Pension boffins like Tom McPhail argue that the defined-contribution pension industry has all the tools it needs to provide good savings schemes for everyone. I fundamentally disagree.
In their current guise, pension schemes are not a solution at all. They need to be redesigned from the bottom up to suit people’s needs rather than being fitted into yesterday’s economic theories and models.
The basic presumption of politicians and the industry is that of the prevailing neoclassical economic model. If given the right choices, rational self-interested humans will make the best choices they can, which will produce the best possible outcomes. People will understand, if politicians and the industry bang on about it, that they need to save more. If this requires spending tens of millions of public money every year on education, it is a necessary part of the process.
The politicians have convinced themselves that by simplifying the choices, they have created the right incentives. Having a flatrate state pension instead of means-tested top-ups that removed incentives to save means people face the choice of saving or being poor in their old age. Surely, that is a no-brainer?
Of course, it is not a no-brainer at all. On the contrary, all the evidence from behavioural finance shows people will not save more even if the choice is that clear. They will not do so because we are hard-wired to hyperbolically discount and hugely overvalue a pound today versus a pound in a decade or two decades’ time.
On top of that, savings decisions require long-term commitment – which we are bad at – and involve complex calculations, which fewer than one in 20 adults are capable of following. Faced with those difficulties, knowing – on the basis of a generalised awareness of bad headlines about pensions over the past decade and more – that pensions are troublesome and problematic, and having a limited amount of time they are prepared to spend on any financial decision, most people will never engage with the pension savings decision. Ever.
We are not talking about the IFA clients here. They are not part of the problem. We are talking about the non-existent mass market for long-term savings schemes of any kind.
Where should we start? First, recognise that big financial decisions are social rather than financial, by which I mean they can and should involve a wide range of people and that people’s decisions are heavily influenced by those of their peer group.
Second, that “unbundling” along DC lines, which multiplies choices, is against the interests of most people because they will make sub-optimal choices as a result of behavioural biases.
Third, that incentives need to be simple and calculable by people with minimal mathematical skills.
The lines of a possible solution then emerge as follows – socialise, mutualise, reward. Socialise means embedding long-term saving in society and directly linking long-term saving to investment in its proper sense, that is, new capital directed to production. Mutualise means building large-scale member-owned institutions to capture economies of scale and build confidence in long-term sustainability and equity. Reward means linking financial incentives to the behaviour – if long-term commitment is what we want, why give all the reward up front in terms of tax relief rather than gearing it to the term of the savings?
Only when we get radical rethinking on these lines will we be heading towards a solution to the long-term savings gap.
Chris Gilchrist is the joint author of The Process of Financial Planning and editor of The IRS Report