Houston, we have a problem – (un)readability of retirement plan documentation 

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. 

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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].  

Illustrative template – Simpler annual benefit statement

Source: The Department for Work and Pensions (2021), https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1025143/illustrative-template-simpler-annual-pension-benefit-statement.odt 

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].

PEPP KID Template

Source: EIOPA, https://www.eiopa.europa.eu/document-library/other-documents/pepp-benefits-statement-and-key-information-document-kid-template_en 

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.

https://www.fssuper.com.au/article/2021-readability-scorecard-for-australian-superannuation-funds

[2] The Department for Work and Pensions (2021). Statutory guidance for simpler annual pension benefit statements. 

https://www.gov.uk/government/publications/how-to-provide-simpler-annual-benefit-statements/statutory-guidance-simpler-annual-pension-benefit-statements#compliance-with-this-guidance

[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)

https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=uriserv:OJ.L_.2019.198.01.0001.01.ENG

The Dunning-Kruger effect and retirement saving

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.  

Photo by Eva Bronzini on Pexels.com

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.”

(Photo: courtesy of BBC, taken from https://tellyvisions.org/2017/09/15/blackadder-third-30)

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. 

Photo by Liza Summer on Pexels.com

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.  

References: 

[1] Kruger, J. & Dunning, D. (2000). Unskilled and Unaware of It: How Difficulties in Recognizing One’s Own Incompetence Lead to Inflated Self-Assessments. Journal of Personality and Social Psychology. https://www.researchgate.net/publication/12688660_Unskilled_and_Unaware_of_It_How_Difficulties_in_Recognizing_One’s_Own_Incompetence_Lead_to_Inflated_Self-Assessments

[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 

Not great, not terrible – Slovenia’s second pension pillar (update for 2021)

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.

Photo by Monstera on Pexels.com

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.   

References:

Ministry of Labour, Family, Social Affairs and Equal Opportunities (2022). Statistic for supplemental pension insurance. Retrieved from: https://www.gov.si/teme/prostovoljno-dodatno-pokojninsko-zavarovanje/

Vižintin, Ž. (2020). Tax incentives for retirement saving don`t work (what does?). Irrational Retirement Blog. Retrieved from: https://irrationalretirement.com/2020/07/17/tax-incentives-for-retirement-saving-dont-work-what-does/

Ireland to introduce automatic enrolment 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)
  • moderate risk fund (government bonds + blue-chip equities, stock exchange indices, …)
  • higher risk fund (equities and real estate)
  • 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. 
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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 be pooled, 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. 

Modified from: Department of Social Protection (https://assets.gov.ie/219768/4aada71d-2731-4522-b218-9184a699652f.pdf)

Decumulation options 

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.    

References:

Department of Social Protection (2022). The Design Principles for Ireland’s Automatic Enrolment Retirement Savings System. Retrieved from: https://assets.gov.ie/219768/4aada71d-2731-4522-b218-9184a699652f.pdf

Mandatory lifetime income projections (case of Slovenian pension funds)

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. 

Photo by maitree rimthong on Pexels.com

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.  

Photo by Greenvalley Pictures on Pexels.com

How we did it

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.  

Photo by Karolina Grabowska on Pexels.com

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

Lessons for retirement saving from the movie Don`t Look Up (Netflix)

End of December Adam McKay’s new movie Don’t Look Up was released on Netflix bringing to us a fun satire of the current state of our society. An acclaimed cast, including Leonardo DiCaprio, Jennifer Lawrence, Jonah Hill, Meryl Streep and Cate Blanchett, show us thru a satiric lens, how our society is totally oblivious to the large challenges it is facing, which are in the movie represented by a large comet on a trajectory to Earth.

The story in the movie goes something like this. A PhD student named Kate Dibiasky (played by Jennifer Lawrence) discovers a comet and when she and her mentor Dr. Randall (played by Leonardo DiCaprio) calculate it’s headed straight for Earth bringing in six months a certain extinction of the human race, they go on a mission to save humanity. First they contact the government and get a meeting with the President of the United States (played by Meryl Streep) only to find out she does not take them even remotely seriously and is more concerned in getting re-elected than to start working on a plan to save humanity.

