And let`s for a second ignore all of the behavioral biases influencing retirement planning decisions we dissect usually on our blog and the fact most people aren’t even remotely interested to read the investment policy of their retirement plan.
So why did the retirement plan documents score low on the readability benchmarks? Well for one, we are talking in most cases about long and complex documents (I work for a Slovene pension plan, so I know this pretty well), covering topics like investment policies of individual investment funds, risk mitigation techniques, … which are not really topics most people are familiar with nor interested in. Retirement plans are one of the most highly regulated areas of financial services in most countries meaning legislators and regulators prescribe in the smallest details what documents plans need to present to members and what those documents must contain. When you type all of it together, it comes in the case of the pension fund I work for in Slovenia down to 18 sheets of A4 paper written on both sides and this includes mandatory documents, like the individual pension plan rules, investment policy and key information document for each investment fund. All of it is mandatory and the scope of it is getting even bigger every few years as the European Union legislation is bringing new and new amendments to the local regulation (GDPR, IORP II directives, …) thus, increasing the volume of pension plan documentation even further.
So when a new member is enrolled in the pension plan, we must send to him or her by registered mail (email can be used, if the member gave the fund his email address and legal consent) all of the documents along with a cover letter informing him or her that their employer enrolled them in the pension plan. We don’t really need a study or a research paper to know most members get scared off by the sheer volume of papers which, even if they are written with the best intent to keep it simple, contain many words that fall in the financial or legal jargon, so the documents usually end up in the bin or a drawer without being read. From what we can gather from the Australian study, even if someone were to actually sit and start reading them, the information would be really tough for them to understand. So we are caught in a vicious circle, where legislators try to protect members by mandating pension plans to include more and more information and disclosures in their documents to help them make informed decisions about their retirement planning. What is forgotten in most cases, that by increasing the volume we are scaring away people and less and less of them read the documents, let alone understand them.
Luckily for us all, slowly a shift is coming at least in some countries, like the UK for one, and policy makers are drafting more and more behaviorally informed policies. This means the awareness is slowly here, that we will not protect or inform consumers purely by providing them more and more information and that new policies must be developed that take into account the phenomenon called information overload and the actual behavior of people and various behavioral biases and heuristics that influence it and are also the main focus of my blog in relation to retirement planning. Policy makers are, at least in some cases, starting to understand people will not start saving for retirement, if we only tell them that this is a prudent thing and they should do it. People will not stop using plastic bags or use more public transport purely because they all of a sudden started to worry about the environment and so on. Also organisations like the Behavioural Insights Team, that started in the UK with just a few people and has grown now to a global social purpose company or the Organisation for Economic Co-operation and Development (OECD) have all started digging in this field and came up with various recommendations for different behaviorally informed public policies.
So what do they recommend regarding pension plan communication? Most recommendations go in a way of simplifying and standardising documents, for example entry forms or key information documents (KID), which members need to get before enrolling in the plans and annual benefits statements all members get once per year. In the UK The Department for Work and Pensions (DWP) published in 2021 a statutory guidance for simpler annual pension benefit statements that also contains a template for a one double-sided sheet of size A4 statement all providers can use and contains all of the key information a member should receive annually plus information where they can get more details if they wish for. The template shown below also has the exact wording that should be used in order to be as readable as possible and provide the appropriate information to members [2].
The European Insurance and Occupational Pensions Authority (EIOPA) is also pursuing a similar way with just published legislation for the new pan-European Personal Pension Product (PEPP) prescribing both the content, format and presentation of the key information document (KID) potential members receive before enrolling in the plan and also the PEPP Benefit Statement members they will receive once they start saving. The legislation makes it also cler, jargon needs to be avoided in these key documents and the font and size must be such that the information is “noticeable, understandable and presented in a clearly legible format”. The KID also needs to answer questions like “What is this product?”, “What are the risks and what could I get in return?” and “What are the costs?”. Similar as in the UK templates are also available and the design of them was publicly debated in consultations to achieve the best results [3].
