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

Mandatory VS voluntary enrollment in retirement plans (Croatia VS Slovenia)

We know from lots of behavioral science literature the initial decision to join a retirement saving plan is one of the hardest, as there are lots of behavioral biases working against it, from loss aversion to status quo bias and many more. But what can we do to make this decision easier? 

One of the best strategies to help people save for retirement is automatic enrollment under which workers are notified at the time of eligibility that they will be automatically enrolled in the plan with a default contribution rate and asset allocation unless they actively decide not to be enrolled. This strategy was much researched by the likes of Brigitte Madrian, James Choi, David Laibson and not to forget Shlomo Benartzi and Richard Thaler. They all proved mostly in the cases of U.S. defined contribution plans, that the strategy effectively increases enrollment rates all the way up to 80 or even 90% of all employees at certain companies that enabled auto-enrollment based retirement plans. In the last years we also saw the strategy proved itself in the United Kingdom that introduced it in retirement plans from 2012. After 9 years it is still going strong and even in the Covid-19 pandemic the opt-out rates remain at only 9 to 10 percent. To date it has helped more than 10 million people to start saving for retirement additionally (more on auto-enrollment in the UK in the report from Nest Insight). So if you ask me, after decades of research, automatic enrollment is the proven way to go, if employers or countries want to increase coverage of their private retirement plans. 

Is there any other way to do it instead of just leaving the decision to the people on a voluntary basis? Sure there is and also quite an effective one. If auto-enrollment is the “soft” way to get people to save for retirement, as they still have the choice to opt-out, there is also the “hard” alternative to get people to save, which is to just make it mandatory. This has been the case in many countries and now after quite some time we can compare the effects on enrollment rates and also accumulated assets of private retirement plans and in the following article I will present a short overview of private retirement plans of Slovenia and Croatia, which are neighbouring Emerging European countries. Both established from scratch private retirement plans after the year 2000 and chose different paths how to get employees to participate in the new plans. 

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Slovenia went for the really “soft” approach and formed occupational and individual defined contribution retirement plans based on voluntary enrollment. Sure, there are tax incentives for participation, but as most by now already know, tax incentives have a very limited effect on individual decisions to save for retirement and they are also very expensive. More on their limited effect in my article from July 2020 and tax incentives only get you this far – which is in the case of Slovenia only 41% coverage rate of the working-age population and total assets of retirement plans of only 6.8% of GDP (both statistics from the OECD pension markets in Focus 2019) after 20 years of the new system.

Croatia chose the “harder” approach and when the system was reformed in 2002 those over the age of 50 remained in the then existing pension system, whilst those between 40-50 could choose whether to join the new individual account system and those under 40 were required to join the new system. For those who joined the new system part of the social security contributions in the sum of 5% of their gross salary was diverted to new individual retirement saving accounts in a so-called carve out of social security contributions. On top of this there was also a new option enabled of totally voluntary contributions to the new retirement saving accounts as the third pillar option.

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So, as is evident from the chart above, the effect on coverage rates is remarkable and in 2019 in Croatia 77% of the working-age population is covered by the retirement saving plans. Also the accumulated assets are now at 27.3% of GDP which is a great number for a system that will only next year be 20 years old. This is both thanks to coverage rates and contribution rates.   

The comparison of annual nominal growth rates of pension assets from 2009 to 2019 in the chart below tells it all, as Croatia was growing annually much quicker than Slovenia. 

No matter what kind of tax incentives governments offer to employees to save for retirement and no matter what kind of other soft promotional activities there are, the underlying fact is, with this approach the best scenario you can hope for is short of 50% enrollment rate. Meaning at best you will have half of the working-age population saving for retirement and even with them in most cases contribution rates will not be sufficient. This was demonstrated in many cases all over the globe and the Croatia VS Slovenia example is just one of many. Time will also not change anything, as even in more mature systems with voluntary retirement saving enrollment rates get stuck near 50% and the only way to get past this is to implement auto-enrollment policies or to just make it mandatory. 

Personally I’m more of a fan of auto-enrollment, as it showed clearly in the UK and now recently in a few US states with state-facilitated retirement saving plans like OregonSaves, Calsavers and others, that it can effectively increase enrollment rates with still leaving people the choice to participate or not. Just the simple, jet brilliant fact of turning the choice about participating in the plan around makes all of a difference and I do hope my home country of Slovenia will also soon follow suit. 

References:

Benartzi, Shlomo & Thaler, Richard (2007). Heuristics and Biases in Retirement Savings Behavior. Journal of Economic Perspectives 21 3 81-104. Retrieved from: https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.21.3.81

OECD (2019), Pension Markets in Focus. Retrieved from: www.oecd.org/daf/fin/private-pensions/Pension-Markets-in-Focus-2019.pdf

Jump-start your retirement saving with the fresh start effect

End of the year brings in addition to New Year’s celebrations also New Year’s resolutions which many people make for themselves and usually include exercising more regularly, eating more veggies, quitting smoking or cutting out some other unhealthy habits. Some might also resolve to start saving for retirement or some other financial goal. So what’s the behavioral science behind New Year’s resolutions and can they really help us change our course for the better? 

New Year’s resolutions go way back. Romans started each year by making promises to their god Janus, who was the god of beginnings and endings and you can guess twice after who the month of January is named after, so we are talking here about a really long established tradition.