Being disappointed by the government they decide to risk it all and go to the media with their story and warn everybody. They tell their story to a newspaper and also go on a popular morning show called The Daily Rip, where again their warning of a certain apolicipse falls on deaf ears. They are made fun of and their calculations are being questioned, as it seems nobody wants to believe the harsh reality, even though it’s backed up by the most prominent scientists. Sounds familiar?

Initially Adam McKay wrote this movie with climate change in mind, but when I was watching the movie it immediately struck a parallel to our denial about the future demographic challenges we are facing. I remember my beginnings 10 years ago in the pension fund industry when I first started reviewing demographic projections, how the working age population will shrink in the European Union in the next decades, how the elderly population will increase and how we will live longer and longer bringing more and more strain on the public pension system. Until recently the population of most western countries were shaped like pyramids, with the larger young population cohorts at the bottom, smaller middle aged cohorts in the middle and at the top the smaller elderly cohorts. This meant the numbers of the working age population were much larger than the population of retirees and under these assumptions the modern day public PAYGO pension systems were devised. But what is happening recently and will play out in the future even more intensely is, the cohorts of the older generations are increasing relative to the younger ones meaning the population is no longer shaped like a pyramid, but more like a box. This transition is nicely seen from the picture below showing the population pyramids of European Union in 2019 and the projection for the year 2100.    

Source: Eurostat (https://ec.europa.eu/eurostat/statistics-explained/index.php?title=File:Population_pyramids,_EU-27,_1_January_2019_and_2100.png

When you tell people that in the future, due to this demographic shift, public pension systems will no longer be able to sustain today’s levels of pensions guess what happens? Nobody cares and you can show all the excel charts and population pyramids in the world and people just shake their heads and move on with their daily lives, like nothing will happen, the same as it was in the movie. Nobody cared about the comet and nobody cares about the future challenges of public pension systems. The few of us who do are rarely taken seriously and to much disappointment, the same as in the movie, the political class is also all too often turning a blind eye to the demographic challenges, because the solutions are in most cases not popular – raising the retirement age and reducing the levels of public pensions. So politicians, who in most cases care only about getting reelected, are all too happy with delaying much needed reforms of the pension systems. 

This is part of the reason why we are all too happy to live in denial when it comes to major challenges like global warming and the demographic shift and we are rather occupying ourselves with celebrity gossip and other “problems” of distant people. Meanwhile the comet is getting closer and closer. You can read more about the behavioral science of why we are bad at identifying and reacting to intangible and distant threats in my article from 2020. 

Some things we can do to help people deal with intangible and distant threats is making them as personal as possible, so they feel it’s affecting them and their loved ones. Excel will not do the job here, so we need to break down the complex information into small bites and communicate it to people in plain language with no jargon and use graphics and imagery, so it’s understandable to a 5 year old. We can help people increase their emotional connection with the future self by using age-progressed digital avatars of themselves like Hal Hershfield suggests or use an age simulation suit that enables people to experience first hand all of the common impairments of older people, like I wrote in last year’s article.

Photo by Sarah Chai on Pexels.com

We can learn a lot here from effective communication regarding the environmental challenges. Instead of only sounding the alarm horns of the impending doom the media and also everyone else should adopt a so-called solutions-oriented journalism which provides examples of how ordinary people are making a difference to big issues like climate change. It illustrates how those changes are having a tangible, positive impact on their lives. More on this novel approach in an article on The conversation.  

