Solving the right problem

We are told to be solutions oriented instead of pointing out problems. This probably explains why there are so many ‘solutions’ out there desperately searching for a ‘problem’. Einstein said that if he had one hour to solve a problem, he would spend 55 minutes defining the problem and 5 minutes solving it routinely.

The pensions and savings industry is clearly solutions oriented, offering products that solve most real and hypothetical problems. The latest set of solutions aim at solving the retirement challenge – transforming someone’s pension savings into an income. It seems like we, the industry, is spending 5 minutes routinely defining the problem and then spend the remaining 55 minutes developing potential solutions. So, let’s take a step back and think about what is the right problem to solve?

Defining the retirement problem

The knee jerk reaction by many in the industry is to advocate for a retirement default solution. Their ‘evidence’ is that a default worked well for the savings phase helping unengaged people to save, so therefore we need a default solution for retirement, since people will not engage. This seemingly plausible ‘evidence’ is followed by the bold statement - that their preferred solution should be the default. This is clearly the case of a solution, looking for a problem. The savings problem and the spending problem are two fundamentally different problems. What made the savings phase easy, makes decumulation difficult. Intuitively, it doesn’t make sense to have the same approach to both.

From a pension savings perspective, all young individuals are the same. Their future is still an unwritten book; privately, socially and career wise. We simply do not know what they will need in retirement. The no-regret advice is: contribute as much as you can and take investment risk to earn compounding returns. Almost everyone agrees that this is the ‘right thing’ to do and therefore it is natural to address the disengagement (inertia) by auto-enrolling people into a default investment solution. This is the solid foundation for Auto Enrolment in the UK and for mandatory participation in Australia.

Closer to retirement, there is much more clarity of what we will have at retirement and what we will need in retirement. Since it is not universally clear what the ‘right’ solution is for everyone, it is not straight forward to determine a default post-retirement solution. For example, we don’t know if a member will opt for part-time retirement unless they tell us. At retirement, members are keen on getting their money, so we don’t need to solve ?a procrastination problem. Instead, individuals near retirement face a daunting information and choice challenge which causes decision paralysis.

Choice architecture, not default

Pensions have earned a reputation for being chronically complicated and most members feel overwhelmed by the different choices they are facing at retirement. This is understandable. Just think of the interconnectivity between different retirement solutions, the ever changing tax code and means tested benefits. It is not the members fault that they need advice and guidance, it is a symptom of a badly integrated system that has emerged from incrementally adding quick-fixes and work-arounds for specific groups. I think the main goal for public policy should be to design an integrated system, where members do not need to take advice in order to make head or tail of their individual situation.

If members do not respond to ‘wake-up communication’ from their provider(s), I suggest that the default option should be to remain invested in the balanced portfolio at the end of the DC investment lifecycle. This could be seen as a holding pattern, keeping all doors open until the member decides what to do with their savings. Forcing members into a pay-out solution just because they do not respond to their providers communication, surely cannot be in the members best interest. The member might be living off savings that has another tax status or be working part time.

When members do interact with their provider(s), there should be a choice architecture that help members to navigate a limited set of meaningful choices. For a trust based scheme, this could be done by offering a guided path towards a solution that does the job for most members in the scheme. Such guided paths should help the member to determine a realistic cashflow profile given their current savings. The investment trade-off between earning the risk premium and income stability could be made by the trustees. For members, who’s needs are not fulfilled by the guided path, other understandable alternatives should be made available.

Nudge for good

The framing of the choice architecture should be done in the best interest of the members, which is not necessarily the same as the provider's best interest. Thaler and Sunstein captured this dilemma by the calling it ‘nudge for good’. To develop a good choice architecture for members, it is useful to reflect over the choices that members need to consider at retirement. If we scale away all technicalities, what remains is one question and two trade-offs.

First the member needs to ask themselves; how do I want to spend my pension savings for the rest of my life? Only the member can address this question based on their personal situation. Second, there is a trade-off between affordability and income stability. By taking investment risk during retirement, the member can, in expectation, get a higher income, but the downside is a more volatile income and that the member can end up getting a lower income than expected. Finally, there is a trade-off between adaptability and earning mortality gains. Pooling longevity risk provides the member with a life-long income, but it is an irreversible decision.

This is my attempt to define the problem rather than discussing the solutions. The problem we need to solve is: How to design a choice architecture that help members find a solution that meet their individual needs? How can we do that without turning our members into technical and legal experts?

?

PS For my next blog, it will introduce a framework, based on these questions/trade-offs, that will help explaining and classifying solutions that are frequently proposed for solving the decumulation problem.