All documents must be clear in both online and offline form and the legislation also encourages the layering of information which is another key feature we can implement to make retirement plan documentation more readable. Layering means that we do not present all of the content at once, but spread it on multiple layers and by doing this we avoid information overload and do not scare away people with long texts in the beginning, but provide at first only basic information and enable for only those who wish more content on additional layers. This is of course much easier in a digital environment, where additional information can be obtained with pop-ups and other similar features.
So to make retirement plan documentation easier to understand, we must first accept that just keeping it nice and short is due to legislation not always possible, but what is possible is, to provide basic documents like the key information document containing just the basic information new savers should receive before starting and once people are enrolled they should receive simple annual benefits statements. Both documents should be standardised so members get the same information with all providers in a certain country or even wider like the European Union, also enabling comparison between providers. Layering should also be used to avoid information overload and from the beginning legislators must adopt a digital first concept taking into account documents will be first in digital form, but can also be printed if needed.
Communication and engagement with members of pension plans is not only about sending them documents and there are many more channels of communications of course, with digital communications as the front runners for the future. This can be anything from just storing documents and delivering them electronically, having simple online accounts where members can see their balance, to much much more, like having personalised interactive communication with members with the use of smart chatbots or using elements of gamification to relay complex information in a simple, fun and engaging way. For one example of how I implemented gamification to communicate adequacy of contribution levels of individual members, you can check my post on LinkedIn from a few years ago and in one of the future articles on my blog I will explore the potential of information technology to enhance communication and engagement with members of retirement plans.
For now the key, when it comes to retirement plan documentation, is to keep it as simple as possible, if not use standardised documents that provide only key information to members and layer the information as much as possible to avoid information overload. Policy makers can make a real positive impact here with proper legislation and guidelines.
*According to The World bank tertiary education refers to all formal post-secondary education, including public and private universities, colleges, technical training institutes, and vocational schools.
References:
[1] Ethan, H. (2021). Readability scorecard for Australian superannuation funds. The Journal of Superannuation Management, volume 14, issue 3.
[3] Commission Delegated Regulation (EU) 2021/473 of 18 December 2020 supplementing Regulation (EU) 2019/1238 of the European Parliament and of the Council with regard to regulatory technical standards specifying the requirements on information documents, on the costs and fees included in the cost cap and on risk-mitigation techniques for the pan-European Personal Pension Product (Text with EEA relevance)
The first rule of the Dunning-Kruger club is, you don’t know that you’re a member of.
A Slovenian news portal ran a terrific article the other day that also featured an interview with professor David Dunning, who together with Justin Kruger discovered the behavioral bias known today as the Dunning-Kruger effect. The effect was described in their paper from 1999 titled “Unskilled and unaware of it: how difficulties in recognizing one’s own incompetence lead to inflated self-assessments”. In the paper they describe four studies in which they found participants scoring in the bottom quartile on tests of humour, grammar, and logic grossly overestimated their test performance and ability. They concluded people tend to hold overly favourable views of their abilities in many domains and suggest this overestimation occurs partly because people who are unskilled in these domains suffer a dual burden, not only do they reach incorrect conclusions and make bad choices, but their incompetence also robs them of the metacognitive ability to actually realize it. To put it in very plain terms, some people are so foolish, that they are incapable of even realising it.
What was also established in their paper, that “paradoxically, improving the skills of participants, and thus increasing their metacognitive competence, helped them recognize the limitations of their abilities” meaning people who are experts in one field have the capacity to better evaluate their skills and are not prone to exaggerating them in the same way as people, who have no clue [1]. If you are a professional in one field, you have for sure come across people like that, who have absolutely no clue about your profession, but are ever so “smart” about even the smallest details and always “know” what should be done, even though their bold ideas are not based on knowledge nor experience.
Many movie characters are an embodiment of the Dunning-Kruger effect, like Steve Carell as Michael Scott from The Office series (or Ricky Gervais as David Brent from the original The Office series). Also Baldrick from the Blackadder 1983 sitcom comes to mind (pictured below), with his “cunning plans” to which in one episode Lord Blackadder replies: “Am I jumping the gun, Baldrick, or are the words “I have a cunning plan” marching with ill-deserved confidence in the direction of this conversation?” to which Baldrick replies: “They certainly are.”