Researchers like Eva Krockow, from University of Leicester, explains in her latest article the year’s end may give us a so-called “fresh start” effect and this new beginning can boost our morale and provide the right setting for behaviour change. Temporal landmarks, such as the beginning of a new year, beginning of a new month or a religious holiday, may serve as a time marker and signal to us a new chapter in our lives that helps to reinforce our commitment to change and form new habits. Leaving away the past people are less likely to feel tarnished by previous failures and this increases the chances new behavioral changes will stick [1]. 

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Dai, Milkman & Riis explain in their research people are more likely to tackle their goals immediately after salient temporal landmarks, like the outset of a new week, month, year, semester or a birthday and they also provide in their field studies evidence of a fresh start effect mentioned before. They propose these landmarks demarcate the passage of time, creating many new mental accounting periods each year (what is mental accounting you can read here), which leave past imperfections to a previous period. This as a result increases aspirational behavior of people. Temporal landmarks have another function besides psychologically separating us from our past failures, as they may also motivate us to pursue aspirations by altering the manner in which we process information and form preferences, more specifically, they create discontinuities in our perceptions of time and that helps us to take a more broader view of our decisions [2] or to put it shortly, to look more at the big picture. 

Don`t forget the why

So when thinking about New Year’s resolutions and what changes you will make in 2021, don’t focus only on what you will change but also why you want to make those changes, as Sara Dolan, an associate professor of psychology and neuroscience at Baylor University explains nicely in a recent New York Times article “You’re not going to sustain a behavior change unless you have internal motivation.” Meaning external motivators, like losing weight to conform to society’s standards, work far less effectively than internal motivators, such as losing weight to actually feel better physically and mentally. In order to succeed with making behavior changes she also advises to pick small goals that are actually achievable and measurable, as each small success can help us to achieve a bigger goal later down the line [3]. 

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Fresh start and retirement saving

So let’s not get carried away and make all kinds of over-optimistic vague goals and let’s start small. When it comes to retirement saving and your future financial welfare the best thing you can do is to muscle the positive fresh start energy of January and make the first big step and start saving with a concrete amount. To make sure your momentum will not run out, start a monthly saving plan individually or if you have a chance to join a corporate saving plan with your employer even better, as they can arrange for you a monthly payroll deduction which will help you stay on the right path. This way you will only have to make the first step and the rest will run automatically until your retirement and if the plan offers automatic escalation of contributions later down the line even better as that means contributions will increase automatically at a set time intervals without requiring any waste of cognitive energy from your part. But at the beginning I wouldn’t worry too much on how much you will save, as long as you start saving, this is the most crucial and also at the same time the hardest step. The same applies for the ones who are already saving – raise your monthly contributions by $100 and the effects later down the line on your savings will really make all of a difference if you will be able to afford that cruise to the Bahamas or not.

As we learned from the article it is important to also think about why you want to start saving for your retirement and find the right internal motivation to follow through. What nice things would you like to do in retirement with your savings, like take a trip to Tuscany or spend quality time with your grandchildren. How will that make you feel? Many studies point out that the mere fact of writing down your goals and why you want to achieve them will help you reach them more easily, as Katy Milkman from Wharton School of the University of Pennsylvania explains this helps to make your goals more memorable and the more deeply you engage with them, the more likely you are to follow through and actually get there [3]. 

So let’s leave 2020 behind and start saving for retirement in 2021. With Janus on your side, what could go wrong?

References:

[1] Krockow, Eva. Why Now Is the Time for a Fresh Start. Psychology Today, 2020. Retrieved from: Why Now Is the Time for a Fresh Start | Psychology Today 

[2] Dai, Hengchen & Milkman, Katherine & Riis, Jason. The Fresh Start Effect: Temporal Landmarks Motivate Aspirational Behavior. Management Science. 60. 2563-2582, 2014. Retrieved from: https://www.researchgate.net/publication/275620856_The_Fresh_Start_Effect_Temporal_Landmarks_Motivate_Aspirational_Behavior

[3] Christina, Caron. This Year, Try Downsizing Your Resolutions, The New York Times, 2020. Retrieved from: Downsize New Years Resolutions for 2021 – The New York Times (nytimes.com) 

Boosting Covid-19 vaccine uptake and saving for retirement – same thing?

Since Covid-19 vaccines are finally being approved by regulators in the US, UK, Canada and many more countries following soon, the second part of the battle is just beginning – how to get as many people as possible vaccinated. One might think this will be first a logistical problem, but in reality it’s more of a behavioral problem. Uptake of the vaccines is voluntary, so the first challenge is how to convince people to get them. Luckily many renowned behavioral scientists, like Nobel laureate Richard Thaler, Katy Milkman, Cass Sunstein and the likes, have already come up with interesting nudges to get the job done as fast as possible and interestingly enough many nudges are very similar to increasing retirement savings. 

Kathy Milkman writes in The Economist the challenge is two fold, first people who aren’t ideologically opposed to vaccines need to be convinced to take the shots, and second, we need to make sure people will actually follow through on their intentions. Keeping in mind vaccines need two doses to reach the full effect, although the first dose already significantly improves immunisation. As one of the strategies to increase vaccine uptake Milkman suggests using “social proof” to increase the appeal of getting the vaccine as research shows people look to their peers for cues about how to behave [1]. A great example of this is the fact former Presidents Obama, Bush and Clinton already volunteered to get a coronavirus vaccine publicly to prove it’s safe and this is a living example of social proof in action. Similarly, getting high-profile people to encourage retirement saving has been a long used and effective strategy. 

