Humanising pensions Understanding the behavioural effects of freedom in pension choice

A Summary of

3 Foreword

4 The retirement puzzle

6 Behavioural barriers

8 The government response: a landscape of nudges

9 Unintended consequences

10 The new DC landscape: how much choice is dangerous?

13 Potential behaviours

16 What is the right answer?

18 About the authors

• Because increased choice over how pension benefits are taken in the UK has created a raft of new behavioural complications for members

• Because only by understanding the types of behavioural responses members will have, can employers plan for the impact on their workforce and pension arrangements

• Because it provides practical suggestions on what steps employers and trustees can take to aid employees in decision-making.

Contents

2

Why read this report?

These changes have not only made an already complicated landscape even more challenging for employers and pension trustees, but for the employee, squeezed between concern about current day-to-day finances and funding their future retirement, a fiendishly complex and daunting set of decisions just got so much worse.

Despite evidence that a majority of savers are broadly in favour of more financial freedom, there is concern that too much choice could overload people and leave them less likely to find a good, or even suitable, solution. We therefore ask the critical question: how much choice is dangerous and how can this be managed?

This report marries together our behavioural finance insights with our experience of pensions consulting, to help explain the role that targeted financial support can play. The fact that people welcome automatic enrolment suggests that there is a broader function for well-thought-out ‘nudges’ that take the onus off the individual to make financial decisions but, importantly, well-designed engagement programmes that go ‘beyond nudge’ to help them to feel more in control of their own future.

Our previous report Steps Towards a ‘Living Pension’ showed that employees are hungry for help with their financial planning. Over three quarters would simply welcome personalised emails about their pension and what they stand to lose by not contributing. So there is real

opportunity to support people now with interventions in the workplace towards their retirement ambitions.

Moreover, organisations can benefit from focusing greater attention on their employees’ financial well-being than they do currently. Employees do not leave their financial worries at the door when they arrive at work; we have found that the impact on company performance through engagement and productivity is greater than most realise, totalling 4% of payroll.

Our intention is that the insights included in this report will help employers to improve their work- place pension and benefits offerings, and enable good employee outcomes from their schemes. In using our behavioural finance expertise to examine the psychology behind financial decision-making, we identify the knowledge and tools required to enable employers and their workforces to provide for their future, and enable more confident and informed retirement decision-making.

Greg B Davies, PhD Managing Director Head of Behavioural and Quantitative Investment Philosophy Barclays Wealth and Investment Management

Lydia Fearn Head of Investment Consulting Corporate and Employer Solutions, Barclays

The last few years have seen unprecedented change in workplace pensions in the UK. From the removal of a mandatory retirement age to the introduction of auto enrolment, and from the retail distribution review to new freedom and choice measures last year, the pensions market has undergone a fundamental shift.

Foreword

3

Instead, in defined contribution (DC) schemes, which are now the standard, the employer contributes a set amount, together with contributions from the employee, but bears no further liability if investment performance is poor. All the pension risk is borne by the employee. Combined with the fact that state pension benefits will not fund the kind of lifestyles that people aspire to in retirement, this makes the choices each investor makes with regard to their DC investment critical to the retirement lifestyle they will experience.

Unfortunately, most of us are not very well equipped to assess whether we are on track for the type of retirement we want. A report from Aviva and Deloitte published in 2010, based on top-down analysis, stated that the gap in accumulated contributions in the UK for those people retiring in the next 40 years is £317bn. Their analysis was skewed by the small number of members very close to retirement with little or no savings, so the headline figure quoted, that on average a further £10,000 contribution per person, per year is required to close the gap, is misleading. Focusing instead on those aged 50 at the time, the equivalent figure from the report is an extra £6,200 per year until retirement.

In our recent publication Steps Towards a ‘Living Pension’, we asked different generations to define their must-have retirement income, the ‘living pension’, and compared this to their projected pension at retirement1. The results supported the general finding in the Aviva and Deloitte study

and showed that, on average, all generations need to contribute more just to arrive at their living pension. For the baby boomer generation (those born between 1945 and 1960) this additional contribution amounted to 26% of their annual salaries, and even then they still needed to work five years beyond their intended retirement date.

Further complicating the issue of saving for retirement, the recent pension reforms have significantly changed the DC pension landscape. Now, in addition to the behavioural concerns of people not saving enough for retirement, the new legislation has given people complete freedom of choice over how they take and use their pension benefits. This adds a raft of new, and very different, behavioural complications.

Hitherto, most people retiring, except those with either very small or very large pension pots, had no choice but to buy an annuity. Now they are given the freedom to select from a wide range of actions, which fit into four general categories: 1) buy an annuity product; 2) remain invested in a portfolio and use income and/or capital to fund

In recent years shifts in pension provision have transferred risks from employers to employees. Many older employees have a defined benefit (DB) pension that does precisely what the name suggests – it pays a defined amount in retirement.

