New research from Cass Business School's Pensions Institute suggests clued-up defined contribution (DC) pension savers would be best served by avoiding saving for their retirement until the age of 35 as well as continuing a high-risk approach of holding equities after retirement
Intriguingly, other research recently released by the business school indicates that pension funds could please their savers by moving out of high-risk equity assets as soon as their pension pot begins to grow too quickly.
The novel suggestions have emerged as part of an attempt to analyse DC investment strategies under the developing discipline of behavioural economics. This seeks to challenge the assumption -which has been the foundation of economic modelling for decades - that individuals always act 'rationally' by looking to maximise their personal financial returns.
It is suggested that a completely rational DC saver would not put a penny into their pension pot before the age of 35 as they would be better of investing in their 'human capital' by spending money on holidays and cars, for example.
Professor David Blake, who led the Cass Business School research, told Pension Funds Insider "When you are young, your income is low, but you recognise that it will be much higher when you are older, so it is optimal for you to spend whatever you have. Any saving you do will be short term in nature, such as saving up for your next summer holiday."
The optimal approach also recommends a 100% initial equity investment and the retention of equity holdings after reaching retirement as phased annuities are taken.
Reality bites
The rational saving model relies on a steep increase in pension saving between the ages of 35 to 55, up to a sizeable 30-35% of salary to compensate for the absence of savings when you are young. Nevertheless, Blake concedes that "very few people would have the willpower to maintain this very high savings rate."
Blake explained: "Our analysis of the ideal rational strategy assumes you are a highly proficient life cycle financial planner who has all the skills to work out the optimal strategy yourself. The percentage of the population which has those skills is actually quite small."
The second paper issued by the Pensions Institute team looks at which DC strategies are most suited to a very different hypothetical saver, with a high level of loss aversion. The researchers have concluded that these fretful savers would be logically ideally suited to a target-driven investment strategy, where funds go equity heavy if they are below a savings target and switch into low-risk bonds if they are above target.
Blake says that the wildly differing investment strategies followed by DC pension savers shows that they a diverse bunch. He adds that "pension plan designers have to look carefully at the kind of people that are joining their schemes. There are those members who focus on long-term retirement outcomes and others who monitor their portfolios too frequently and panic every time they make a loss. It's important for providers to recognise the difference between the latter group of 'human' investors who suffer from a behavioural bias called loss aversion and the former group of rationally-driven 'econs' - to use the terminology from the (influential behavioural studies) book Nudge".
Nudge describes 'econs' as ideal rational human beings, who economists have rather unrealistically assumed for decades always look to make optimal economic choices and rarely act impulsively. The book believes that people should be subtly encouraged to make rational choices by making the best choice the easiest option.
Next year's introduction of auto-enrolment in workplace pensions also relates to behavioural economics. The reforms are an example of the 'nudge economics' that the book promotes, and of which UK Prime Minister David Cameron is a self-confessed fan.
Blake advises, as a result of the research, that a single default fund should not be seen as a catch-all option for all DC savers.
"When it comes to the optimal investment strategy for a DC pension plan, three factors – salary profile, attitude to risk and personal discount rate – need to be taken into consideration," he says.
"These factors vary too much from person to person for one default fund to fit all circumstances. But 'humans' do need to be nudged towards the investment strategy most suitable for their personal characteristics and away from one that overtrades their portfolio in a forlorn attempt to avoid short term losses."
The latest research builds on a growing amount of insight into savings behaviour as the increasing switch to DC pensions places risk on employees rather than employers to save for satisfactory retirement outcomes. The government-backed NEST retirement scheme is basing its default investing strategies on research that states its target group of young low-income earners "is largely loss averse and exploratory research suggests that responses to investment loss are likely to be negative and strongly emotional."
06.09.2011
dbillingham@wilmington.co.uk
