If you have ever shared the delight, and not a little frustration, of feeding a small child their dinner, you will know that how the meal is presented influences how much is consumed. Such is the art of presenting the food – as a happy face or, my favourite, the fish finger train replete with cherry tomato wheels – that there are books and websites dedicated to it.
Even for adults, the way choice and information are presented can have a significant influence on the financial decisions we make. Behavioural economics, the study of how humans operate and make decisions based on psychological, cognitive and emotional factors, presents interesting and deep-rooted lessons for us as we make sense of the brave new world in pensions paved by George Osborne in March’s Budget.
As of April 2015, people at retirement will have the freedom and flexibility to take all the money accumulated in their pension and do with it as they wish – once the tax has been paid, of course. Heralded as financial liberation, many commentators have jumped to praise the idea and suggested that, as a consequence of these freedoms, we will all save more for the future. But the opposite outcome is in fact more likely: that by focusing on large lump sums of money for retirement, we will feel less inclined to save.
Lessons learned in behavioural economics illustrate how our hard-earned pensions are presented back to us (“choice architecture”, in academic parlance) matters a great deal when it comes to our saving behaviour. Research from Goldstein, Hershfield & Benartzi (2014) sought to assess how middle-aged people would assess the adequacy of retirement savings when expressed in two different ways: as a lump sum and as equivalent regular monthly payments, having first worked out life expectancies.
Goldstein, Hershfield & Benartzi predicted that the perceived adequacy of a pension would vary depending on how it was presented. They anticipated that savers at lower levels of accumulated funds would be more sensitive to changes in monthly sums (illustrated by the dotted line in Figure 1) than to changes in lump sums (illustrated by the straight line).
So whereas a £50,000 lump sum appears a satisfying amount for someone retiring, the same amount expressed in monthly annuity-style payments spread over an expected lifetime in retirement appears less satisfactory.
This is because monthly payments can be more easily considered alongside our usual monthly outgoings such as utility bills and rent or mortgage payments. As such, it is easier to judge the adequacy (or inadequacy) of the £250 or so a month that a £50,000 pot will give. A person may reasonably judge their £250 a month is not sufficient when they know their mortgage payments alone total £400.
Figure 2 shows the outcome of the research from Goldstein, Hershfield & Benartzi. It illustrates that at lower levels of wealth, people are more concerned about their pension wealth when it is expressed as an annuity – that is, regular monthly income payments – than when presented as a lump sum. As such, they view it as less adequate.
Interestingly, there is a tipping point when pension pots expressed as monthly amounts are viewed as having greater adequacy than their lump sum equivalent. In this study, the figure is around the £200,000 mark – which seems roughly the amount at which most people’s living costs are met when expressed as monthly amounts.
As a consequence of people appraising their pension pots as less adequate when presented in regular monthly amounts, they become inclined to save more. Research by Goda, Manchester & Sojourner (2013) with 17,000 US employees found people presented with projected monthly incomes increased their saving rates more than those who saw projected total accumulations. Therefore, the benefits of increased saving are greater when pensions are presented as monthly amounts.
Framing pensions as lump sums creates what is called an illusion of wealth, which is both a blessing and a curse for annuities. It is a curse because at low levels, annuities do not create an illusion of wealth and therefore are viewed less favourably than taking lump sums. And it is a blessing because by realising how little regular income this wealth generates, we should be more aware of its adequacy or likely inadequacy and therefore inclined to save more for the future. The danger here is that under next year’s new pension rules and freedoms, people will focus on their lump sums as they accumulate and plan retirement.
Providers and advisers need to exercise caution. In a new world where annuities are not the vogue, it will arguably be easier to talk about options and outcomes as lump sums rather than regular monthly incomes. And as there will no longer be a need to take an annuity, this will become easier. But behavioural economics demonstrates that when presented with retirement incomes as lump sums, people become more easily or quickly satisfied and therefore have little impetus to save more.
So while politicians and the pensions sector work through the changes, we must collectively be conscious of creating these illusions of wealth in case we discourage savers with the new freedom and flexibility.
We must be mindful that in presenting the freedoms people can enjoy through the reforms, we do not inadvertently cause illusions of wealth and lead people to believe their level of saving is adequate for retirement when it may not be.
One idea is to continue to present illustrations of how lump sums may look when spread over peoples’ expected lives in retirement.
This is clearly something the industry has done for decades with annuities; it provides meaningful projections and can prompt people to save more.
The Government is seeking to provide one part of the equation by giving people access to tools that will enable them to calculate their likely life expectancy.
So we need a system that demonstrates the reality of lump sums; a system to make sure people know what a lump sum will provide by way of a regular income. Maybe the retirement world is not changing that much after all.
Aston Goodey is sales and marketing director at MGM Advantage