Transcript Nudges and Networks: How to use behavioural economics to

Nudges and Networks:
How to use behavioural economics to improve the
life cycle savings-consumption balance
Professor David Blake
Director
Pensions Institute
[email protected]
May 2012
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Agenda
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Most people are not rational life cycle financial planners
Identifying behavioural barriers
How behavioural economics can help overcome barriers
Speedometer Plans
How networks can help
How to implement: A life-cycle fund + corporate platform
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Most people are not
rational life cycle financial
planners
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Most people are not rational life cycle financial
planners
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This would require people to accurately forecast:
 Total career income
 Total available retirement resources
 Asset returns
 Interest rates
 Tax rates
 Inflation
 Longevity
 Medical and health costs
It would also require people to have the commitment to start and
maintain a very long-term savings and investment programme
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Identifying behavioural barriers
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What needs to be recognised
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In reality, individual decisions subject to:
 Bounded rationality:
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Bounded self-control:
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Certain types of problems are too complex for individuals to
solve on their own
Many people have a poor sense of the ‘time dimension’ of
their lives
Individuals lack willpower to execute plans
In view of these limits on optimising behaviour, we need to
change our understanding of individual economic decision
making:
 Especially long-term savings decisions

Such as those involved in accumulating and decumulating
assets in a pension plan
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Pre-retirement behavioural barriers
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Starting to save
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Procrastination and inertia are bad for saving:
 Employees fail to join pension plans where they are
required to opt in
Retirement saving means reducing consumption now in order
to have a comfortable income in future:
 Requires self-control - not always easy
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Similar to losing weight or giving up smoking
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How much to save
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It is difficult to know how much to save for retirement
Members may be anchored by irrelevant information
 Default saving rate is 5% - that must be the right rate?
Cognitive polyphasia:
 People can think about the same issue in contradictory
terms in different situations
 ‘I know I should be saving 15% of my income if I want a
good pension’
 ‘I think I will be able to live on much less when I retire, so I
do not need to save as much as I thought, which means I
can spend more today’
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What to invest in
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Most DC members don’t want to choose funds
 90% take-up of default funds
There are many behavioural biases relevant to investment:
 Regret
 Loss aversion
 Mental accounting:
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How people keep track of financial activities
Framing
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‘You are aware equities are risky’
• Leads to ‘reckless conservatism’
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‘You are aware that equities tend to generate higher returns
in the long run, despite short-term volatility’
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What to invest in
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There are many behavioural biases relevant to investment:
 Choice overload/anxiety (problem of complexity):
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Too many investment funds means no decision at all
When faced with difficult choices, individuals often employ
simplifying heuristics (simple rules of thumb)
• E.g., choose default option on grounds that someone
else must have thought that it was good idea
Herding – follow the herd
Weak investment preferences (problem of complexity):
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Individuals can easily be led
Evidence suggests menu design influences fund choice
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When to retire
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Time inconsistency:
 When you are young, you believe that you will be able and
willing to work longer if necessary to compensate for
inadequate pension savings:
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Even if someone tells you that you will probably not feel like
that when you are older
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When you are old, you regret not saving enough, because
you do in fact want to retire earlier
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Another example of the poor understanding of the time
dimension of people’s lives
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At-retirement behavioural barriers
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What retirement income strategy
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Effective retirement saving needs an optimal decumulation
strategy as well as optimal accumulation
Need to deal with:
Human spenders
 Spend too quickly in retirement
Human hoarders or squirrels
 Spend too slowly in retirement
 Wish to guarantee inheritance for their children
Properly designed retirement income strategy can help both
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People have a poor understanding of
longevity risk
% deaths at each age
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Life
expectancy =
86.6
Most likely
age
at death =
90
4
3
2
1
25%
25%
Random
Variation
Risk
Random
Variation
Idiosyncratic risk
Risk
0
65 70 75 80 85 90 95 100 105 110
Age
Expected distribution of deaths: male 85
Most likely age
at death = 86
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% deaths at each age
Expected distribution of deaths: male 65
Life
expectancy =
91.6
9
8
7
6
1 in 3 will reach
93 and 5% will
reach 100
5
4
3
2
Idiosyncratic risk
1
0
85
90
95
Age
100
105
Source: 100% PNMA00 medium cohort 2007
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What retirement income strategy
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Many scheme members dislike the idea of buying an annuity:
 Annuities are perceived as poor value
 This may be because members underestimate how long
they (and their spouse) are likely to live
There are many behavioural biases relevant to decumulation:
 Illusion of control:
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People like to feel in control of their capital but annuitisation
leads to a ‘loss of control’
Framing:
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Expressed using a ‘consumption’ frame, annuities are
desirable
Expressed using an ‘investment’ frame, annuities are risky
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What retirement income strategy
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There are many behavioural biases relevant to decumulation:
 Regret/loss aversion rather than risk aversion:
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‘Annuities are a gamble’
Probability of dying very soon after purchasing annuity is very
low, but this probability is likely to be overestimated:
• So ‘loss’ perceived to be high
• Dying AND losing all your capital too!