So where can the Dunning-Kruger effect have a negative influence on our retirement saving efforts? One area which comes to my mind first is its effect on how we invest our retirement savings. In many retirement plans members can choose freely in which funds or the combination of them they can invest and here the problems start. There are many studies analysing these self made portfolios that are most of the time badly diversified. Benartzi and Thaler [2] describe this nicely in their 2001 paper exposing how many members of defined contribution retirement plans naively diversify their portfolios following the “1/n strategy” in which they divide their contributions evenly across the funds offered by their pension plan. They found out that the proportion of assets invested in stocks depends strongly on the proportion of stock funds in the plan, and not on any expert knowledge or advice. This means if my pension plan offers me 3 funds, I just split my contributions between the 3 funds equally and if my plan would offer me 5 funds, I would without thinking split the contributions evenly between the 5 funds. The problem here is of course, that I am not paying any attention to the funds themselves, are they equity funds, bond funds, what are their fees, their allocation, … but I just skip all this and naively diversify my portfolio and think to myself I did a pretty good job. What if my plan only offered me 5 funds that invest in US stocks, or maybe all 5 funds invest in “emerging markets”, how well is my portfolio really diversified now? Not very well.
This is also one area that plan designers need to be very aware of and don`t design plans that would enable their members to easily fall victim to naive diversification, meaning don`t let your members make the hard choices without giving them proper advice. If this is not an option, I’m personally a huge fan of smart defaults and for most pension plan members a well balanced offer of default target date funds will do the job nicely, meaning members don`t need to make any investment decisions on their own and by default their contributions go to the appropriate target date fund with an investment mix designed by experts to best fit the individual members age. Those members who wish, can still make an active decision and switch funds, but we know from numerous studies, most stick with the default and in this case this is good for them (given target dates funds are designed appropriately and regularly monitored by plan sponsors for performance and fees). Similar to target date funds, which are very popular in US pension plans, in Europe some countries feature so-called life cycle funds, where the member is switched between funds when he ages, from more dynamic funds in the younger ages, to more conservative funds in the years closer to retirement.
What else can we do to battle with the Dunning-Kruger effect in retirement plans? Well taking professional advice from financial advisors is also one important step and this goes for the initial period, when we decide where we will invest our contributions and how much we will contribute, to the final stages of retirement saving, which is the decumulation phase, when we need to decide how we will convert our assets into an income stream. This phase is particularly difficult as one must factor in many variables, from estimates of our longevity, to future market performance. Different ways in which we can draw down our savings also have many small, but important details, so this is for sure one area where we do not want to let the Dunning-Kruger effect run loose, so seeking prudent advice can for sure help us navigate this.
Governments in some countries are also starting to help their citizens to navigate personal finances and a good example of this is the UK with their Money and Pensions Service (MaPS) which provides free and impartial debt advice, money guidance and pension guidance to members of the public. Making services like that free for the public can have huge advantages later down the line, as they help to steer people away from bad financial decisions and if this becomes more widespread and if we would have better financial education in our schools, just think of how many financial pitfalls we could avoid.
Also employers have a huge role to play not just in the design of their pension plans, making sure smart defaults are in place when it comes to contributions, investments and decumulation, but also making sure their employees receive proper financial advice regarding their choices in the entire life-cycle of their retirement plan and this is one area where plans can hugely improve their services.
So the next time when we want to get “smart” about some area in which we are no experts, don’t forget the first line of this article – The first rule of the Dunning-Kruger club is, you don’t know that you’re a member of.
[2] Benartzi, S., & Thaler, R. H. (2001). Naive Diversification Strategies in Defined Contribution Saving Plans. The American Economic Review, 91(1), 79–98. http://www.jstor.org/stable/2677899
Since the Slovenian ministry of labour just released fresh stats for the second pension pillar, this just calls for an updated article on the evolution of the second pension pillar represented by defined contribution retirement plans.