The same can be applied to retirement saving, we need to show more concrete stories how additional retirement savings improved the lives of people and tell their stories and only then more people will be able to identify with them. In the pension fund I work for I saw first hand how this can work. In Slovenia private pension funds exist now for only 20 years and in the first few years there was lots of scepticism about it, people were asking will I ever get my money, and had similar concerns. In the last few years this has improved very much thanks to one simple reason, our first members were starting to retire and when they retire they also start to receive a lifetime monthly annuity from our pension fund. This had a dramatic influence on their perception as members were actually starting to receive the promised benefits and they shared this positive experience with their coworkers and this increased the positive attitudes of whole companies. We registered noticable change in positive attitude towards private pension saving in companies with high shares of ex-employees, who have already retired and started also to receive the private annuity from our fund and now we know those are our best promoters to increase positive attitudes towards additional retirement saving.       

Here we need more interdisciplinary work and exchange of best practices from pension funds to environmental awareness campaigns, road and workplace safety and many other areas that all have one thing in common – addressing intangible and distant threats. 

What a shocker – automatic enrolment in retirement plans works (How it started and how to make it better)

Automatic enrolment (AE) in retirement plans is far from a new idea, in fact it’s now more than two decades old, but I’m still surprised how many people in the industry (finance, insurance, retirement, …)  and also in the government, are not aware of how powerful it really is. Every time the debate in my home country of Slovenia comes to the second pension pillar and how to increase enrollment rates, I mention AE as being the no-brainer solution, but it is always received with scepticism. Also at international panels, pondering on how to get people to save for retirement, there isn’t a general consensus that this is “the solution” and we always end up with general remarks like, we need more financial education and raise awareness, we need to increase tax incentives, yada yada yada. 

So in light of the new fascinating numbers the UKs Department for work and pension (DWP) has just released – more than 10 million people saving thanks to AE in the UK and a great overview just published – Best practises and performance of auto-enrolment mechanisms for pension savings [1], I think it’s the right time to make the case again for AE in retirement plans and see how the idea went from concept to reality in the last 20 years and what are the latest best practices to make AE a success. 

How does it work?

We know from lots of behavioural science literature the initial decision to join a retirement saving plan is one of the hardest. There are numerous behavioural biases working against it, from loss aversion to status quo bias and many more. While seeking an alternative way of how to get people over this hard decision researchers like Brigitte Madrian, James Choi, David Laibson and not to forget Shlomo Benartzi and Richard Thaler with their breakthrough Save more tomorrow program, made the case of how to use inertia to help people save for retirement. They turned the concept around and instead of trying to convince people to join a pension plan with all kinds of awareness campaigns, tax incentives, … , they turned things around and proposed to auto-enrol all employees in the pension plan and to just give them the option to opt-out. 

This way the participation in the retirement plan is still voluntary and everybody has the right to say no. There is just one crucial detail, saying yes and enrolling in the plan requires no effort and the only time you need to make any effort is if you want to exit the plan. What kind of an effect this can have on enrollment rates is more than obvious from the chart below from UKs DWP showing how AE in the UK raised participation in retirement plans. You need to be looking at the orange line representing participation of private sector employees in retirement plans and after 2012 when AE was introduced the effect is obvious.  

What a stroke of genius AE is and I still remember reading the first time about this concept, as I was just blown away by its simplicity. Also the employee doesn’t have to make any hard decisions before joining the plan, like how much to contribute and in which fund to invest, as every plan featuring AE has a predetermined default level of contributions and fund selection, which is in most cases a target date fund. This way starting to save for retirement is totally effortless.  

How it started and how it’s going

The US was one of the front-runners of AE. It all started in 1998 by the Internal Revenue Service Revenue Ruling 98-30 which clarified that AE was permissible for new employees and this meant new employees could be automatically enrolled in their company’s 401(k) and their contributions automatically deducted from their pay. The Pension Protection Act that followed in 2006 helped to popularise the concept even further, but always kept it on a voluntary level, so today more than half of employers feature AE in their retirement plans. This also means many are still not covered by AE. 