Conversely the significant probability of out-living one’s
resources if one doesn’t annuitise is underestimated:
• So ‘gain’ perceived to be low
Hence ‘gain’ to annuitising will give small utility benefit, while
‘loss’ of dying early may have large utility loss
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How behavioural
economics can help
overcome barriers
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Behavioural economics
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Combines economics, finance, psychology and sociology
Recognises:
 Individuals do try to maximise personal welfare
 But limits to the extent they can do this
 Individuals are Humans not Econs and need nudging
towards optimal solutions
Recognises:
 Importance of social norm groups and social networks in
helping individuals improve outcomes:
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‘People like us’
Comes out of the US, so needs to be adapted to other
countries
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Overcoming pre-retirement barriers
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Starting to save
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Behavioural traits have been exploited to design pension
schemes that increase long-term pension savings.
Classic example is Save More Tomorrow (SMT or SmarT)
plan:
 Thaler and Benartzi (2004)
Scheme member agrees to start or increase savings on
regular basis:
 Not now but on future significant date
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E.g., date of next pay rise
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Starting to save
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SMT plans deal with a number of behavioural traits:
 Accept individuals have self-control problems:
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Utilise inertia:
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And benefit from using pre-commitment devices:
• Auto-enrolment with payroll deduction
• Auto-escalation
• Withdrawal restrictions:
– creating psychological and financial barrier to
accessing funds
Since, once signed up, workers typically do not cancel payroll
deduction facility
Uses herding behaviour constructively:
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A worker will join if other workers are joining
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How much to save
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Importance of an appropriate default contribution rate
Contribution matching by employers provides a powerful
incentive
Once enrolled, members tend not to alter contribution rate
 Unless automatic annual increases are in place
 Again exploits inertia positively
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Impact of pre-commitment devices and inertia:
Savings rates in SMT plans
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What to invest in
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To deal with choice overload/anxiety (problem of complexity):
 Have only a small number of investment funds to cover the
range of risk tolerances
 Individuals want to know what a fund does, not what its asset
mix is
To deal with simplifying heuristics:
 Have a well-designed and low cost default fund
To deal with inertia:
 Use lifestyle investment strategies:
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De-risking near retirement is automatic
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Overcoming at-retirement barriers
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What retirement income strategy
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Overcoming the illusion of control:
 ‘All-or-nothing’ annuitisation likely to be suboptimal as well as
undesirable
 Gradually purchasing annuities over time might be better
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Deals with:
• Interest rate risk – hedges interest rate cycle
• Possibility that investment returns might be higher in future
• Possibility that mortality rates might be higher in future
• Possibly long period of retirement and not wanting to be locked
into a low-yielding bond-like investment
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What retirement income strategy
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Overcoming regret/loss aversion:
 Any pooling of mortality needs to be perceived to be fair by the
public
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Currently, this is not true!
At younger ages annuity mortality cross-subsidy or survivor credit
gives poor value to those dying early
Solutions:
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Money-back or capital-protected annuity
Impaired life annuity
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Survivor credit %
It is not a question of IF but WHEN pensioners
should annuitize
30%
25%
20%
15%
10%
5%
0%
Limited value from
annuitization – Death
benefit seen as more
valuable.