In December 2021 the number of employees saving in the second pension pillar in Slovenia reached a record 585.154 members, representing a 1,9% increase from the last year. The growth rate is quite disappointing, since the growth rate is almost identical to the growth rate of employed persons. This means the growth of members came predominantly from the increased employment in companies, which already have collective pension plans, and not from companies starting new pension plans or from individuals deciding to start saving on their own.
The coverage rate of pension plans is 59,9 % of all persons in employment, which you would say is a fairly decent rate for a 21 year old voluntary pension saving system, but if we deduct from this the number of civil servants, who are enrolled in a special mandatory retirement plan (approx 245.500), the coverage rate drops to a more realistic 35% of all persons in employment, which is the same as last year. Also worth pointing out, the vast majority of members (94 %) are enrolled in collective pension plans financed by employers, so jet again backing up the age old argument, that individuals very rarely save on their own for retirement, because of the many behavioral biases plaguing this decision and some also because of structural (economical) reasons.
All this confirms my views expressed in previous articles, that unless we implement necessary reforms of the pension system by introducing mandatory auto enrollment in pension plans, the coverage rates will not increase on its own and will stay under 40 %. And all the financial education in the world and tax incentives for retirement saving will not change this. Of course they are important, but they will not change the existing state noticeably (more on how financial incentives have a very limited effect on retirement saving in my article from 2020).
If we continue the updated review of the second pension pillar in Slovenia, assets of pension funds increased to 3,06 billion euros by the end of 2021 which represents a 9 % annual increase. Assets of pension funds as a percentage of GDP are at around 6%, which is low compared to some other emerging European countries, like neighbouring Croatia, where assets of retirement plans are closer to 30 % of GDP. Croatia chose in 2000 a different path than Slovenia and implemented mandatory enrollment in the second pension pillar, which clearly shows to be the better choice now, as both coverage rates and assets of pension funds far exceed the ones in Slovenia. More detailed comparison of the two models of retirement plans and their success in my article from last year.
Pension plans in Slovenia can be managed by dedicated pension funds, insurance companies or mutual and umbrella pension funds and you can see the breakdown of the market in the chart below.
Average monthly contributions were 87 € for members of pension plans managed by insurance companies, 71 € for dedicated pension funds and 98 € for mutual and umbrella pension funds (not counting contributions to the mandatory plan for civil servants). This means monthly contributions were in the range of 4,4 % of the average monthly gross salary for insurance companies, 3,6 % for dedicated pension funds and 5 % for mutual and umbrella pension funds, which is not great, not terrible, if i borrow the words of Anatoly Dyatlov from the Chernobyl TV series.
Benefits of the second pension pillar
Keeping in mind private pension plans in Slovenia exist now for only 21 years, the numbers of members receiving annuities is fairly limited and is currently just below 50.000 and official statistics on them are fairly limited. Regarding decumualtion options for private pension plans in Slovenia, under current rules, for collective plans life annuities are the only possible option (only exception if assets at retirement are below 5.000 €, they can be paid out as a lump sum), for members of individual pension plans they can choose between lump sum payout or one of the life annuities on offer.
From first hand experience (I work for one of the largest pension funds) I can say the members that start to receive annuities are our best “promoters”, as they confirm to all other employees that they actually receive an additional income thanks to their participation in the private pension funds. This is still, after 21 years, the biggest concern most members have, will we receive something in the end, and this is massively improving in the last years, when more and more members are starting to receive benefits. Also worth noting is the success of life cycle funds, which were introduced only in 2016 and from that point on members can choose between three investment funds, and the younger members can also have their assets invested in high equity exposure funds that invest globally and this choice was lacking before.
Returning to the point already made in the article, from all the behavioral science literature out there, and there is a lot, and also hard data from other countries, I’m quite certain that unless we follow countries like the UK, and Ireland recently, and implement policies requiring all employers to mandatory auto enroll their employees in retirement plans, we will never get past the 40 % coverage rates and the second pension pillar will in Slovenia continue to play a marginal role at securing additional income to retirees, which will be more and more needed, as first pillar pensions will continue to decline, meaning retirees will need additional streams of income to supplement this in order to live a decent life in retirement everyone deserves after 40+ years of work. For more insights on how auto enrollment was introduced in the UK and what was the genius thinking behind it, you can listen to the latest episode of The accidental plan sponsor podcast, which really nicely reveals how this interesting policy change came to life.
