PPI’s Op-Ed
By Eduardo Rodriguez Montemayor
Rapidly aging populations are forcing policymakers to rethink pensions. Defined contribution schemes are quickly becoming the norm, but people don’t yet seem ready for them.
Academic evidence from economics and behavioural finance suggest that under many circumstances people may not be ready to take control of retirement savings investment. This is a challenging finding in a context where traditional defined benefit (DB) schemes, (which typically depend on individual salary history and length of service) are waning in favour of defined contribution (DC) schemes, where people can have a say on how to diversify retirement assets and future benefits. Pensions will come to depend on the accumulation of such assets and the returns they get.
The asset allocation decisions made by contributors to pension funds often seem naïve, which raises concerns about DC pension schemes because it is the individual who faces the investment risk (i.e. if the pot loses money, then the person will receive a lower pension). Since the seminal research work by Shlomo Benartzi from UCLA and Richard Thaler from the University of Chicago in the late 1990s, different scientific papers (many focused on the U.S. pension system) show that people’s investment decisions are often driven by rules of thumb or mental accounting. For example, many individuals will follow a “1/n strategy” by dividing their contributions evenly across the different funds offered in the pensions plan. Sometimes asset allocations can be extreme (either 100 percent or zero percent in equities) and there is inertia in asset allocations.
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