Annuitization essential
to provide income for life
Level of survivor credits
65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99
Age
Equities
Bonds / Annuities
Investment split - Equities : Bonds/Annuities
Source: Own analysis; 100% PNMA00 2010 plus improvements in-line with CMI_2009_M [1.00%];
Survivor credit = qx / (1 - qx)
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Death benefits under a money-back annuity
On death any excess of the original purchase price over the gross
annuity payments already received is returned to the annuitant’s estate
£
ACCUMULATED INCOME
DEATH BENEFIT
Accumulated
gross payments
Purchase price
65
67
69
Source: Own calculations 100%
PNMA00 2010 plus improvements
in-line with CMI_2009_M [1.00%]
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73
75
77
79
81
83
85
Age at death
What retirement income strategy
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To deal with framing:
 Pose problem in a way that generates the optimal outcome for
most people
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Talk about the income stream ‘generated’ by the annuity rather than
the ‘loss’ of the lump sum
Explain the annuity in a ‘consumption frame’ (which makes an
annuity look safe) rather than an ‘investment frame’ (which makes
an annuity look risky)
Emphasize risk of living in poverty in old age, rather than giving
up the lump sum
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Studies show people with annuities are happier:
• they can spend their annuity payments knowing they have full
longevity risk protection
• show series of photos of decreasing bundles of goods that can
be purchased due to inflation
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Speedometer Plans
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Spend More Today Safely:
Using Behavioural Economics to Improve
Retirement Expenditure Decisions
David Blake & Tom Boardman
February 2012
(pensions-institute.org/workingpapers/wp1014.pdf)
SPEEDOMETER retirement expenditure plan
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Spending Optimally Throughout Retirement:
 First,
make a plan
 Second, secure 'essential' income
 Third, have insurance and a 'rainy day' fund to cover
contingencies
 Fourth, secure 'adequate' income
 Fifth, achieve a 'desired' standard of living and make
bequests
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A universal plan for all retirees
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First, make a plan
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Either ... by using an on-line or telephone-based service
providing generic financial advice
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Or ... if wealth permits, involving a financial adviser
whose role is to assist with making and implementing
the plan and conducting annual reviews
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Second, secure 'essential' income
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Plan manages all assets and income sources
holistically to secure essential income
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Defined as the minimum, core inflation-protected
income sufficient to meet the retiree’s ‘essential’ needs
for the remainder of their (and their spouse’s) life.
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Third, have insurance and a 'rainy day'
fund to cover contingencies
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Use insurance solutions, when available and cost
effective, to cover contingencies,
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Where appropriate, rely on state support
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Where possible, maintain flexibility by holding sufficient
assets to meet uninsurable shocks (i.e., a ‘rainy day’
fund)
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Fourth, secure 'adequate' income
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Secure an ‘adequate’ level of life-long income above
the minimum if there is sufficient wealth
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‘Adequate’ income defined as that needed to achieve
the minimum lifestyle to which the pensioner aspires in
retirement.
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Fifth, achieve a 'desired' standard of
living and make bequests
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The plan uses a simplified choice architecture for
managing any residual wealth
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Aim of achieving a ‘desired’ standard of living in
retirement, while allowing part of the remaining wealth
to be bequested at a time of the retiree’s choosing.
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How a SPEEDOMETER plan deals with
behavioural traits
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Use of commitment devices and inertia
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Use of defaults
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The plan NOT the member deals with complexity of decumulation
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Use of money-back annuities
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Use of phasing
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Positive norming via effective communication
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The slogan ‘spend more today safely’ to reinforce the idea that
‘buying an annuity is a smart thing to do’.
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The SPEEDOMETER plan involves just
four key behavioural nudges:
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First, make a plan
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Automatic phasing of annuitization
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Capital protection in the form of ‘money-back’ annuities
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The slogan ‘spend more today safely’ to reinforce that
‘buying an annuity is a smart thing to do’.