Photo by Oleg Magni on Pexels.com

The United Kingdom followed later with the Pensions Act 2008 under which every employer had to enrol their staff into a workplace pension scheme and contribute towards it. A mandatory version of AE was phased in from 2012 onward. First it was mandatory for big companies, then medium and down to small. What was really smart about AE in the UK was that also the minimum level of contributions was auto-escalated from the initial 2% of employees gross salary, to 5% up to April 2019 and now 8%, of which the minimum level from the employer is 3%. Another great feature of the UK`s AE is that even if employees opt-out of the system, the employer will “re-enrol” them back into a scheme every three years. After 9 years AE in the UK is still going strong and even in the Covid-19 pandemic the opt-out rates remain low at only 9 to 10 percent. Overall 88% of eligible employees (19.4 million) were participating in a workplace pension in 2020 according to the latest Department for Work & Pensions statistics which is miles away from how things were just 10 years ago and today more than 10 million people started to save for retirement thanks to AE. 

Ireland is following and plans to implement by 2023 a defined contribution AE system of supplementary pension savings for all employees between the ages of 23 and 60 who earn €20,000 or more. Auto enrolment will be phased-in and minimum mandatory contributions will be set at 1.5% of gross earnings and then increasing by 1.5% every three years until year 10, when they will reach 6%. The detailed legislation is still being drafted and initially it was planned to be in place by 2022, but was unfortunately pushed back to 2023 and fingers crossed it’s not pushed back again. More details on the plans in the report by Mercer. 

As mentioned before AE never became mandatory in the US, but a growing number of US states, like California, Oregon, Illinois and the latest New York, decided to push ahead and started to implement state-facilitated retirement savings plans in which employees are automatically enrolled. Oregon’s plan OregonSaves began in 2017, Illinois in 2018 and California started its CalSavers at the end of 2018. You can find detailed data on how the existing state plans are growing on Massena Associates website which is regularly updated. 

A nice example is CalSavers, which grew in just a few years to 209,033 funded accounts and 140 million USD assets by the end of november 2021, represented in the chart below. 

Source: CalSavers Snapshot report november 2021, retrieved from: https://www.treasurer.ca.gov/calsavers/reports/participation/november2021.pdf

New York is the latest state announcing such a plan that will require certain employers to enrol their employees in a new state-managed retirement savings program funded by employees. The plan will be mandatory for all employers that had at least 10 NYS employees during the entire prior calendar year and have been in operation for at least two years and also don’t have a qualified retirement plan, like a 401(k). More on the latest NYS plan in the report from Willis Towers Watson. 

In New Zealand, AE was introduced in the KiwiSaver Act 2006 and the KiwiSaver funds have been going strong ever since. Employers have to enrol their employers automatically and there is also a minimum rate of contributions for employers set at 3% of employee’s gross salary. Employees have a time limited option to opt out – only between 2–8 weeks of starting work. At the end of march 2021 members of KiwiSaver plans totaled 3 million and assets amounted to 81,6 billion USD according to the latest Financial Markets Authority report. KiwiSaver isn’t just a retirement savings plan, it can also help members buy their first home either through the ability to withdraw some of the savings or through a special First Home Grant. When buying your first home you can make a one-off withdrawal of most of your savings if you’ve been a member for at least three years. Opt-out rates remain low at around 15% making KiwiSaver a big success. 

For a more detailed overview of AE in various countries I really recommend the report Best practises and performance of auto-enrolment mechanisms for pension savings by LE Europe, Redington and Spark written by Patrice Muller, Rohit Ladher, Shaan Devnani and Luke Pate.

How to make it work

The report mentioned above also nicely sums up some key recommendations for implementing AE schemes and how to make them work, from defining clear policy goals, establishing a wide consensus around both the goals of and the implementation, a supervisory framework empowering risk-based supervision of providers, phased introduction, and a nationwide information campaign ahead of the scheme’s introduction. 

Photo by Brett Jordan on Pexels.com

A clear best practice recommendation from the report is to provide mandatory access to occupational auto-enrolment pension schemes or in other words, to make it mandatory for employers to grant access to employees to an AE scheme. This feature is seen as a key feature that influences participation rates. Also recommended are: to have no waiting period (minimum tenure requirement) for employees to join AE schemes, to allow for automatic re-enrolment as in the UK example, to have mandatory employer contributions and to also cover self-employed workers. One feature also nicely executed in the UK was to raise the contribution levels over time making sure they are appropriate for the long term.  