Milkman also suggests making people getting vaccinated more visual, to encourage others to follow, the same as people get The “I Voted” stickers when they vote people should now get the “I got the Covid-19 vaccine” sticker. This suggestion is great, as I wrote also in my article from July, the challenge of intangibility was already very much present in relation to keeping up preventive measures against the epidemic in the first place (hand-washing, wearing masks, …) and this nicely addresses it. Retirement saving faces a similar challenge as the benefit of retirement saving is also for the most part intangible.   

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If we return to Covid-19 vaccines, Nobel laureate Richard Thaler proposes in his The New York Times article selling a small proportion of early doses to the rich and famous. Besides raising money that could be used to help the ones most hit by the epidemic, Thaler believes other people seeing celebrities make large payments for vaccines could be persuaded to follow them and also get vaccinated. One important thing Thaler also stresses is making it easy to get the vaccine. Making the process as smooth as possible and also once people get the first shot immediately scheduling their second shot and get them to make specific plans to come and then send them electronic reminders for their appointments [2]. These kinds of electronic or phone prompts have been well proven to increase anything from credit card repayments to visiting doctors appointments and Nina Mazar, Daniel Mochon and Dan Ariely have written a nice piece about it [3].

Making saving for retirement easy with as little friction as possible has been one of the priorities of many programs designed to promote retirement saving and the program Richard Thaler devised together with Shlomo Benartzi (Save More Tomorrow) emphasised among many things just that. One of the more ingenious ideas in their program was automatic enrolment in workplace retirement saving plans that turns the behavioral bias of procrastination (status quo bias) around to help us save for retirement instead of hindering it. Just an idea, but maybe automatic enrolment with the option of opt-out could also be used in vaccination programs with large employers once the supply of vaccines will be sufficient and that will for sure massively increase the uptake, as the default option would be for all employees to get vaccinated and the ones who will not won’t it will need to opt out.  

The World Health Organization also did not forget about the role behavioral science can have in increasing vaccine uptake and published a special report on behavioural considerations for acceptance and uptake of COVID-19 vaccines prepared by it`s Technical Advisory Group chaired by Cass Sunstein.

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The report explores many factors influencing vaccines uptake, from environmental factors giving vaccination in a close by, convenient locations free of charge, to making social norms in favour of vaccination more salient, supporting health professionals to promote vaccination and amplifying endorsements from trusted community members. The report also establishes it will be key to increasing motivation of people through open and transparent dialogue and communication about uncertainty and risks, including around the safety and benefits of vaccinations [4]. 

With all the behavioral science experts contributing their ideas on how to increase covid-19 vaccinations I have no doubt we will quickly get there, I just really encourage politicians and others influencing public policies to listen to them and use their wast experiences to help end this pandemic as soon as possible and save as many lives as possible. And once it’s over let’s not forget the lessons learned and put our focus on the next big threat to our societies which is the demographic shift and the retirement saving crisis which is also intangible and distant, the same as Covid-19 was in march, and we need to address this issue head on and behavioral science can make all the difference. We just have to use it. 

References:

[1] Kathy Milkman, Katy Milkman on how to nudge people to accept a covid-19 vaccine. The Economist, 2020. Retrieved from: Responding to covid-19 – Katy Milkman on how to nudge people to accept a covid-19 vaccine | By Invitation | The Economist 

[2] Richard H. Thaler, Getting Everyone Vaccinated, With ‘Nudges’ and Charity Auctions, The New York Times, 2020. Retrieved from: Getting Everyone Vaccinated, With ‘Nudges’ and Charity Auctions – The New York Times (nytimes.com)

[3] Nina Mazar, Daniel Mochon and Dan Ariely. If You Are Going to Pay Within the Next 24 Hours, Press 1: Automatic Planning Prompt Reduces Credit Card Delinquency. Journal of Consumer Psychology published by Wiley Periodicals, 2018. Retrieved from: If You Are Going to Pay Within the Next 24 Hours, Press 1: Automatic Planning Prompt Reduces Credit Card Delinquency – Mazar – 2018 – Journal of Consumer Psychology – Wiley Online Library

[4] Behavioural considerations for acceptance and uptake of COVID-19 vaccines: WHO Technical Advisory Group on Behavioural Insights and Sciences for Health, meeting report, October 2020. Retrieved from: 9789240016927-eng.pdf (who.int)

The behavioral side of ESG investing in retirement plans

ESG are the three letters that are nowadays tough to avoid in any conversation about retirement saving. Some even call it the next big thing after target date funds. ESG stands for using Environmental, Social and Governance factors to evaluate potential investments of pension funds. Looking at it from an alternative perspective, not just purely financial, brings to light some interesting new arguments in favor of ESG, that might just bring to retirement saving something that has long been missing. What am I getting at?

One of the main challenges of retirement saving is that you have to pay contributions for 40 years and in this long time period you get nothing in return, except the promise of financial security in retirement, which doesn’t really make most people sleep any better at night. Buying a new car or a house with credit gives you just the opposite, for a monthly installment you get to drive your dream car every day, or you and your family get to enjoy your beautiful new country home, giving you lots of joy and other positive emotional rewards every single day. Retirement saving is intangible and if you are not like me and get excited over looking at your online savings account, doing the right thing and saving for retirement doesn’t really give you much positive emotional rewards while you are doing it and you have to wait a long time for the reward. Even when you finally get it, whether it be a monthly annuity, or some other form of draw down, it is far from something exciting.

