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Will new pension rules lead to less saving?

Behavioural economics presents interesting and deep-rooted lessons for us to learn as we make sense of the brave new world in pensions, paved by George Osborne in March’s Budget

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.

Choice architecture

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).

Aston 1

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. 

Aston-2

Tipping point

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.

Collective awareness

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

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Comments

There are 3 comments at the moment, we would love to hear your opinion too.

  1. I recall what was, for me, a most compelling graphic representation by Allied Dunbar on the perils of not saving for retirement. The horizontal axis was age (20 to 65) and the vertical axis was income level. I’m not normally a fan of multi-coloured graphs and charts. They look impressive but, unless kept ultra-simple, I really wonder if they make any lasting impression. Allied Dunbar’s graph had just two lines, each a different colour. One showed the progress in income throughout life without saving, peaking some time in middle age, then levelling off and, at retirement, with perhaps 25 years ahead, it fell to the bottom of a cliff. The other, allowing for regular saving for retirement, showed an only slightly lower level of income throughout one’s working life but, as you’d expect, the downward lurch at retirement was vastly less dramatic. Which line would you wish your income throughout the rest of your life to follow, Mr Client? Anyone choosing the first line would need their head seeing to, it was as simple as that.

    The other ad I recall was just two pictures. The left hand picture showed a retired couple lounging on the deck of a yacht with a glass of wine in some sunny place, whilst the one on the right showed a couple sat on deckchairs under a cloudy sky in the lee of a canvas windbreak on an empty, windswept beach lapped by a grey North Sea, probably somewhere like the north east coast of England. In the latter picture, the man was wearing a cheap suit and a stuffy little bowler hat. Which sort of retirement would you like to be able to look forward to, Mr Client? Anyone choosing the picture on the right would need their head seeing to.

    Yet, by putting off taking action (or perhaps not bothering at all), people are passively choosing the poor pensioners option. Why? In part, it’s probably due to a combination of endless prejudicial government meddling with the pensions framework, the drag on performance of heavy charges and low annuity rates. To its credit, the government is tackling the latter two but, I suggest, a lot of it too is due to the current government having failed to initiate a major public awareness campaign of the perils of doing nothing. Plus not stamping definitively on rumours about abolition of the 25% tax free lump sum option at retirement, not restoring ancillaries such as Contributions Protection Insurance, not restoring the facility to include life cover as part of a PP and allowing prats like Steve Webb to talk about cutting tax relief. Enhanced tax relief for basic rate payers just isn’t going to happen.

    Stakeholder charges have hardly helped either ~ where’s the incentive for intermediaries to sell PP’s any more? The idea that beating out of PP’s all margins for profit and advice would lead to people buying on their own initiative has been proven to be completely erroneous and has probably done more harm than good. Yet, despite all that, civil servants, with their comfy index-linked final salary pension schemes, refuse to accept this fundamental reality.

    Meanwhile, the FCA’s new rules on PP projections have done yet more damage to public confidence. It’s one thing to avoid painting an unrealistically rosy picture of what the future may hold, but quite another to force providers to paint such a dispiriting one that those who bother to read them will think to themselves This just isn’t worth carrying on with.

    Penury in old age is a common terror that the government should be seeking to exploit. Are you content with the prospect of being poor in retirement? Of course you’re not ~ so what’s your plan to make sure it doesn’t happen to you? You haven’t got one? Why aren’t you talking to a financial adviser? Can you afford not to save for your retirement?

    AE RS schemes will make a bit of difference but, let’s be honest, not a massive one. What significant difference will a pension fund of £40,000 in 20 years time make? Very little. People need active encouragement to contribute more from their own resources, not just AE into a compulsory employer-sponsored scheme that they probably don’t understand and therefore don’t appreciate.

    Contrary to what some people might have us believe, saving for retirement can never be sexy or even really interesting, but a list of all the benefits of a radically reformed and improved pensions framework and the consequences of inaction might at least encourage people to give it fresh and more positive consideration. To hell with behavioural economics. People aren’t saving because pensions have had so much bad press for so long, and the reasons for all that bad press need to be tackled in a way with which ordinary people can engage. George Osborne’s big announcement back in March was the first of what should be a series of cut-the-crap new government initiatives. Anything less just isn’t going to engender the sea-change in public thinking on the subject that’s so desperately required.

  2. @ Julian – an excellent argument for making pension contributions without any tax incentives compulsory.
    No one has the right to be poor in old age – and then expect me to feed them. Pensions should be seen for what they ought to be – compulsory savings to provide an income sufficient to live on in old age.

  3. .1. A pension is (and should not) be the only retirement provision.
    2. If the average pot is below £50k this is a complete waste of time.
    3. The constant tinkering and reneging is a distinct disincentive.
    4. Those that can afford to build up a decent pot should be given every incentive and not have changes to their planning every Tuesday.
    5. If there is a problem with the less well- off saving for retirement (which seems to be manifest) then it is up to the State to increase taxes and pay a decent retirement income to those who have worked and paid tax into the system.
    6. There needs to be a distinct disincentive for those who don’t build enough tax credit and don’t save either. (With appropriate arrangements for those with a legitimate (and carefully examined) reason for nor fulfilling either of those requirements)

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