Regarding investment choices of members the recommendations are to have the presence of a default fund with capped cost, use of life-cycle funds and no joining fee and also to limit the number of investment funds per provider. Regarding decumulation, that is in recent times in developed private pension markets the number one topic, the report recommends to design the transition from accumulation to decumulation and to have a default option in place and not to force the members to make an active choice. According to the report, the default option for decumulation could consist of programmed withdrawals and a deferred life annuity for all but small savings balances and to have a free signposting service that would direct members to providers who could give them advice on decumulation options. 

Trust is key

One important element nicely highlighted in the report as being a key component is trust. For AE to be introduced successfully, people must have trust in the system and if it does not exist, AE will not be successful and many people will use the option to opt out from such a scheme. So this crucial piece is sometimes forgotten and trust is something that can take years or decades to build, only to evaporate in days, so this issue is to be taken into consideration before introducing AE to a certain pension system. If there is no trust in the system itself, then even AE will not work. 

To finish on the positive note, AE now has quite a strong and proven track record – given the right preconditions, and although it’s not the silver bullet solution to the retirement saving challenge, it comes very close and in my mind it’s the no brainer every country should implement in a way that best suits their existing retirement system taking into account the aforementioned best practices. 

References:

[1] Best practises and performance of auto-enrolment mechanisms for pension savings (2021). Patrice Muller, Rohit Ladher, Shaan Devnani & Luke Pate. LE Europe, Redington and Spark. Retrieved from: https://op.europa.eu/en/publication-detail/-/publication/6f40c27b-5193-11ec-91ac-01aa75ed71a1/language-en

The forever young ideology does not help retirement saving – what to do?

While vacationing I try to catch up on my reading (as much as family life allows), and once in a while to take a break from more serious reading, I browse over my wife`s “lifestyle” magazines that she usually reads on the beach. Scanning over them this year, what struck me was how many articles were somehow related to ageing, or to be more precise, being and staying young. Just some of the titles that caught my eye: 5 exercises to keep you forever young, superfood for youth, Anti-ageing drinks, … not to mention many paid articles from cosmetic surgeons and other »beauty experts« promoting botox and other treatments to keep you young and firm. 

What’s going on here, as these were not magazines for teenagers, but rather middle aged women and men. So it got me thinking – no wonder no one is interested in retirement saving, if all they are reading is eat papaya and drink carrot juice and you will be forever young. This disconnect or denial about ageing must for sure not be good as if I will be forever young, then why save for retirement or even think about it? I will rather spend all my money now on papaya and botox, forget about topping up my 401(k) retirement plan. Forget about saving for retirement at all, rather embrace the la dolce vita ideology and live the life. 

This strengthens the already powerful present bias which has long been associated with undesirable spending and borrowing behavior. Present bias is the tendency of people to discount their future preferences in favor of more immediate gratification or to put it more simply, we are more inclined to spending and receiving short-term gratification – buying a new pair of shoes or that brand new Iphone, then to delay our gratification and save our paycheck and contribute to our retirement plan from which we will receive gratification only many years or sometimes even decades into the future. The concept was derived from the theory of self-control in behavioral finance back in 1981 by Thaler & Shefrin and you can find more details about it along with the latest research on this topic in an article by Jing Jian Xiao & Nilton Porto [1]. Their latest study also confirmed the theoretical predictions about the present bias, such as preferring to spend now and postpone saving. 

