The Government and FCA must tread a fine line in using behavioural nudges to encourage consumer engagement with financial services, experts warn.
The UK Government has been a vocal champion of nudge theory, with Prime Minister David Cameron setting up a behavioural insights team which aims to influence public behaviour within months of coming into office in 2010.
The “nudge unit” claims to have saved the Government hundreds of millions of pounds and is now exporting knowledge to other governments around the world.
The pension freedoms announced in the Budget, however, are about as far away from a nudge towards good behaviour as it is possible to get. Instead, the reforms trust consumers to make the right choices when accessing their cash at retirement.
The reforms may be underpinned by a major nudge – the guidance guarantee – but with a Legal & General pilot of the service seeing take-up of just 2.5 per cent, this could fail spectacularly to prevent poor outcomes.
The nudge unit is currently looking at ways to boost take-up of the guidance guarantee, while Barclays is running similar tests. The nudge unit is also understood to be assessing how a “pension passport” could improve decision making at retirement.
Royal London chief executive Phil Loney, who is working with policymakers to test different approaches, says: “The kind of things to be considered are who should the guidance letter come from, the Government or the provider, and should it be an add-on to the existing six-month wake up packs or a standalone communication?
“Another idea we are looking at is whether the letter should give consumers a date and time for their guidance slot, or invite them to make an appointment.”
The tight timescales of the reforms mean testing and implementing these approaches will be a challenge, however.
Hargreaves Lansdown head of pensions research Tom McPhail says: “When and how people access the guidance is something we are only just getting to grips with.
“Pre-booking of appointments and the timing of communications needs to be thoroughly tested. It might be another year or two before we get a clear sense of what the best strategies are to maximise the take-up and impact of guidance.”
Experts argue a further wave of auto-enrolment nudges are needed to ensure the initiative is a success.
Currently, minimum auto-enrolment contributions are set at 1 per cent from the employer and 1 per cent from the employee.
From October 2018 the minimum employer contribution will rise to 3 per cent, with 4 per cent paid by the employee and the remaining 1 per cent coming through tax relief.
Independent regulatory consultant Richard Hobbs says: “Steve Webb would have us believe young people saving 8 per cent of their pay will somehow reduce the savings gap. When you think the accrual rate on a DB pension is about 28 per cent, clearly that is not going to work.
“The risk with auto-enrolment and Nest is they create a false sense of security.”
Barclays head of behavioural finance Greg Davies says: “My concern is that when you do something for people you give them an excuse not to engage with it further. So people think ‘the Government has thought about this for me and I don’t need to do anything’.”
Earlier this year, pensions minister Webb said the next Government will need to address the “8 per cent question” as current contribution levels are “not enough” to deliver sustainable retirement incomes.
Hobbs says: “What officials and ministers say privately is that current contribution levels are just a start, and in due course they will go up.
“But it is difficult to see where the Government will go next, not least because we do not know who will be in power in May.
“Cameron’s closest advisers appear to be big fans of behavioural economics, but it does not follow that other people are and if Cameron is not in Number 10 next May it is hard to see how the next incumbents will deal with what is actually a colossal mess.”
But Cicero Group director Iain Anderson argues nudge theory will continue to be a “cornerstone” of pensions and savings policy beyond the general election.
He says: “Regardless of what happens in May, the principles of behavioural economics are embedded across all parties. Listening to the Labour frontbench, they understand behavioural economics and I don’t think they would go back on it.
“The most likely outcome in May is another coalition, and if that is formed by Labour and the Liberal Democrats then action on contribution levels looks likely.”
A Department for Work and Pensions spokesman says: “We are concentrating on rolling out auto-enrolment which will take until 2018. We need to get to that point before we start thinking about how to take it further.”
So what options does the Government have to close the gap between current contributions and sufficient retirement incomes?
Save More Tomorrow, a concept pioneered in the US by behavioural academics, is one option. It requires employees to sign up in advance to increase their pension contribution each time they get a pay rise, and has been lauded as a success.
Davies says this is more likely to be effective than increasing contribution rates across the board because if an employee’s contribution is raised without them receiving a pay increase, they may be tempted to opt out.
He says: “With individually-targeted escalation you never have the psychological pain of seeing your pay go down.”
Others, however, argue Save More Tomorrow is unlikely to succeed in the UK while wage growth remains stagnant.
Lydia Fearn, investment consultant at Barclays Corporate and Employer Solutions, says: “Save More Tomorrow has been tried and tested, but the problem at the moment is the lack of pay rises across the UK. If you overlay that with the auto-enrolment escalations already planned, this could lead to pay cuts in real terms.”
Another option is for employers to encourage staff to increase contributions through better engagement and education.
McPhail says: “Automatic escalation is another behavioural nudge that could be used, but policymakers must recognise that nudges cannot take us the whole way – we need better engagement and communications.”
Fearn says employers need to give employees continued guidance in creating a financial plan, rather than taking a “light touch” approach until retirement.