To borrow Einstein’s words, “The definition of insanity is doing the same thing over and over again, but expecting different results.” so we really need to grasp this in Slovenia. Unless changes are made, the second pension pillar will have no more than 40 % coverage rate, the third pension pillar is almost non-existent, leaving heavy reliance on first pillar pensions alone. Given the massive demographic shift already underway in Europe decreasing the sustainability of first pillar systems, relying only on one stream of retirement income is not a prudent solution, to put it mildly, and we should strive to have multiple sources of retirement income to live as comfortably as possible.
A new government is just forming in Slovenia in the days of me writing this article and I sure do hope one of the first things they will tackle is the evolution of the pension system and we will follow proven examples from the likes of the UK, that managed to increase coverage rates drastically by introducing auto enrollment in retirement plans.
Ireland just published ambitious plans to introduce automatic enrolment (AE) in retirement plans from 2024 onwards and since I always back AE as the single most important policy that can help people save for retirement, it’s well worth to look at the details, which are quite interesting and some came with some surprise for me.
According to the detailed plans published by the Ministry for social protection Ireland plans to have AE and all of the supportive systems up and running by the end of 2023 and ready to take first enrolments from early 2024 onwards. All employees aged between 23 and 60, earning over €20,000 per annum (across all employments), which are not already contributing to an occupational pension plan, will be automatically enrolled. They will be free to opt-out at the end of the minimum membership period during the 7th and 8th month and on each occasion during the first ten-year period in which contribution rates will increase. Those who opt-out will also be automatically re-enrolled after two years (smart feature).
Once employees are enrolled they will have to make their own minimum contributions as well as receiving 100% matching contributions from their employers and an additional top up from the state. In the first 3 years employees and employers will each contribute 1,5% of a person’s gross earnings and the state will top this with an additional 0,5%. This means for each €1 saved by an employee, €2.33 will go to their savings account (Employee €1 + Employer €1 + State €0.33). The smart thing here is, that similar as in the UK, minimum contributions will increase over time every 3 years until they reach 6% after 10 years. From that point on the minimum contributions will be 6% employee, 6% employer and 2% from the state, which is quite ambitious and rightly so, as we all know that we need sufficient levels of contributions to ensure adequate retirement pots. So again one really positive feature. Employer contributions will also be deductible for corporate tax purposes.
Investment choices
Regarding investment choices all members will be able to choose from a range of four funds:
conservative fund (mainly government bonds, cash, or cash equivalents)
special default fund which will operate on a life-cycle principle, meaning having more equity investments at the start and then reducing this to lower risk investments as the member nears retirement.
From behavioral economics and decades of experience we now know that most members will be enrolled in the default fund and they will not make any investment choices on their own. In Slovenia all members of retirement plans choose at the start one of the three life cycle funds we have on offer and the vast majority does not make any active choice and are enrolled in the fund according to their age, meaning the younger members go in the equity fund and the older to the guaranteed fund.
What is interesting and specific about Ireland’s plans is that the funds will be provided by four commercial investment managers that will be selected through an open tender, and each provider will be required to offer all four funds. All contributions to a particular fund type will be pooled and distributed between the providers and also all returns will bepooled, which means all employees in the same fund type will receive the same return. Quite an interesting solution, I have to say. Also annual management fees will be capped at 0.5% of assets under management. Also interesting, employees are to have no direct contact or relationship with the investment managers. This will also, according to the ministry, minimise the administrative burden for employers, as they will not have to select any provider and will only have to make payroll deductions of contributions. I would add this also means employers will not have any fiduciary duty and be liable for the selection of providers. This also presents a certain departure from the existing system of occupational pension plans in Ireland, so this solutions comes as quite a surprise for me.