What can we do about it? Xiao & Porto bring to light in their article an important role financial planners and other intermediaries can have in helping their clients be more patient and methodical when preparing long-term financial plans. Auto-enrollment saving programs can also in this case help tremendously to improve consumers’ financial well-being and get them to automatically contribute from their paycheck to their retirement plans and start building their nest egg, before they can spend it. The key element here being automatic payroll deduction of contributions to retirement plans before you get the chance to spend it. State-facilitated retirement savings plans in some US states like Oregon`s Oregon Saves and California`s CalSavers in which employees, who are currently not saving, are automatically enrolled in the new plans, are great examples of this. Not to forget auto-enrolment in workplace pension plans in the United Kingdom which has in less than 10 years increased coverage rates from 60 to 90 % and today more than 10 million people are saving additionally for their retirement because of it.

Hal Hershfield also has some interesting ideas to help people save for their future by increasing their emotional connection with the future self and as a result promote savings behavior. According to research, we consider our distant future selves, as if they are other people, and we of course don’t want to save our money for some stranger to spend in the future. To change this and increase our connection with our future self Hershfield experimented with using age-progressed computer renderings of people to see if that would increase the connection and help our saving efforts and it actually worked. In one experiment he used instead of age-progressed pictures only written and verbal exercises, like imagining or writing about your future self, and also that increased the connection with the future self [2]. He wrote many articles on this topic and they can be found on his website and I’m really looking forward to seeing more of his findings materialize in the future being integrated in features of retirement plans, for example using online retirement saving accounts with pictures of savers that could be aged. Bank of America Merrill Edge already integrated these features years ago with their Face Retirement App and you can check out the video on the link to see how it works.

Image source: https://charlotteultraswim.com/the-app-that-makes-your-face-old/

When I was thinking of how to bring the future to members of the pension fund where I work, to increase their connection with the future self, I stumbled online at GERT. The name is short for gerontologic simulator, which is best described as a sort of age simulation suit that enables you to experience first hand all of the common impairments of older people, like narrowing of the visual field, hearing loss, reduced grip ability, mobility restrictions, … you get the idea. Once you put it on even the most every day things become very hard, like sitting down at a desk and writing an email or walking down a flight of stairs and ordering a cup of coffee at a bar. 

In the picture you can see me presenting the age suit at an HR conference and the suit was a great success and everyone wanted to try it. Personally the experience of wearing it was one of the most rewarding for me, as you experience first hand how tough it is to function in older age and my respect for older people grew to new heights, as it is incredible how tough life can be and before you feel it on your own you just can’t imagine it. The main purpose of the suit is to enable companies like retailers and banks to test their shops and branches and see how they cater to older people and to adapt them to become more friendly (at the link you can see how Barclays bank used it). 

Our pension fund used the suite for a bit of a different purpose, which was to bring the future closer to our members and other people and to warn them about a not so distant future in which they will be in the shoes of today’s older people and how vital it is that we start preparing for the future today. That means living a healthy lifestyle to be more physically fit and also taking steps to secure a financially sound future, meaning putting some money aside today and not get lost in the la dolce vita ideology, as once we retire every penny will count and wearing the age simulation suit I’m even more sure we will need all we can get to make our retirement an enjoyable part of our lives.     

References:

[1] Jing Jian Xiao & Nilton Porto (2019). Present bias and financial behavior. Financial Planning Review, Volume 2, Issue 2. Retrieved from: https://onlinelibrary.wiley.com/doi/full/10.1002/cfp2.1048 

[2] Hal E. Hershfield, Elicia M. John & Joseph S. Reiff (2018). Using Vividness Interventions to Improve Financial Decision Making. Policy Insights from the Behavioral and Brain Sciences. 2018; 5(2):209-215. Retrieved from: https://irrationalretirement.files.wordpress.com/2021/09/cc3fc-hershfield_john_reiff_2018_pibbs.pdf 

Assets and members of Slovenia’s second pension pillar on the up, coverage rates are down

End of 2020 the number of employees saving in the second pension pillar in Slovenia reached a record 574.219 members. This means the coverage rate is roughly 60 % of all persons in employment, which is a fairly decent rate for a 20 year old voluntary system, but if we correct the number and deduct the members of the civil servants retirement plan (approx. 240.000), which is mandatory, the coverage rate drops to a more sobering 35 % which is 1 percentage point lower than last year. Also not encouraging is that one third of members (32 %) were inactive last year, meaning they did not make any contribution payments in 2020. 