Well ESG might just help with that as incorporating ESG principles in the investment strategy of your retirement plan might give you some benefits of retirement saving now, as you will literally help save the environment, get cars of the streets, shut down those pesky coal plants and save the wildlife all in one go (not being cynical at all here). The biggest side effect of ESG investing might be just that –  giving savers some tangible rewards now and with that helping them to overcome intangibility and also the other bias working against retirement saving, which is present bias. It refers to our tendency to give stronger weight to payoffs that are closer to the present. Most of us are impatient and would like immediate gratification if possible and that has a big influence on our daily decision making and for sure does not help retirement saving. We will always rather spend our paycheck on new shoes, purses or other consumer goods that promise us instant satisfaction, than save it for our retirement. That’s just how we are wired and you can read more about the present bias and financial behavior in an article by Jing Jian Xiao and Nilton Porto [1].

Thinking about it I really believe ESG might help with giving pension plan members some instant satisfaction and every month when they will make their contributions to the plan they might just feel some warmth in their hearts about doing something good in this world and it’s all thanks to their retirement plan. And when did you last feel some warmth in your heart when thinking of your retirement plan? Probably never. So ESG has potential to capture people’s hearts and minds, as the saying goes, but as always, the devil is in the details. Key to this will be communication with members and folks at UK`s Nest Insight are already on to this and have ongoing studies focusing on how ESG investing can be used as a motivator of pension engagement. Their latest research programme looked at whether communicating with pension plan members about the positive impact of their investments could make them more likely to engage more with their retirement plan. So what did they find out?

As expected ESG is no silver bullet and their research suggests communications around ESG issues do not engage everyone in the same way and for some the additional information is too much and reduces potential engagement. Still they found out that overall, a responsible investment message had broader appeal than a more traditional investment message. Interestingly “ESG” does not seem to be the term that engages pension plan members very effectively and they suggest the phrase ‘responsible investment’ to work better by conveying prudence and safety and also at the same time communicating a focus on investing more sustainably for the future. Framing the messages related to ESG or responsible investment will be key and they provide some good hints on framing the messages in the right way, for example framing the messages about investments as proactively doing good instead of framing them as avoiding the bad. Their initial findings suggest ESG investments have potential to increase engagement with pension plan members, if done the right way and to reach members who would otherwise not be engaged at all [2]. 

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We also need to keep in mind that the generation of millennials is more and more represented in retirement plans as baby boomers are entering retirement so finding topics to engage millennials in connection with retirement saving will be key for the future and what better topic to connect millennials and retirement saving than ESG. Millennials are already known for preferring to invest in alignment with their personal values. Survey of high net worth investors from Morgan Stanley Institute for Sustainable Investing found that 95% of millennials were interested in sustainable investing [3] and EY`s research suggests millennial investors are nearly twice as likely to invest in companies or funds that target specific social or environmental outcomes [4]. So with millennials soon becoming the most important generation for retirement plans they need to adapt to this and start addressing the issues that matter to millennials, if they will want to win them over, otherwise they may save for retirement somewhere else.  

Clearly the topic of how ESG investing should be communicated to members of pension plans needs to be more researched and foremost tested in real life. Luckily Nest Insight already plans to go further with their research in this field and I really look forward to more of their results that are scheduled to be published in 2021. The new generation of savers will look not only at yields and fees, but will expect something more of their retirement plan and it`s investments – making a positive impact now and the retirement industry needs to adapt to this for the good of all of us.

References: 

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

[2] Jo Phillips and Will Sandbrook, Nest Insight, London, 2020. Retrieved from https://www.nestinsight.org.uk/wp-content/uploads/2020/11/Responsible-investment-as-a-motivator-of-pension-engagement.pdf

[3] Sustainable Signals: Individual Investor Interest Driven by Impact, Conviction and Choice. Morgan Stanley Institute for Sustainable Investing, 2019. Retrieved from: https://www.morganstanley.com/pub/content/dam/msdotcom/infographics/sustainable-investing/Sustainable_Signals_Individual_Investor_White_Paper_Final.pdf 

[4] Why sustainable investing matters, EY Americas, 2018. Retrieved from: https://go.ey.com/2DGmfWr

The dangers of anchoring in retirement saving

Ever wondered why many restaurants feature lobster or other expensive dishes at the top of their menus? Well one thing is for sure, it’s not a coincidence and the main function of the lobster is not for you to order it but to make other dishes look less expensive. Let me explain.

Anchoring is one of the more well-known behavioural biases in finance and also many seasoned marketers are well aware of it. Anchoring is a form of priming effect whereby initial exposure to a number serves as a reference point or anchor that influences all our later decisions. If that sounded too complicated here is a short example. If you go to a coffee shop and see first on the menu a $4,65 Cinnamon Dolce Latte this serves as an anchor to which you compare prices of all other beverages and all of a sudden that $3,45 Caffee Latte looks like a real bargain. But what would happen if you would not see the initial high anchor of the Cinnamon Dolce Latte, would you still perceive the $3,45 Caffe Latte as a bargain? Probably not. This is why nowadays many bars and restaurants turn the design of their menus in real science and you can read more about it here. Also providers of other goods and services, from mobile operators to tourist agencies, use anchoring extensively to sell us more. 

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But since I write about retirement saving let’s look at anchoring in finance. Nobel laureate Robert Shiller was one of the first to study anchoring in stock exchange trading and found investors are often anchored on the purchase prices of shares that serve as a psychological benchmark for future investment decisions [1]. The anchor price carries a disproportionately high weight in an investors decision-making process and often leads to bad investment outcomes. For example, if you purchased Tesla shares this august for $300, then this price will serve as an anchor for all future sales or purchases of this stock, regardless of how the stock actually performs and how Tesla is operating in reality. All future trades will always be measured to the $300 anchor. Because of this investors tend to hold investments that have lost value, because they hope they will return to the purchase price and by that they are taking on greater risk and blindly chase the purchase price, sometimes even to zero. 