The state plans to establish a special “central processing authority (CPA)” as they call it, that will be the single point of contact for the members. All members will be able to access their account information directly with the central processing authority that will also enable the so-called ‘pot-follows-member’ approach meaning portability of pension pots will not be an issue. The CPA will also contract a small number of commercial auto-enrolment providers to offer a range of savings/investment products and it will facilitate the collection of the employee and employer contributions and the State ‘top-ups’ as well as distribute funds to members when they reach retirement age.
Once members reach retirement they can start to drawdown their savings (this is currently at age 66). Drawdown of the pension pots is possible by using the existing range of regulated pension products (lump sum (subject to regulated limits), annuity or an ARF – Approved Retirement Fund) and members can engage with existing commercial providers on the market. If the need would arise, the Central Processing Authority mentioned before might select by tender a set of pension drawdown products.
The impact of AE
According to the Department of Social Protection approximately 750,000 workers will be enrolled into the new scheme. In total, the new system will, according to state estimates, generate €21 billion in funds under management over the next ten years excluding investment returns which is a sizable amount of assets for Ireland. Looking at the individual level, estimates from the state predict for an average worker earning €40,000 annually, the new system could generate in total after 43 years of saving a pension pot worth more than €560.000 including estimated investment returns. This is life changing amounts of assets that can have a dramatic positive effect on people’s lives in retirement and I will follow the implementation of the new AE system in Ireland with great interest.
In many countries with developed defined contribution retirement plans, like the US, UK and Australia, the debate around the decumulation phase of retirement saving is taking centre stage, as an ever growing number of plan members are entering retirement and looking to convert their savings into an income stream.
End of the day, that was always the initial reason most people joined retirement plans, not only to amass savings, but to generate some form of income in retirement and to be able to live (ideally) as comfortably as possible. To be able to take that trip to Europe you always wanted (we Europeans probably wrongly envision that taking a trip to Europe is a dream for any american retiree), buy that red Corvette or take a long cruise to sunny Aruba. If the retirement industry in previously mentioned countries has been reasonably successful in auto-enrolling large numbers of employees in retirement plans and with the help of target date funds invest their savings quite well until the point of retirement, what happens next is still quite up in the air.
You enter retirement and have half a million dollars in your 401(k) and then what? What kind of income will that provide for me, will it be guaranteed, where and in what way will it be invested, will it provide me with lifetime income, if not how do I know how many years I will live, what about my spouse, … and many similar questions go thru the mind of most newly retirees that are fortunate enough to amass some savings. Coming from Slovenia, where you can only draw down savings from collective retirement plans in the form of a life annuity, I was quite surprised years ago when I started to study retirement industries in the leading markets and found out the situation is quite different. In the US for example, annuities are not the main way of decumulating retirement assets. Many follow a well known rule of thumb called the 4% rule under which you just leave your savings invested and if you retire at 65 you withdraw 4% of your assets in the first year, and then increase this amount by the rate of inflation every year after that. The rule has some supporters and even more critics. Blanchett, Kowara, and Chen wrote a nice review of it and also other withdrawal strategies way back in 2012 [1].
What the 4% rule and other similar strategies don`t cover is longevity risk, which basically means the risk that you will outlive your savings. None of us know (luckily) how long we will live, so it’s impossible to calculate in advance how much money I can draw down from my savings every year and it’s no wonder Nobel prize winner William F. Sharpe called this the single nastiest, hardest problem in finance. One of the main challenges of the retirement industry is also, that we focused for too many years or decades on the amount of saved assets and not on the income those assets can generate. If I have half a million saved for my retirement, that does not tell me much about what kind of life I will be able to live, will I be able to pay my bills together with my social security, will I be able to take that cruise to Aruba? At the end of the day, this is exactly what interests retirees.