So realistically the coverage rate is not great, which is no surprise given the voluntary nature of the second pension pillar in Slovenia, as we know from decades of behavioral science research and hard data that individuals very rarely save on their own for retirement and you can find many articles on my blog about this very subject. There are of course tax incentives to save for retirement in Slovenia, but also they have a very limited effect on encouraging individual retirement saving, as I had written in an article from July 2020. This is confirmed by data in Slovenia, as only approximately 2 % of employees save in individual retirement plans, the vast majority is saving in employer sponsored retirement plans. This is why access to an employer sponsored retirement plan is so very important. 

On the positive note, total assets of pension funds recorded steady growth despite the pandemic and reached 2,81 billion Euros, representing a 7 % growth from 2019. 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 close to 30 % of GDP. Croatia implemented mandatory enrolment in the second pension pillar roughly 20 years ago and now the big difference in the success of each system is clearly showing and you can read more about the comparison between the Slovene system with voluntary enrollment and Croatian with mandatory in my article from March 2021.   

As is clear from the chart below, most assets in the Slovenia’s second pension pillar are managed by mutual and umbrella pension funds, followed by dedicated pension funds and insurance companies. 

Given the relative youth of the private pension system in Slovenia currently only around 40.000 people are receiving monthly annuities and the statistics around how high are average annuities is unfortunately not compiled. I hope we will have more data on the decumulation phase in the future as this part is of course crucial for any retirement system and its main point to provide together with state pension an adequate income in retirement.

If we look at the replacement rate of public pensions alone, we see they are continuing their decline and by the end of 2020 the average net public pension replacement rate fell to 57 %, well below the levels of decent retirement income, which OECD sets at 70 % of preretirement income. I would put the number even a bit higher at 80 or 90 % of preretirement income, so the challenge for the second pension pillar to fill in this is getting bigger every year. 

Where do we go from here?

One thing is certain, if we will not have any major reform of the private pension system in Slovenia the situation will remain as it is. The smaller percentage of people who are currently saving in the second pension pillar will reach adequate income in retirement, the rest unfortunately not and even though some still dream public pensions will in the future provide decent income in retirement, we see this is far from reality even today, let alone in the future, when the unavoidable demographic shift will put even more pressure on public finances and the first pension pillar will have less and less people (employees) paying into it and more and more people receiving benefits (retirees).  

There are proven examples of possible solutions in other countries, such as auto-enrolment in workplace pension plans in the United Kingdom. It has in less than 10 years increased coverage rates from 60 to 90 % and today more than 10 million people are saving additionally for their retirement because of it. The Irish government is following the example and plans to introduce auto-enrolment in the next year and also some US states, like California, Oregon, Illinois, etc. are following the lead with implementation of state-facilitated retirement savings plans in which employees, who are currently not saving, are automatically enrolled in the new plans. You can read more about the latest progress of state-facilitated retirement plans in the US from Lisa Massena on the link.  

As Einstein nicely put it “The definition of insanity is doing the same thing over and over again, but expecting different results.” meaning if the pension system in Slovenia is to provide adequate income in retirement for all, we need changes that will bring to life all three pension pillars as only the combination off all sources, both public and private, will be enough to provide adequate income in retirement in a sustainable way. 

Did the stock market volatility in 2020 affect asset allocation of pension plan members?

We all remember the roller coaster ride stock markets had in the year 2020 that started in march with a sharp drop in stocks of almost all sectors and industries, followed by equally or even higher rises of some industries in the later months of the year. All in all, most of the markets recovered by the year’s end and the S&P 500 finished in green with an annual total return of 18,4 %. If even professional traders were taken aback by last year’s volatility, the obvious question to be asked is, how did members of pension plans, represented mostly by ordinary employees, react to the volatility? Did they panic and switch funds from more dynamic to conservative, vice versa, or did they do nothing and hold their ground?