We judge other financial products in a similar way, and if I had the last deposit at a 3% interest rate, I am very disappointed with the deposit offer today, as I still judge all current offers by how much they are lower or higher than the last offer I got. The fact the interest rates plummeted to zero or even negative doesn’t change my sentiment as the anchor effect still follows me.

Can anchoring also hurt my retirement nest egg? 

Unfortunately in many ways. One thing professor Shiller also found out was that besides the so-called quantitative anchoring, which is related to numerical values, we are also influenced by moral anchors which is the influence of intuition and emotions. A nice example of moral anchoring is investing pension savings in shares of the company where you are employed. This is very common in the US, where even today more than half of employees have most of their retirement savings invested in shares of the company where they work and you don’t need a Nobel prize in economics to figure out this is not wise. Shlomo Benartzi and Richard Thaler wrote back in 2007 about employees investing retirement savings in their employer’s stock as an example of poor diversification [2]. This occurs because we feel, when investing in shares of companies where we work, a false sense of security, as we feel we know the company more than others and because of this, we perceive it as a safer investment. Because of moral anchoring a plant worker employed by Ford, will much rather invest his retirement savings in Ford shares than BMW shares or even a diversified portfolio of shares. By doing this 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 retirement savings.  Not to mention investing in only one share is far far more risky than investing in a diversified portfolio.

Anchoring also has a big effect on contribution rates of retirement plans as employees often anchor on the maximum rate matched by the employer, the maximum rate allowed by the plan, or a round number. So for example, if the employer matches contributions up to 4% of employees salary, most employees will also contribute 4%. I see the same pattern in the corporate pension plans we manage in the pension fund I work in Slovenia (Pokojninska družba A) where we manage more than 200 corporate plans and in the plans with an employer match most employees contribute the same amount. To test if individuals are also influenced by anchoring I conducted an empirical analysis of contribution rates of our individual pension plan a few years ago. The analysis included four years of data (N = 5,678) and revealed members chose monthly contributions that were round numbers and multiples of five far more frequently than would be expected by chance. Two levels of contributions in particular (€50 and €100) stood out. The analysis also revealed the power of anchoring as the plan’s minimum monthly contribution of €26.8, which is stated on the entry form, was also among the most frequent contributions. You can read more details about the analysis and round number bias in my article for the Behavioral Scientist Magazine [3].

15 most frequent monthly contributions to the individual pension plan of Pokojninska družba A in 2015. Members who chose annual contribution were excluded as the focus was on monthly levels only.

Minimum contributions will not be enough

Anchoring on the minimum level of contributions is really dangerous as they will just not suffice to build up a big enough retirement nest egg to provide sufficient income in retirement. One quick fix we did in our pension fund right after my analysis, we eliminated from the entry form the caveat where minimum monthly contributions were stated and we designed a special mobile app and web calculator that enabled potential members to calculate how much they should contribute in order to accumulate sufficient assets. This way we established a connection between the level of contributions members pay, to the amount of income they can expect to receive once retired and this gave them a better indication of how much they should contribute and steered them away from anchoring to the minimum amount. 

Defaults to the rescue

Voya Financial, a provider of retirement products in the US where professor Shlomo Benartzi also works as an academic advisor for their Behavioral Finance Institute, experimented with pushing up default contribution rates in their retirement plans and found out pushing default contribution rates on the high side is less likely to generate unintended consequences than erring on the low side. This means, it absolutely makes sense for default rates of corporate plans to be as high as possible and go even into double digits, as they do not scare off employees from saving. More details on how defaults can be used to increase retirement saving in a working paper by Beshears, John et al [4]. 

One also very effective way of getting members off their default contribution rates is automatic escalation of contributions which is quite an old idea, but one still not explored enough. This way contributions rise automatically every year and even if I start with a low level they will be, effortlessly and without any decisions and cognitive effort from me, increase over time to an appropriate level. When mandatory automatic enrollment in corporate retirement plans was introduced in the UK a few years ago it featured a smart policy of automatically increasing contribution rates over time and it worked marvelously as research from NEST Insight shows the increases had no material impact on members and the proportion of members ceasing payments because of it was minimal. 

Defaults can also help against moral anchoring on company stocks mentioned before and retirement plans should have diversified life cycle funds as the default investment choice and this way most members would be saved from investing in risky company stocks. The same can be used in the future to promote ESG investing that could be made the default option in corporate pension plans.

As we see, we can quite quickly and without even noticing it anchor ourselves into bad choices and they can in the end cost us much more than juts paying for that over priced Cinnamon Dolce Latte. Hopefully the retirement industry will be, with the rise of smart decision tools like retirement calculators, advanced online accounts incorporating robo-advisors and personalised recommendations, able to harness anchoring for positive reasons to help people save more for retirement and keep their savings invested in the right way. Until then, we need to be aware of its presence and not be tricked into ordering too many lobsters or overpriced coffee along the way. 

References:

[1] Shiller, R. J.. Irrational exuberance. Princeton, NJ: Princeton University Press, 2015.

