Investments - a red herring?

When I mention to friends that I work in pensions, I often get asked for investment advice. To me, it isn’t a surprise that our minds instinctively hone in on investment choice when thinking about pensions. But it that the most relevant member choice?

When talking about risk and pensions, our mind intuitively links that to the volatility of our investments. Hardly anyone bothers to raise an eyebrow over the fact that half of us are going to live longer than the average life expectancy and that a few of us will reach 100 years.

This got me pondering. When it comes to pensions, is investments a red herring that distract our minds from looking closer at more important choices and risks??

The value of choice

Investment choice is important for outcomes, but even portfolio managers and Nobel Prize laureates struggle with this decision. When Harry Markowitz, the father of modern portfolio theory, was asked how he invests his pension savings, he replied that he splits his contributions 50/50 between stocks and bonds. His motivation for that was to reduce his own regret risk, and he then added that he should have computed the historical co-variances of the asset classes and drawn an efficient frontier.

From experience we know that the vast majority of pension savers remain in the default choice for investments. This is not bad since most default investment plans follow a lifecycle strategy. Without having to make an active investment choice we end up holding a reasonable balanced and well-diversified portfolio that de-risks as we approach retirement.

But there are other choices that are more relevant for savers than investments. As individuals, the future is unpredictable when it comes to career, health and longevity, but we do have some influence over it. The simplest way to deal with it is to save more and build up a buffer. This is much more effective than ‘playing’ around with investments. For choices relating to our personal situation, it is helpful to understand the consequences before making a decision. For example choosing phased retirement, working part-time to care for an older relative or taking paternity/maternity leave.

Actuarially rational

The perception of risk is in the eye of the beholder. In my younger years, I knew a guy who was afraid of flying but rode an Italian motorcycle daily. I did not think much about it back then, but looking at the statistics it is fair to say that my friend was not actuarially rational when it came to accessing the mortality risks of the different modes of transport. Actuarially speaking, the biggest risks for members are not the frequent booms and busts in the stock market. But instead the biggest financial ‘risk’ in retirement is not dying and living to 100.

Still when thinking about risk with pensions, most think of the booms and busts of the financial markets. The financial risk is frequently reported as a two standard deviations confidence interval. Based on some strong assumptions this is explained as a 2.5% probability we will experience an investment outcome that is worse than the lower boundary of the confidence interval.

Biometric risks, which are linked to us as individuals, are treated in a much more laissez-faire manner. The consequences of dying before retirement, or facing a severe illness that reduces our ability to work can be mitigated by purchasing an insurance policy. But for those who make it to age 65, the average remining (gender neutral) life expectancy is another 20 years in the UK. By definition it means that 50% of us who reach 65 will live longer than that and that 2.5% will reach an age of at least 98 years…

The mental power of the latest fads

The latest investment fads are usually the talk among investment professionals and extensively covered in media. Also we often hear people talking about their investment success stories, but no-one ever talks about their personal investment failures. The ‘booms and busts’ get unproportionate attention in history books and popular culture. Our minds love a good narrative, even if it turns out to be a red herring, so it is not surprising that many look in the rear view mirror and end up buying high and selling low.

A long-time ago, when working for an insurance company, I had the largely unglamourous task of putting together the strategic investment portfolio based on extensive asset liability modelling study. It was plain vanilla work, where I proposed the long-term strategic portfolio and defined benchmarks for the internal investment teams based on that. In the discussions that followed with the non-executive board members, it was interesting to see how they got highly interested and personally engaged in the very small allocations to hedge funds and alternatives.

Mentally it is not that strange, since those investments represented complex high-octane investment strategies. In practice, the allocations were so small that it had hardly any impact on the overall return. It illustrates that even experienced decision makers, supported by investment professionals, tend to focus their attention on the red herring.

Eyes wide open

Is the focus on investments distracting us from the real choices and risks? In my opinion, the short answer is yes. The mental connection between pensions and investments could be the reason why many pension savers are not engaging with their providers. Investments are often perceived as difficult and frightening and we therefore procrastinate and convince ourselves that it is going to be fine.

So why do we, as an industry, spend all this time and attention on encouraging members to become ‘engaged’ when they most likely will focus on the wrong thing? We cannot change people but, we can change our approach and help people to understand how they can influence their pension outcome by looking beyond the red herring.

Perhaps the solution is to focus more on inertia programmes, such as more enrolment, better contributions, and use inertia to the members’ advantage rather than encouraging members to focus on the red herring in the name of engagement.