Few studies on this very topic were published in the last days and all tell a similar story. The Investment Company Institute (ICI) report establishes that most members of defined contributions retirement plans in the US stayed the course with their asset allocations despite high market volatility. The report states 10,6 % of DC plan members changed the asset allocation of their account balances in 2020, which is a bit more than 8,3 % in 2019, but lower than 11,8 % in 2009, as the stock market started to recover from the global financial crisis. The data for the report came from ICI’s survey of a cross section of recordkeeping firms representing a broad range of DC plans and covering more than 30 million employer-based DC retirement plan participant accounts. The report also provides a nice historical comparison of what percentage of members changed their account balance asset allocation from the year 2008 to 2020, shown below [1].

Source: ICI Survey of DC Plan Recordkeepers (2008–2020)

To check if the same pattern would also be found on the other side of the Atlantic, I did a short analysis of how many members changed their account balance asset allocation of Pokojninska družba A, Inc. pension fund where I work, which is a private DC pension plan from Slovenia with 51.500 members end of 2021. Members in our fund can choose between three life cycle funds, ranging from the Equity fund, with obviously high equity exposure, to the Balanced fund with medium equity exposure and the most conservative Guaranteed fund, with 80% bond allocation and capital guarantee. As is evident from the chart below, showing what percentage of members switch their investment allocation annually, the average numbers are much much lower than in the US. In fact even less than 0,5 % of members annually change their asset allocation and 2020 was no exception. 

Even though I did not expect high numbers of members to change their asset allocation in the last year, I was really surprised at how low the numbers really were. Only 0,18% of all members changed their asset allocation in 2020, which is a bit less than in the year 2019 and basically on the average of the last four years. If we look from which fund members were switching out the most and adjust the numbers to represent how many members are in each fund, then most changes of allocation were done from the Equity fund to one of the more conservative funds.     

If we dig further and look at the monthly levels we can see most members in our funds change their asset allocation in the first quarter of the year. There are probably many reasons for this seasonality, one for sure being all members receive at the end of January their annual account balance statement in which they also see the funds performance for the last year and that can stimulate some movement. We saw most changes to the asset allocation in the first few months of the year 2019 where members saw the equity fund achieved a negative yield in 2018 and that could scare a few members to change their allocation to the conservative guaranteed fund which recorded a positive yield. 

The difference in the percentage of how many members change their asset allocation annually in Slovenia and the US is huge, but some of the reasons for it make it not so surprising. In Slovenia pension funds started to offer life cycle funds only from 2016 onwards, before the legislation did not unable fund selection and the only option was the guaranteed fund, so people even today are not so much aware of the investment options as are savers in US pension plans which have for long had a much wider fund selection.    

So to answer the question from the beginning of the article, did the stock market volatility in 2020 affect asset allocation of pension plan members? The answer is short, no. The majority of members held their ground and did nothing which is good, as we all know changing asset allocation in panic results in most cases in suboptimal performance, to put it mildly and Morningstar had a nice article on why investors should stay the course throughout market turmoils [2]. One thing that we also need to keep in mind, most members of pension plans contribute to their accounts on a monthly basis and that evens out fluctuations in the members balances. So If you are checking online your account balance the monthly contributions make it tougher to see how much the value of your assets went up or down in a certain month which is good, as there is not much good from being fixated on monthly fluctuations if you are saving for the long run, which saving for your retirement for sure is.    

References:

[1] Holden, Sarah, Daniel Schrass, and Elena Barone Chism. 2021. Defined Contribution Plan Participants’ Activities, 2020. ICI Research Report (February). Available at http://www.ici.org/pdf/20_rpt_recsurveyq4.pdf


[2] Lauricella, Tom. 3 Charts That Show Why Investors Should Stay the Course Throughout Market Turmoil, 2020. Morningstar, Inc. Available at https://www.morningstar.com/articles/972119/3-charts-that-show-why-investors-should-stay-the-course-throughout-market-turmoil