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How networks can help
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How networks can help
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Now beginning to be recognised that nudging is more effective in
networks:
Employment-based networks are most effective for:
 Encouraging pension savings
 Helping to pay-off debt via pay-roll deduction with payments used
to create positive savings once debt paid off
Social networks:
 Family, friends and neighbours
Internet-based networks
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Daily Dollar - Daily Budgeting Facebook App (facebook.com/LiveSolid)
“brings to life the notion that small lifestyle changes can add up to big
savings.”
publish the results on your profile
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Age-based networks
Age range
Description
Baby Boomers
(1946 – 64)
Gilt Edge Lifestyles
Mid Life Affluence
Modest Mid Years
Advancing Status
Ageing Workers
Generation X
(1965 – 81)
Successful Starts
Happy Housemates
Surviving Singles
On The Breadline
Flourishing Families
Generation Y
(1982 – 95)
Happy Housemates
Surviving Singles
On the Breadline
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Networks based on personality types
Personality type in retirement
Description
Empowered Reinventors (19%)
Can easily adapt to change –
welcome adventure and new
challenges
Carefree Contents (19%)
Optimistic about coping with
change – but do not seek
adventure or new challenges
Uncertain Searchers (22%)
Recognise change could be
fulfilling and satisfying, but still
trying to make sense of change
Worried Strugglers (40%)
Worried, bored or saddened after
the change. Lack of planning and
preparation play a role here
Source: The New Retirement Mindscape (Ameriprise Financial, January 2006)
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How to implement:
A life cycle fund +
corporate platform
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First, get ‘em young
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Savings is a habit that needs to be engendered from a very
early age
Four boxes for pocket money
Immediate spending
(Instant gratification)
Short-term saving
for specific item
(Deferred gratification)
Charity:
Spending on other than self
(Feel good)
Saving for an
unspecified purpose
(Precautionary and long-term savings)
When grown up, this becomes
the rainy day fund and the pension fund
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Life-cycle fund
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Manages savings and loans around key life events:
 Paying off student loans and future debt management
 Tax-efficient short/medium term savings:
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ISA (individual savings account)
Share incentive plans
House purchase
Marriage
Children & school fees
Holidays
Retirement
Inheritance and tax planning
Long-term care
Life/health assurance
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Implemented using (corporate) wealth
management platforms/wraps
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Employer as facilitator:
 Exploiting one of the most effective networks
But how much choice and flexibility should be offered?
Econs like lots of choice and flexibility:
 Many people, especially the young, claim to like choice
and flexibility
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Especially the flexibility to delay starting a long-term pensions
savings programme!
So provide lots of self-selection?
Humans do not really like that much choice and flexibility:
 They like well-designed defaults
 So provide segmented information and products?
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Based on effective client profiling
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Conclusions
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Lessons from behavioural economics
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Assume nothing (or very little)
Design products and marketing strategies with abilities of less
sophisticated, less experienced population in mind:
 guiding choice, choice-editing …
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Wherever possible, work with human biases – not against
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Nudging will help if the product design is good
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Networks can help support and reinforce good individual behaviour
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Well-designed pension plans recognise…
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Need to help both Human Spenders and Human Hoarders
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People need reassurance that it pays to save
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Pension death benefits need to be as generous for annuities
as they are for income drawdown
Phasing into annuitisation may be more acceptable
Annuity products with equity linking might be valuable for
those who are sufficiently risk tolerant
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Better communication and education alone will
not work
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Need good design of default option:
 “Education no substitute for good default”
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David Laibson, Harvard University
Pioneer Investment’s European Colloquia 2007
Because vast majority of individuals will not be able to design their
own retirement income programme:
 Who wants to go into a car show room and be offered a choice
of car kits to self assemble?
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Thank you!
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References
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Mitchell, O, and Utkus, S. (2004) Pension Design & Structure: New
Lessons from Behavioral Finance, Oxford University Press, Oxford
Thaler, R, and Benartzi, S (2004) Save More Tomorrow: Using
Behavioral Economics to Increase Employee Saving, Journal of
Political Economy, 112, S164-S187
Thaler, R, and Sunstein, C (2008) Nudge: Improving Decisions
about Health, Wealth & Happiness, Yale University Press, New
Haven & London
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