Nor does the decision seem to be predicated on members’ assessments of their risk profile. Thaler and Benartzi discovered that when they gave workers an opportunity to choose between their own age/risk-appropriate portfolio and the portfolio of the median participant, 8 out of 10 participants preferred the median portfolio to their own. The implication here is that members have little clear insight or commitment to the investment rationale of their own portfolio. As such, when confronted with the reality that the average member of the fund has a very different portfolio, the preference was clearly to go along with what the rest of the members did – whether this is an appropriate solution or not.2
But we are describing only one of a half dozen behavioural phenomena that are contributing to the most important reality our industry has yet to properly face. In spite of the extensive amount of intellectual capital being applied by investment professionals to identifying the “optimal investment strategy” for accommodating every possible attitude for risk, every possible funding requirement, over every imaginable time-frame, it appears as though the industry is still failing at the most basic step in the process: getting the member into the right solution in the first place – and then getting them to where they need to go over time to address a lifetime of savings requirements and investment concerns.
As Olivia Mitchell and Stephen Utkus summarised the problem in their excellent working paper “Lessons from Behavioral Finance for Retirement Plan Design”: “Behavioral research…challenges some of the most central assumptions of decision-making: that workers are rational, autonomous, microcalculators who exercise independent and unbiased judgment when it comes to their retirement plans.”3
We are only just beginning to appreciate how powerful this force is. Consider this conclusion of the authors, for example. In their estimation, the dominant factor dictating investor decision-making in retirement fund investing appears to be inertia – not a rational process of weighing up the options. Inertia is what keeps members from signing up for plans in the first place (unless plans are compulsory); it’s what keeps members from increasing their savings rate when failure to do so will clearly create a drag on achieving their replacement ratio targets; it’s what accounts for the fact that once investment programmes are set, only 10% of members make any further changes in their portfolio asset allocation (unless a Lifestage portfolio forces the appropriate change over time)4; and, most disturbingly, it’s what accounts for the fact that even when pension plans set up elaborate member education programmes, these too fail to get members any closer to their optimal investment strategy over the course of their membership.5
Why is inertia such a dominant force? To begin with, we probably grossly underestimate how difficult and complex a job retirement plan investing really is. As Mitchell and Utkus state the problem:
“Being good at retirement savings requires accurate estimates of uncertain future processes including lifetime earnings, asset returns, tax rates, family and health status and longevity. In order to solve this problem, the human brain as a calculating machine would need to have the capacity to solve many decades long-time value of money problems, with massive uncertainties as to stochastic cash flows and their timing.”6
So inertia is really just one way our brain tells us that it simply doesn’t know how to resolve all the complexity.
But, there are a number of other equally dysfunctional behaviours that our brains revert to during the complex member decision-making process and these also demand our attention.
Consider this example:
Can’t make a decision about the optimal path to retirement investing? Then the “path of least resistance” heuristic (short cut) leads members to either:
- Just go with the crowd – pick the median portfolio selected by all the members of your Fund (regardless of their ages or years to retirement)
- Buy a solution that has an equal exposure to all of South Africa’s top fund managers – regardless as to whether this solution meets your own funding retirements and time frame.
- Let an expert do it for you. Fall back on the default selected for you by the trustees of the Fund. Perhaps they know a thing or two that you don’t.
The examples go on and on. We will come back to a few more. Bottom line is that unless our industry gets serious about understanding and addressing these types of behavioural issues, and works collaboratively to develop ways to mitigate against these sub-optimal decisions, then the best laid investment plans will continue to fail the members – and not because the investments have gone sour.
What Behavioural Finance Can Teach Us
What behavioural finance is beginning to teach us is that we need to re-examine a number of conventional practices if we are going to get it right. What follows is a discussion of where these practices are failing the process, why they’re failing the process, and what we, the broad group of fiduciaries responsible for these assets, can do to ensure a better outcome. We grant that these suggestions may prove to be quite provocative at first – but, in light of the findings of our authors – they may actually redress some of the problems we all grapple with.
Point 1: Risk profiling by itself can be hazardous to your wealth!
Just how do we structure investment options to members of pension funds?
