Retirement income review – a behavioural take

How do we deal with people’s behavioural biases when they make complex retirement-related decisions? This was one of the central issues discussed in the recently released Retirement Income Review. In particular, a key problem that addressed by the Review was that retirees might have enough assets to provide an adequate income in retirement but fail to use those assets appropriately. “Retirees are generally reluctant to draw down their savings in retirement” the Review stated, resulting in a lower standard of living than they could otherwise enjoy. So what causes this problem?

Complexity

That complexity is a problem was something the Review was well aware of. It stated up-front that “the retirement income system is complex”, and that “complexity, misconceptions and low financial literacy have resulted in people not adequately planning for their retirement or making the most of their assets when in retirement.” Consistent with this, psychological research demonstrates that when faced with complexity, people are more likely to be impacted by decision-making biases and to use a range of decision-making short-cuts.

Of course, it would be great if we could dramatically simplify the retirement income system, but I’m not holding my breath. Rather, super funds and financial advisers will have to find ways to manage the impact of complexity on their clients/members. Decision-making research provides a number of strategies to achieve this. They include by layering and chunking information, by triaging and filtering it, and by providing checklists and decision-trees. We might not be able to avoid the retirement income system being inherently complex, but we can avoid the client experiencing a lot of the complexity that they are currently confronted with.

Uncertainty

Related to complexity is uncertainty. Not only are there many things to consider, but retirees don’t know how important those things are likely to be. As the Review pointed out, retirees can have concerns about possible future health and aged care costs, and concerns about outliving their savings, for example.

But the Review argued that these concerns were not as important as they might seem. It stated that “while health spending increases as a proportion of overall expenditure for people between ages 55-80, it remains a relatively small share of total expenses in retirement. This is largely due to public expenditure on health absorbing much of the cost of ageing. The same applies for the cost of aged care services.”

And the Aged Pension provides a backstop to cover other risks. “When tested under different assumptions — such as shorter working life, lower wages and lower investment returns — replacement rates are within or above the 65-75 per cent range for most income levels. A major reason that incomes remain adequate under different assumptions is the Age Pension offsetting any resulting reduction in retirement income for middle-income earners.”

Not everyone wants to rely on the Aged Pension, of course. For these retirees, providing guaranteed income products might be part of the solution to mitigate their uncertainty. However, the Review noted that even people with guaranteed incomes fail to draw on their other assets, suggesting that “concern about outliving savings is unlikely the sole driver of current drawdown behaviour.”

Framing

The Review also argued that one of the problems retirees face relates to terminology. When your superannuation is referred to as a ‘nest-egg’ or ‘savings’ the conclusion that you are drawn to is that it shouldn’t be consumed. As any self-respecting bird knows, if you have an egg in your nest you should leave it there and wait for it to hatch, not start to nibble away at it!

This analogous reasoning works well during accumulation phase, but is less appropriate during drawdown. During retirement different terminology should be used to help guide clients and members, terminology focussed more on income and consumption, and less on investments and their balances. Behavioural finance research demonstrates that this type of reframing can significantly impact people’s retirement income choices.

Mental accounting

Related to the ‘nest egg’ problem is how people mentally account for their assets and income. As the review highlights “many people misunderstand the purpose of superannuation, believing that in retirement they should only draw on the return from the investment of their retirement savings and not touch the capital amount. Yet the system is designed on the basis that people should draw down their savings to support them in retirement.”

The problem here is that people mentally account for the income they receive on their investments in a different way to the way they account for the capital value of those same investments. Money in the ‘income’ mental account is psychologically able to be spent, while otherwise equivalent money in the ‘capital’ account is not. This fact reveals why many retirees gravitate to investments that generate income: it’s because it allows them to mentally account for their returns it in a way that gives them psychological permission to spend.

Anchors

Theoretically, when a retiree is told the minimum income they are required to draw, that number should only impact their choices if they would otherwise have chosen an amount below the minimum. However, the minimum can act as an anchor, and this is not how anchors work; anchors often draw people’s decisions towards them, even when they are irrelevant. The Review noted this problem: “research indicates retirees are strongly influenced by the statutory minimum drawdown rules”. That research demonstrated that these minima reduced retiree’s draw-down intentions, reducing their consumption to match.

I can imagine the resultant conversation: “Sorry kids, your grandparents won’t be visiting this Xmas because they have been influenced by a salient anchor in the choice architecture their super fund provided when they chose their pension income, and therefore they believe they can’t afford to make the trip. But the good news is that you should receive a nice inheritance one day!”

Information and education?

So what are the solutions to these problems? The Review toys with the idea that we need to educate people about superannuation, stating that “there is a need to improve understanding of the system”, that improving financial literacy could help, including “educating people that their health and aged care costs are heavily subsidised by the Government”. This intuitively makes sense, and I’m sure many would agree.

However, the Review quickly pivots to the evidence on what improves decisions and outcomes, and what consumers actually want, stating that “limited evidence exists that programs aimed at improving financial literacy are effective”. It also highlighted qualitative research done for a consumer group that “indicated that people did not want to be educated about superannuation; instead, they wanted assistance in making decisions”. Consistent with this, the Review noted that ASIC has switched its focus from ‘financial literacy’ to ‘financial capability’. It’s not what people know that matters, it’s what they do.

This might seem like a subtle difference, but in my experience is an important one. Too much of what the industry does currently is provide education, while too little is designed to help consumers make a decision. They are related concepts but can lead to very different ways of engaging with clients and members. The end outcome should be a good retirement for members, not them walking away with a diploma in superannuation.

Nudges

As a general rule my philosophy is that we shouldn’t try to fight consumers’ decision-making biases; they are too deeply engrained and difficult to overcome. Rather, where possible we should try to align with them. The decision-making biases above give a guide to this. If there is unavoidable complexity then let’s give people simple ‘rules-of-thumb’ or ‘heuristics’ to follow. Ideally these heuristics would be at least somewhat tailored to their individual needs and circumstances, more so if the client is receiving personal advice of course.

And if people are influenced by the terms used to describe their retirement options or cashflows, then let’s use terms that align with their existing mental accounting predilections. And if they’re influenced by theoretically irrelevant anchors and defaults, then let’s create ones that are most likely to suit their needs.

Some of these things super funds can do, some of them financial advisers can do, and some of them legislators and regulators could help with. Hopefully the result is that the kids might be able to see grandma while she can still kick the soccer ball in the back yard!

More information:

• These behaviour finance eLearning modules for financial advisers demonstrates the behavioural strategies advisers can use with clients.
• This article explains how super funds and others will need to incorporate some of these types of concepts into their response to the new DDO requirements.