[2] Benartzi, Shlomo & Thaler, Richard. Heuristics and Biases in Retirement Savings Behavior. Journal of Economic Perspectives, 21 (3): 81-104, 2007. Retrieved from: https://www.researchgate.net/publication/4981794_Heuristics_and_Biases_in_Retirement_Savings_Behavior 

[3] Vižintin, Žiga. Why Five and Not Eight? How Round Number Bias Can Reduce Your Nest Egg. The Behavioral Scientist. Retrieved from:  https://behavioralscientist.org/five-not-eight-round-number-bias-can-reduce-nest-egg/ 

[4] Beshears, John and Benartzi, Shlomo and Mason, Richard and Milkman, Katherine L.. How Do Consumers Respond When Default Options Push the Envelope? 2017. Retrieved from : https://professionals.voya.com/stellent/public/6114876.pdf

(Over)optimistic Millennials and Gen Z wishing an early retirement

According to the latest Vanguard Digital Advisor survey, Millennials and members of the Gen Z generation are planning an early retirement as most of Gen Z (67%) and Millennials (61%) plan to retire before the age 65. Some are even more optimistic, as nearly a third of Gen Z (31%) and nearly a quarter of Millennials (22%) plan to retire before 60. Just to clarify, the survey counts as members of Gen Z people born from 1997 to 2002 and as Millennials all born from 1981 to 1996. More results from the Vanguard survey below [1].

So what’s going on and why would Millennials and Gen Z think they will be able to retire early, as on the other side the legal retirement age, at which employees can start receiving public pension, is increasing all over the globe. In the US the full benefit age is currently 66 years and 2 months for people born in 1955, and it will gradually rise to 67 for those born in 1960 or later. In the UK the state pension age is currently 65 and will gradually increase to 67 by 2028.

Optimism bias

Optimism bias can partly explain the survey results as behavioral and neuroscientists established humans have a natural tendency to overestimate the probability of positive future events and underestimate the probability of negative ones. Here the positive outcome is obviously being able to retire early. 

Nobel Prize-winning economist Angus Deaton explains that one possibility is, that overoptimism is biologically built into human beings as we need to believe that the future is going to be better than today, or else we wouldn’t be as motivated to survive and that optimism bias may be part of the normal healthy brain. Deaton analysed in his National Bureau of Economic Research paper data of 1.7 million individuals across 166 countries from 2006 to 2016 for the Gallup World Poll and found people to be weirdly hopeful about their future [2]. 

Photo by Lynnelle Richardson on Pexels.com

One of the leading neuroscientists researching optimism bias is Tali Sharot. She describes it as a cognitive illusion that developed during our evolution as the answer to another unique human ability of conscious foresight (mental time travel). This ability enables us to think about ourselves in the future and by doing this we can, among other things, also imagine our own death or other bad things. The reasoning goes, optimism bias developed as an answer to this, as without developing positive biases during evolution, we could not function normally every day knowing death is around the corner [3]. For more info on optimism bias you can check out a great TED talk from Tali, where she also shares some fun experiments exposing our over-optimistic outlooks. 

Older workers too optimistic about their ability to work

If young workers are too optimistic about when they will be able to retire, the older workers are influenced by optimism bias in a different way, as most of them overestimate their ability to work.  

The Health and Retirement Study from the Center for Retirement Research at Boston College reveals roughly 37% of those working at age 58, in the end, retired earlier than they were planning [4]. Prudential’s latest study also reveals the similar gap in optimistic outlooks and reality as 51% of retirees in reality retired earlier than planned. Only 23% retired earlier than planned voluntarily, meaning they had enough money saved 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 for a loved one.

Retiring early has a big negative impact on income in retirement, because of lower social security and also lower private savings due to a shorter saving period. The last few years before retirement are important to building our retirement nest egg as they are on average also our top-earning years and losing just one year can influence our quality of life for the whole retirement.

High cost of overoptimism

So our overly optimistic outlook of the future can have dire financial consequences for our retirement and we need to acknowledge this and factor it in our prediction on when we will be able to retire, or on the other side how long we will be able to work. Let’s keep in mind life is not always just about the optimistic scenario and the current pandemic can serve as a grim reminder of this and let’s make calculations also for the pessimistic scenario. This way, we will be good either way.   

References:

[1] A Vanguard Digital Advisor survey. The Vanguard Group, 2020.

[2] Deaton, Angus. What do Self-Reports of Wellbeing Say about Life-Cycle Theory and Policy? NBER Working Paper No. 24369, 2018. 

[3] Sharot, Tali. The optimism Bias – A Tour of the Irrationally Positive Brain. New York, NY, US: Pantheon/Random House, 2012.

[4] Munnell, Alicia H., Sanzenbacher, Geoffrey T. & Rutledge, Matthew S. What causes workers to retire before they plan? Center for Retirement Research at Boston College, 2015.  

Behavioral lessons for the second pension pillar in Slovenia

Existing from 2001, the second pension pillar in Slovenia is represented by private defined contribution retirement plans managed by specialised pension funds and insurance companies. The number of members has been steadily growing and at the end of last year reached 560.722 members, which is the highest number ever. This means the coverage rate is roughly 62 % of all persons in employment, which is a fairly decent rate for a voluntary system. But if we take away members of the civil servants mandatory retirement plan (approx. 235.000) the coverage rate drops to a more sobering 36 %. 

One interesting statistics exposes nicely the power of behavioral biases working against individuals to start saving for retirement, as the vast majority of the second pension pillar members in Slovenia (97%), are enrolled in corporate pension plans financed by their employers and only 3% of members save individually, despite the government’s tax incentives. 