So to help combat this and reframe retirement saving and individual savers to start looking at what kind of income their savings will provide for them in retirement, legislators all around the globe started passing laws that would mandate the retirement industry to provide to members of pension plans some kind of projections of lifetime income. In the US, the SECURE act and the later more specific rules from the Department of Labor, make it mandatory for 401(k) plan sponsors to annually disclose to plan participants estimates on how much income their account balance would produce, if used to purchase an annuity. First estimates will be already included on statements this year, so I thought it might be of interest to some, how we did this in Slovenia and what was the feedback from members, as pension funds in Slovenia had to send to all members projections of their lifetime income for the first time this January.
Mandatory lifetime income projections in Slovenia
In Slovenia the story of income projections started more seriously in 2020, when the Ministry of labour prepared the draft rules for projections and started consultations with the retirement industry, which we all welcomed (disclaimer: I work for one of the pension funds in Slovenia and was involved in the proceedings on behalf of our fund). The initial idea was, all members would receive the projections along with their annual balance statement which all members receive at the end of january. Projections would have to be made for all members assuming they keep saving until age 65 with their current saving rates. For their existing savings three scenarios of future investment returns would have to be calculated (target, pessimistic and optimistic). From the three scenarios of accumulated assets at age 65, each member should receive a calculation of the basic life annuity that his or her pension plan provides under current rules using current interest rates and mortality tables. The annuity amount should be rounded up and given in monthly gross amount (in Slovenia 50% of the annuity is calculated in the income tax base due to special tax treatment).
In the later consultations the future investment returns scenarios were much discussed and at first there was an idea the ministry would, along with the Insurance supervisory agency and the Securities market agency, calculate each year what yields should be used in the projections and that they would be the same for all providers. In Slovenia pension funds manage so-called life cycle funds with three funds, more dynamic equity funds, balanced funds with medium equity exposure and the most conservative guaranteed funds with minimum equity exposure and principal guarantee. Members are switched automatically between funds as they reach certain age limits, from more dynamic funds to more conservative, the closer they get to retirement. So future assumptions of investment returns would be made for the three funds for three scenarios each year. Similarly, it was predicted for the fees used to calculate future assets (management fee and entry fee) that they should be in accordance with the rules of each pension plan.
After a long exchange of ideas and some delays the ministry published the final version of the rules for projections in November 2021 – meaning we (the funds) had only 2 months to bring to life the projections and make them work. The final version of the rules mandated projections to be made under the following conditions:
Predicted retirement age of the member is 65 years (the member has the right to reduce this number but not lower than 60 and the pension plan has to make a new calculation if the member expresses this desire).
The amount of future payments is calculated by taking into account the average monthly payments of the last 12 months.
When calculating the entry fee, the actual entry fee according to the policy of each member is taken into account.
For the existing assets two scenarios of future investment returns have to be made – the target and the pessimistic scenario (the optimistic scenario was left out unfortunately).
Each fund has to calculate projections of future investment returns for all funds for the two scenarios every year under the set out conditions. The projections of returns are based on historical average returns of benchmarks that best represent each fund and their structure. For the pessimistic scenario the average annual return of the benchmarks for a period of the worst 10 years within the last 30 calendar years is used and for the target scenario the average annual return of the benchmarks is calculated for a period within the last 30 calendar years (also taking into account the average annual operating costs of each fund that reduce the calculated future returns). What returns were used specifically in the pension fund I work for (Pokojninska družba A, Inc.) you can view at the end of the article.*
From the accumulated assets at retirement, calculated under the two scenarios mentioned above, a standard life annuity is calculated for each member using current conditions for annuities of each provider (interest rates and mortality tables). The annuity has to be rounded up and given in monthly gross amount.
Each provider must also explain to members that the projections are only estimates and that the figures are only to be taken informatively.
If the calculation of savings at retirement does not exceed the € 5,120 threshold, the member is shown only the amount of assets and no annuity is calculated (this was added at the last minute to avoid really low annuities that would not make much sense).
The mountain trembled, but …
Everybody in the industry was anxious how our members will react to the projections. Will they be disappointed by the annuities their savings will generate for them, will they be maybe positively surprised? Will they wonder, why are we sending this projections to them, will they mix them with projections of public pensions and all sorts of other considerations were going thru our minds. We were also afraid the sheer increased volume of calls and emails would be tough to handle, so we all braced for impact but in the end guess what?
