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Behavioural finance does just that: by stepping in to understand the retirement problem. Exploring consumers' self-control, how they handle choices and fret about losses, it provides fresh insights to help investors ensure a more comfortable retirement. Such findings are valuable as South Africa embarks on its retirement reform process.
It's your problem
Not only are saving rates in the Western world falling to new lows but people are also living much longer. In addition, the rapidly growing demographic burden on social spending is leading governments to dilute retirement provision. Increasingly, initiatives developed in response are placing more emphasis on the individual to save, such as British personal accounts or US 401(k) plans.
That leaves investors to make key retirement investment decisions themselves: entry into DC schemes, how much to save and how to save. So what are the barriers to doing what you know you should be doing?
Behavioural finance looks at what prevents us "normal" human beings from being the "Rational Economic Man" expected by economics textbooks. What motivates us to make our financial choices?
Chocolate or bananas? Our self-control
Given the amount of education concerning the need to save, just how well are we doing it? Behavioural finance theorists explain it in terms of poor self-control.
Read and Van Leeuwen (1998) observed inconsistency about good intentions in their chocolate or banana study. When asked for their snack preference a week before the event, people choose much healthier options then, than what they finally selected. (See graph). That could be applied to savings: we plan to save but do little when faced with the prospect of consumption.
Choi et al found exactly that in their studies in the US retirement space. Two-thirds of the participants observed that their savings rate was too low - but just 14% acted to save more. That's a substantial hurdle for personal retirement provision.
Self-control also comes into the poor preservation of retirement benefits in SA. As we're changing jobs with more frequency we need to have more discipline not to cash in our retirement benefits - an issue that retirement reform is likely to address.
Overwhelming choice
While we live in a consumer paradise with hordes of options, the freedom can be overwhelming for investors choosing funds in their DC schemes. Iyengar, Huberman, Jiang (2004) found that extensive fund choice can decrease participation rates in schemes.
In addition, large numbers of funds on offer also affected investment strategy.
They saw increased conservatism as the number of fund choices grew, with more allocations to cash and bonds. That suggests when it comes to pension fund choice, less is more.
No regrets
Herding isn't only found amongst investment managers. In Britain, default funds are the prevalent option in most funds and 89% of people stick with that choice.
That's not surprising, given the concept of regret risk. People don't want the pain of going against the grain and then getting it wrong. Especially as we feel the pain of losses twice as much as the thrill of gains.
That's a problem in cases where the default fund isn't appropriately structured (such as in cash) or where a default option is offered on the basis of cost rather than on solid investment grounds.
Loss aversion studies show investors make decisions based on changes in wealth and not necessarily absolutes. The website retirement calculators that show "the scary number" (see www.six-steps.org) needed for retirement can too easily shock investors into ostrich behaviour. Being more educated or forewarned doesn't guarantee wisdom.
Just think about the bananas and chocolates study.
Good, better, best - improving retirement practice
HSBC found when studying global retirement attitudes that individuals want help to save and they favour the option of enforced additional private savings. Retirement reform should take into account human behaviour to maximise the success of the final outcome.
Retirement planners should focus on turning the weaknesses uncovered by behavioural finance into strengths to maximise benefits:
Get me started... and keep me going
Auto-enrolment is the antidote to poor self-control when it comes to retirement savings. It means that savers are automatically added to an available fund and they have to choose to opt out.
That's very successful at getting more people saving and the SA retirement reform process is looking to adopt that valuable technique.
Auto-increases are another technique to help savers and their behaviour. The affordability challenge of residential property is taking precedence for younger savers. A technique used in the US is to start auto-enrol savers at a low savings rate but then have a planned increase in the contribution rate over time.
When you get an annual salary increase, then the contribution rate to retirement is increased. The advantage is that you still see your after-tax earnings increase and you can feel smug that you've put some capital away for later.
Keep the investment choices simple
We now know the dangers of too much choice. Retirement funds should be looking at how they present investment options and consider rationalising the list of available funds for investors.
Some funds use the technique of tiering options - a smaller list of options is initially presented but there are tiers below with more flexibility. That allows the minority who do want more active involvement to dig deeper without negatively overwhelming the majority of investors.
Do the investments for me
Retirement isn't a priority in people's lives, despite the potential of being their second biggest asset after their house. Therefore, retirement products should have embedded advice in them to make it easier. That explains the surge in balanced multi-asset investment funds, like balanced and absolute return funds.
Also rapidly rising in popularity overseas are target date funds. You choose a fund closest to your retirement date - eg, Fund 2030 - and leave the asset manager to dynamically manage the asset allocation over time. The funds move to more protection as you near retirement.
Be bolder if younger
The availability of retirement investment information is breeding inappropriate conservatism. Investors must combat loss aversion fears and think in terms of when they'll retire. Flying in a fighter jet versus a microlight may take you further but it will be a more dramatic flight path.
Expect and appreciate the volatility of equities.
The absolute return fund craze is fine for those near retirement needing capital protection, but those in their forties - 20 years from retirement - may be taking too much risk off the table. The implicit costs to guarantees must be recognised, so retirement designers must guard against playing it too safe.
Conclusion
The actions of the individual are at the heart of future retirement success. Retirement reform needs to consider thoughtfully how to maximise potential and design should combat poor self-control through auto-enrolment and auto-increases.
Funds must have well-considered amounts of choice to balance freedom and avoid consumer vertigo. Investment funds that take charge with embedded advice need to be part of the solution.
Being on our best behaviour can ensure a brighter future... with enough chocolate to go around.
REFERENCES
* Choi, Laibson, Madrian, Metrick (2001): "Defined Contributions: Plan Rules, Participant decisions and the Path of Least Resistance" (working paper).
* HSBC (2006): The Future of Retirement (Global survey).
* Iyengar, Huberman, Jiang (2004): "How Much Choice is Too Much? Contributions to 401 (k) Retirement Plans."
* Read and Van Leeuwen (1998): "Predicting Hunger: The Effects of Appetite and Delay on Choice"; Organizational behaviour and human decision processes Vol 76, No 2.
Michael Streatfield
STREATFIELD is a strategist at Investec Asset Management responsible for assisting the MD with leadership and business strategy issues. He previously headed the marketing division at Investec Asset Management, primarily involved in investment marketing and product development for the institutional and personal investment businesses.