This percentage has been the same for 19 years proving jet agin, tax incentives for retirement saving have a very limited effect and only a very small percentage of employees decide on their own (not by their employer) to start saving for retirement. You can read more on why tax incentives for retirement saving don`t work in my previous blog post

Total assets of pension funds also recorded steady growth and reached 2,62 billion Euros, representing a 12% growth from 2018. Despite the relatively large growth, assets of pension funds as a percentage of GDP remain at around 5% which is low compared to some other emerging Europe countries, as is evident from the chart below based on OECD statistics. The main factor influencing the growth of private retirement assets was the original design of the system and how members were enrolled. In countries like Croatia, Kosovo and Estonia, large assets are mainly thanks to mandatory enrolment in private retirement plans.

After 19 years we can say the second pension pillar in Slovenia reached average coverage rates for a voluntary retirement system and even that is mainly thanks to employer sponsored corporate plans. Tax incentives proved, as in many similar cases, ineffective to generate individual retirement savings. The main challenges for the future remain, how to increase enrolment and contribution rates in order to provide adequate income in retirement for the majority of future retirees, which will be more and more dependent on private pensions.

Where to go next?

Automatic enrollment in retirement plans is a great example of behavioral economics in action, where workers are defaulted into saving, but can always opt out. The United Kingdom is a great example of a successful implementation and employees were automatically enrolled in retirement plans from 2012 onward (first big companies, then medium and down to small), and to date it has helped over 10 million people to start additionally saving for retirement. After 8 years the coverage rate of retirement plans increased from 60 % to 90 % making it a great success. They did not stop at just auto-enrolment, but also contributions of members are auto escalated over the years making sure members will have sufficient assets at retirement. You can find more info on UK`s auto enrolment and the behavioral science behind it in the recent report from Nest Insight.  

Ireland is following and plans to implement by 2022 a defined contribution auto enrolment 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 but you can find some more information on the plans in the report by Mercer

Some US states, like California, Oregon and Illinois, are also following the lead with implementations of state-sponsored 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. What is even better, more and more states are following their lead and the existing plans proved very resilient even to the latest COVID-19 crisis.

Auto enrolment in retirement plans and then auto escalation of contributions proved as a wining combination and I see no reason, why we should not learn from their experiences also in Slovenia and implement the proven lessons from behavioral economics to our retirement plans to increase coverage and assets and by that securing a brighter future for our citizens. With more and more strain on the public first pillar, additional revenue from private retirement plans will in the future not be any more a luxury, but a necessity.      

Saving for retirement with your credit card (Overcoming loss aversion and temporal discounting)

Why would anybody in their right mind pay pension fund contributions in installments with his or her credit card is the question most would ask after reading the title, but if you give me a bit of “credit” I will try to explain the logic. 

Retirement saving is unfortunately plagued with behavioral biases that negatively affect various stages of retirement saving, from why we don’t start saving, to where we invest and how we draw down our savings. Renowned behavioral economists like Shlomo Benartzi, Richard Thaler and Brigitte Madrian, just to name a few, identified many biases in retirement saving more than a decade ago and among the more prevalent are also loss aversion and temporal discounting. 

Loss aversion was described nicely by Kahneman & Tversky with “losses loom larger than gains”, meaning the pain of losing is psychologically more powerful as the pleasure of gaining an equal amount so “it is better to not lose $5 than to find $5”. That is why, when we are faced with paying contributions in a pension fund, we only feel the pain of paying. To make it even worse, we get nothing back in return as the “reward” of retirement saving comes only decades later, when we retire. 

Now we come to the second bias which is temporal discounting. Research shows we value more present rewards than future ones. If the reward is very distant in the future our perceived value of it goes towards zero. If we promise someone to save for 40 years and after that you will have a $400.000 pension pot, the 40 years of temporal distance reduces the psychological value of the savings close to zero. 

So what can we do about it?

In the pension fund I work in (Pokojninska družba A, Inc.), we experimented with a surprising solution that comes in a form of a Diners Club credit card that enables payment of various goods in up to 12 installments. Most people use Diners Club cards, or any other credit cards, to purchase in installments a new sofa or a new ultra HD television, but we decided to use instalments in another way. As in most countries, the government in Slovenia also incentivizes private retirement savings with special tax incentives. If you save on your own the contributions reduce your income tax base and you get part of the contributions back the next year. For example, if you pay annually €2.000 and are in the highest tax bracket, you get refunded €1.000. Not bad, right. The catch is, you have to pay contributions until the end of December in order to lower your income tax for the current year. 

The challenge

Many people don`t pay contributions regularly during the year and would then like to pay all of them in December, which is also a month that is “heavy” on the wallet with expenses for Christmas and New Year`s. Every year I had many talks with clients, who would like to pay their annual contributions, but were running low on cash because of gifts and in the end they missed the payment and by January all was forgotten. The story repeated every year and one day, when I was thinking how we could fix this, it came to me. Why not pay pension fund contributions in several instalments with your credit card in the same way you use it to pay for a new sofa? This way you could still get the tax incentive and lower your income tax, even though you would actually pay contributions in the next year. To test if the theory could be put in practice I called up the Slovene franchise of Diners Club and after their initial surprise we came to the conclusion, that it could work. 

We decided to go for online payments only via our website where anybody can fill in a special web form to first become a member of our individual retirement plan and at the end they have a choice to select online payment of contributions with Diners Club credit card. Once selected they input the annual contribution amount and select the number of installments (limited to 12). Then they are redirected to the payment gateway where they finish the transaction in the same way as buying a new book on Amazon. The whole process takes minutes and the next working day we receive the payment of the whole annual contribution from Diners Club which goes immediately on the individual saving account and also reduces the income tax base of the member. The cost of the payment in instalments is also low and transparent at €1 per installment. 