It is the rare investment tender or beauty parade of manager skills that doesn’t request that an asset manager provide trustees with their very best (house view) recommendation for an “aggressive”, “moderate” and “conservative” investment option. What comes across as a perfectly straightforward request actually masks a minefield of potential problems.
Here’s the crux of it. What exactly is meant by “aggressive”, “moderate”, “conservative”? Do the consultants, the trustees, the members, and the investment managers/multi-managers even begin to share the same understanding of these adjectives and, more importantly, do they have the same expectations as to how these different solutions should:
- Be structured?
- Behave under different market conditions?
Not likely.
Even more problematic is whether members can meaningfully assess their own risk profile. Chances are that a 28-year-old mother who is the sole provider for two children is going to view her current situation as precarious and readily tick the “conservative” risk profile box. But is a cash or the low-risk portfolio the right long term retirement funding strategy for someone who will undoubtedly be required to work for most of her life to provide the required family support?
Similarly, is it the right strategy for a senior member of the fund, who has the bulk of their external wealth tied up in market-related assets, to compound their bet on the markets so close to retirement by selecting a high risk, high performing single manager portfolio for their “asset holding of last resort”?
These are complex questions. But two things are clear:
Risk profiling questionnaires are unlikely to get us any closer to the right answer. With such thought-provoking questions such as “do you like bungee-jumping?”, it’s little wonder that research is now suggesting that risk aversion questionnaires do little more that help members identify what their attitude towards risk is at that specific moment in time – an insight that may bear little relationship at all to what their attitude would be should their pension fund replacement ratio fail to hit its mark twenty years from now.
To begin with, we are up against an all-too-human tendency known as “hyperbolic discounting”.7 This is the mental sleight of hand that leads individuals to undervalue (under-prioritise) future long term benefits and overvalue the nearer dated opportunities. It’s the same behavioural phenomenon that results in many members of provident funds simply opting to take as large a lump sum payout as they possibly can at retirement, in spite of all the well-meaning advice to invest that cash in some form of annuity. And it’s the same phenomenon that results in risk profiles merely capturing the risk attitudes of individuals to the environment that surrounds them in their present circumstances, and not the environment that might meet them 20 years from now if they failed to meet their funding requirements. No questionnaire would be likely to elicit that emotional response.
Point 2: Menu design may have a greater impact on decision-making than option design
For most trustees, consultants, and service providers such as ourselves, the primary focus is typically on the extremely complex problem of making sure that the investment strategy or range of investment strategies selected have the highest probability of delivering what is promised to members. The irony is that much of this good work may be completely undone by – of all innocuous-seeming things – how we present these options on the decision forms we give members!
To start with, “the path of least resistance” phenomenon stacks the odds heavily in favour of whatever gets listed first. Even when a default option is made available, if it is listed last, as they often are, the very members who should be opting for the default may not be reading far enough into the document to actually select it.
But the behavioural phenomenon known as “framing” also plays an important role. Here the issue refers to how the layout of the options may end up inadvertently leading the decision-makers to the wrong decision simply because of the way the decision was “framed”.
Consider that most option sheets typically list available choices in order of their riskiness. List the least risky portfolio first and this will become the dominant choice. List the most risky portfolio first and this too will get selected more times than our calculated distribution would suggest. For many individuals, listing something first subliminally suggests that it may well be best.
A better example of framing is perhaps illustrated in another fascinating study by Benartzi and Thaler. In this study they developed four portfolios ranging from portfolio A to D that each reflected a different risk profile ranging from most aggressive to least aggressive. Different groupings of these portfolios were presented to three different groups of members to determine their preferences. Astonishingly, although portfolio C reflected the same risk profile in each grouping, how it was positioned relative to other options being offered to members impacted their preference for the portfolio. For example, if the C portfolio was positioned last – indicating that it had the most extreme risk profile, it would garner the lowest number of preferences. If C was one of two options available (although still the last listed option) the preferences increased – but still didn’t exceed the first option. And If C was sandwiched in between two other options, this is when it would attract the highest number of votes (this is when the “select the median” heuristic clearly kicked in). See Graph 2 below.8