She says: “We suggest employers have regular touch points with employees, which can take the form of group sessions, a web portal or behavioural interventions such as personalised emails. Our research has shown members would like information from their employer on what retirement income they should aim for and what contributions they need to achieve that.
“Another initiative is “people like me”, which shows members what people in a similar situation are contributing to their pension.”
Fearn adds that as well as increasing contributions, investment strategy will be a key next step for auto-enrolment.
She says: “Typically members do not engage with investments but the reforms next April mean they will have to, and employers will be key in giving a framework to devise an investment strategy. As pot sizes grow the need for that will increase.”
Earlier this year, chief executive Martin Wheatley said behavioural economics is quickly becoming a game changer “for the shape of regulation”, as well as for firms and consumers.
The FCA has a behavioural economics team which analyses consumer and firm behaviour and feeds into the regulator’s policy and actions.
The regulator has already used trials to help firms increase response rates to customer communications by adjusting the layout and content of letters.
Speaking to Money Marketing, FCA chief economist Peter Andrews says the behavioural economics team is working on a number of projects, including exploring the extent to which people understand structured deposits.
He says: “This may provide some evidence on whether better disclosure can help consumers when products are complex. We are also running a field trial with a firm to find out whether a well-timed reminder letter or other kind of communication changes consumer behaviour in relation to a decrease in their savings account interest rate.”
Andrews says the major challenges for regulation include consumer inertia and market complexity and argues many firms seek to “exploit” behavioural biases.
He says: “All the evidence shows consumers do not want to engage with finance so there is a lot of inertia.
“US research shows, on average, consumers take less than a second before ticking the terms and conditions box when agreeing to an online contract.
“Over time, firms change the terms of the contract because they know nobody will read it. We see a lot of examples of what can only be described as exploitative business models where firms are taking advantage of behavioural biases.”
He adds: “Our team are effectively analysts and we can make recommendations to the FCA, so our work feeds into its actions.”
Hobbs says it is welcome to see the FCA using behavioural economics, but argues its effectiveness can be difficult to measure.
He says: “The problem with behavioural economics is it is half art, half science. What the regulator needs to do is build up a database of research to establish what does and doesn’t work and then adapt its strategies.
“The obvious areas for its use are disclosure and client communications. At the moment the regulator relies too heavily on classical economics and needs to be more savvy in recognising the actual behaviour of consumers.”
Tom Kean, director, Thameside Financial Planning
It was always pretty clear that you didn’t have to buy an annuity from the pension provider you had saved with, yet people did because they simply do not read financial documents. Trying to tinker with market forces will not work.
Alistair Cunningham, director, Wingate Financial Planning
While auto-enrolment and the pension freedoms may appear to be at opposite ends of the behavioural economics scale, in fact the freedoms act as a behavioural nudge by giving people a reason to save.
Auto-enrolment is a good thing: we need to have nudges and default opt-ins to ensure there is a safety net for people who either cannot or will not engage with the issue themselves.
My concern is when you do something for people you give them an excuse not to engage with it further. Auto-enrolment on its own reduces the incentive for a large proportion of the population to think about their pension provision.
It will increase participation rates but it is not likely to prompt people into more informed decision-making.
We now need to put in place a programme that allows the individual to explore how right or wrong that default solution is for them and how they can improve it. There is an opportunity for employers to educate people about what the default option will deliver and how to fill in the gaps and create something better. We need to move beyond nudge to active engagement.
The escalation built into auto-enrolment is rapid and most employees are unlikely to receive a pay rise of the same level in that time. Many will therefore see their pay reduce, which could lead to greater opt-out rates. Save More Tomorrow, on the other hand, is individually-targeted escalation which means employees will never have the psychological pain of seeing their pay go down.
Auto-enrolment assumes that left to their own devices people will not make the right decision, but the Budget pension reforms make the opposite assumption. I find it astonishing that these two polar opposites of behavioural thinking are being implemented at the same time.
Faced with a multitude of options, people’s natural inclination is to reach for the easiest option which is typically to do nothing. We may be in a situation next April where people let their savings sit in a current account and are not equipped with the tools to make a decision. The guidance service will therefore be crucial.
Greg Davies is head of behavioural finance at Barclays
How Governments around the world are using behavioural economics
US: Save More Tomorrow, which asks employees to commit a proportion of future pay rises to their pension, has increased the average participant’s pension contribution from 3.5 per cent to 13.6 per cent in just three and a half years. It is now offered by more than half of US companies which operate a DC scheme.
UK: The Government’s nudge unit claims to have brought forward the payment of £30m a year in income tax by introducing new reminder letters that informed recipients that more people living in their town or postcode had already paid.
Australia: A Government trial achieved a 27 per cent faster return to work time for injured employees through focusing communications on recovery, and asking employees to make personal commitments to support their return to work e.g. “I will walk for 30 minutes on Mondays and Thursdays.”