Photo by Pixabay on Pexels.com

It works

This new payment option addresses the behavioral biases of loss aversion and temporal discounting mentioned before, as it allows people to receive the full tax incentive on the payment and by that giving them some gratification now. Secondly, the pain of paying contributions is pushed into the future and the same temporal discounting is now working for us positively to reduce the pain we feel when making pension fund contributions. There is an added positive effect of instalments which split the annual contribution into smaller amounts thus reducing the pain of paying even more. The whole service is fully digital and someone can complete the whole process with a few clicks, thus simplifying and removing behavioral burdens of retirement saving. We launched the program at the end of 2016 and so far it’s been a great story. In majority, we found people who used this option did not save before for retirement which proves it solved a real practical problem. At the end of last year more than 10 % of all annual individual contributions to our fund were made with credit cards. Increased contributions mean people will have a better retirement because of it and that’s what it’s all about.  

Further Reading & References:

  1. Thaler, Richard & Benartzi, Shlomo. (2007). Heuristics and Biases in Retirement Savings Behavior. Journal of Economic Perspectives. 21. 81-104. 10.1257/jep.21.3.81. https://www.researchgate.net/publication/4981794_Heuristics_and_Biases_in_Retirement_Savings_Behavior
  1. Brigitte Madrian (2018), LESSONS FROM BEHAVIORAL ECONOMICS FOR PROMOTING RETIREMENT INCOME SECURITY, Retirement Research Consortium Annual Conference, Washington DC, August, 2018 http://www.nber.org/2018rrc/slides1/2.5%20-%20Lunch%20Speaker%20-%20Madrian.pdf
  1. Kahneman, Daniel & Tversky, Amos. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263-291. doi:10.2307/1914185
  1. Bickel, W., Odum, A., & Madden, G. (1999). Impulsivity and cigarette smoking: Delay discounting in current, never, and ex-smokers. Psychopharmacology, 146(4),447-454.

Tax incentives for retirement saving don`t work (what does?)

Most countries, if not all, encourage saving for retirement by taxing retirement savings in private pension plans more favourably than savings in alternative vehicles. The goal is to increase how many people save for retirement and how much they save and with that enable them a better life in retirement. 

Most countries apply a variant of the “Exempt-Exempt-Taxed” (“EET”) regime to retirement savings, where both contributions and returns on investment are exempted from taxation while benefits are treated as taxable income upon withdrawal. There are also other regimes (EEE, TTE, …), but I won’t bore you with them. The main question remains, do tax incentives actually increase retirement savings and at what cost?

Do they work? Not really.

There is a growing body of literature confirming the effect of tax incentives on retirement savings is very limited and also very expensive. According to John Friedman, retirement saving incentives in the US reduced in 2016 the government revenue by $180 billion, which is just over 5 percent of the total federal tax revenue. He finds tax subsidies for retirement saving have a limited effect on how much households actually save and that an increase in savings is in most cases attributed to shifting assets from taxable accounts to retirement accounts, which does not increase the total savings rates, as incentives largely benefit wealthy households who would save anyway. 

A very vivid example of how tax incentives have a limited effect on retirement saving is my home country of Slovenia, whereas in most countries, the government incentivizes private retirement saving. If you save on your own the contributions reduce your income tax base and you get part of the contributions back the next year. For example, if you invest in a pension fund annually €2.000 and are in the highest tax bracket, you get refunded €1.000. Not bad, right and for sure lots of people take advantage of this fantastic tax incentive. Not really, as approximately only 2% of all employees in Slovenia have individual retirement plan. For sure the tax incentive is not the only one to blame for this low number, but it also clearly demonstrates that in the last 19 years, that the tax incentive exists, it convinced almost no one and the percentage of savers did not change over time. You can read more on private pension plans in Slovenia in my LinkedIN article.   

The same findings are confirmed by a large sample study from Denmark that finds tax incentives for retirement accounts, which rely upon individuals to take an action to raise savings, mainly induce individuals to shift assets from taxable to retirement accounts. They estimated that fewer than 20 percent of people respond to changes to tax incentives and that each $1 of government expenditure on incentives increases total saving by only 1 cent. On the other side they find policies that raise retirement contributions if individuals take no action – such as automatic employer contributions to retirement accounts – increase savings rates substantially. Automatic contribution policies also have lower fiscal costs, generate relatively little crowd-out, and have the largest impacts on individuals who are paying the least attention to saving for retirement.

What works?

Automatic enrolment in retirement saving is a great example of behavioral economics in action, where workers are defaulted into saving, but can always opt out. The United Kingdom is a great example of a successful implementation of automatic enrolment in retirement plans which was phased in from 2012, and now after 8 years it is still going strong with opt-out rates of only 9 percent. To date it has helped over 10 million people to start saving for retirement making it a great success. 

Some US states are also following the lead with implementations of state-sponsored retirement savings plans in which employees are automatically enrolled. Oregon’s plan called OregonSaves began in 2017, Illinois began its programme in 2018 and California started its  CalSavers programme at the end of 2018. Even better, more and more states are following their lead. Results so far from all the state plans are very encouraging and many new employees are now covered by retirement plans making a huge impact on their future life quality, showing jet again it’s not about tax incentives, but about designing smart retirement plans incorporating the latest findings from behavioral economics and with the help of modern information technology sky is the limit.