Nothing happened. All members received their projections at the end of this Januarja. We had increased volumes of calls and emails as every year, when members receive their annual statements, but not more than usual. We had in the end very little questions regarding the projections and almost no bad feedback. We had a handful of members asking if we could make projections for them with their retirement age reduced from 65 to 60 and that was it. So in short, the mountain trembled, but at least in Slovenia there was no earthquake following. I also spoke to colleagues in other pension funds in Slovenia and all had similar experiences with very little feedback from members about the projections.
Possible reasons for this could range from – people did not read the projections, people dismissed them, to that the projections were quite in line with other projections of retirement income funds in Slovenia already communicated to their members, so it did not surprise them. I can speak for the fund I work in, we already enabled similar projections of lifetime income in our online account where members can monitor their assets and also make projections of retirement income under various scenarios of investment returns that were not the same as the ones under the ministry’s guidelines, but still not that much different. And we have had these features for more than eight years, so members are aware of them and use them. We also have a mobile app ePokojnina (ePension) with similar features for more than eight years, so these kinds of projections, I would speculate, came as no surprise to a part of our members and also actual projections of income did not differ that much.
From speaking with colleagues in the US retirement industry, I know many are also guessing what the reaction from their members will be, when they will receive their lifetime income disclosures this year. Josh Cohen from PGIM and Yanela Frias from Prudential cover this nicely in their white paper analysing several potential responses members will have based on a survey they made [2]. What is especially interesting (and worrying at the same time), is that lifetime income illustrations in the US will, according to the DOL guidelines, exclude future contributions to the member accounts and also any future investment earnings. This means younger members, who just started saving and have small pension pots, will receive very low projections of income. This may cause them to question their saving and have all sorts of doubts and questions for their plan provider and as the above mentioned report nicely puts it “the illustrations will greatly underrepresent future retirement income for most plan participants other than those very near retirement.” So this is one angle where income projections could raise many questions and I’m glad we in Slovenia avoided this by including future contributions as well as investment earnings.
Future potential of income projections
All projections of the future are wrong, but I still feel that if the assumptions are as realistic as possible and most importantly show various scenarios, they still provide valuable information to members about what kind of range of income they can expect in retirement based on their current saving rates. This of course also presents a fantastic opportunity for plan sponsors to engage with their members and present to them also scenarios what happens if they increase their contributions, how is that likely to impact their income in retirement and also how will their investment choices impact potential future investment returns (here the impact of fees can also be added). So these are all key issues that can be communicated to members of retirement plans along with projections of retirement income and we plan to further incorporate the above angles in pension funds in Slovenia in the following months building on the initial projections. The reframing of retirement savings mentioned in the beginning of the article is also crucial, we must stop looking only at how much assets we will accumulate, but also what kind of income those assets will provide for me in retirement. Then we can get into specifics about what are the best vehicles to decumulate savings and probably also here there isn’t one “silver bullet” that would fit all, but a combination of products that would fit one members needs to make their life in retirement better (but that will be the topic of another future article).
*Future investment returns used in 2021 income projections for Pokojninska družba A, Inc. pension funds calculated in line with the Ministry of labour guidelines (Target scenario – Guaranteed fund +2,02%, Balanced fund +4,37% , Equity fund +5,91%; Pessimistic scenario – Guaranteed fund +0,14%, Balanced fund +1,65% , Equity fund -1,67%). These numbers will be updated every year.
References:
[1] Blanchett, D., Kowara, M. and Chen, P. (2012). “Optimal Withdrawal Strategy for Retirement Income Portfolios”. Retrieved from: https://investmentsandwealth.org/getattachment/90eb6376-d090-4904-9f82-786553ff5ed9/RMJ023-OptimalWithdrawalStrategy.pdf
[2] Cohen, J. and Frias, Y. (2021). “Lifetime income illustrations: Preparing for participant reactions (PGIM / Prudential Retirement)”. Retrieved from: https://www.pgim.com/white-paper/lifetime-income-illustrations-preparing-participant-reactions
Irrational Retirement 