The retirement puzzle

1. Buy an annuity product?

4. Combination of 1, 2 and 3?

2. Remain invested in a

portfolio?

3. Withdraw the whole

fund in cash?

4

retirement (drawdown); 3) withdraw the whole fund in cash (subject to paying income tax); or 4) some combination of these.

There is real concern that retirees may simply choose to spend the money earlier than they would have been able to under the previous system. The first major difficulty we all face is estimating how long we will live in retirement. We may look at relevant data points like mortality rates or, more specifically: at the age our parents lived to, whether we worked in strenuous, physical jobs that could have affected our health, or whether we have had any major illness in earlier life. Almost certainly we will underestimate the progress that medical science will make in keeping us all alive for longer, significantly increasing the chance that we will run out of retirement savings before we pass. Now, more than ever, the choices we make throughout our working lives to build our pension savings, and into retirement regarding our spending and standards of living, will be hugely important.

In recent years, the UK government has taken major legislative steps to make some of the most sweeping changes to the pensions landscape we have ever seen. These steps are built on the best intentions to achieve better outcomes for its citizens. Yet it is interesting to reflect that, from a behavioural perspective, the approach taken to achieve these outcomes is not always as consistent as it could be. With that said, there is a clear recognition of the importance of behavioural finance. The FCA’s latest report, for example, acknowledges how an understanding of decision science provides insight into the likely outcomes of the decisions people take.

Given the current landscape it is crucial for employers to understand and appreciate their role in helping employees provide for retirement. This includes, but is not restricted to, the investment options for employees and the appropriateness of default solutions.

The retirement

puzzleand behavioural barriers

Lack ofurgency

Underestimating the effect of

compounding and benefits of tax relief

How much money will I need for

my retirement?

Lack of awareness for

the need to save

Current self and future self

Pension

New car

Why?

Z Z Z

?

1Based on current pension fund balance and current contribution levels.

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This is a particularly big problem for those with low levels of numeracy and education, which are strongly linked to lower retirement savings and lower use of investment products2. The complexity of the problem, and not knowing how to approach the many choices involved, can also be off-putting for many, leading people to bury their heads in the sand.

How do you know how much money you will need in retirement? The answer to this is the most basic building block of a sensible solution, but we find it very difficult to put ourselves in the shoes of our future selves. We struggle to perceive the importance of, and particularly to quantify, our future needs such a long time in the future. Translating these into requirements for our present selves is a tall order.

Another important factor is the lack of urgency people exhibit – there is always something more pressing than planning and saving for retirement. We become focused on the more immediate issues in our lives and this ‘tunnelling’ leaves us little bandwidth to spare on planning for our future. Let’s consider an example. There will be many non-retirement goals that are important in earlier life, such as saving for a home deposit, which will conflict with saving for retirement. Achieving these goals fills the ‘tunnel’ of issues that you have the cognitive capacity to cope with thinking about. You might recognise that retirement planning is important but it is just not in the tunnel and consequently it doesn’t receive any of your bandwidth. This is a situation that

might last many years as more pressing and urgent goals continue to fill the tunnel. After all, we can always start thinking about saving tomorrow once we have taken care of whatever is front of mind.

Saving for retirement is how you transfer money from your current self to your future self. However, this also means you are probably transferring the happiness derived from consumption from your current self to your future self. This is a trade-off that needs to feel worthwhile, but we humans are not very good at making such inter-temporal judgements, as illustrated by a study of students at a top US university3. They were asked to predict how much a USD$400 monthly contribution would be worth if compounded annually at 10% for 10, 20, 30 and 40 years. Figure 1 shows the predictions versus the actual calculated value through time. The average predicted value after 40 years was around $250,000, whereas the correct value is closer to $2.5m! A set of participants were even given calculators to help them calculate the value, which didn’t materially change their estimates.

Underestimating the effect of compounding means people are much less likely to save. If you think those contributions give you a $250,000 pension pot, which might provide an income of about $980 per month4, then delaying your consumption happiness by 40 years for such a small increase ($400 only buys you $980 in retirement), may not be that appealing.

There are many reasons why we find it hard to save for retirement, something that is a long way off for many. Perhaps one of the most pertinent barriers to retirement planning is a lack of awareness of the need to save, especially in the early stages of working life.

Behavioural barriers

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We have inaccurate perceptions about the incentives to save for long-term goals. In reality, the $2.5m of savings provides a much more valuable income (more like $9,800 a month) and greater level of consumption in retirement that, if correctly estimated, should encourage much more saving. All of this leads to the commonly expressed attitude of ‘I am too young to start saving for retirement’, when the more accurate phrase, at almost any age, would be ‘I am too old not to’.

In addition to underestimating the power of compound interest, people underestimate the benefits of tax relief and employer-matching incentives – ‘free money’ which increases the amount contributed. A reduction in take-home pay of £100 would give rise to a pension contribution of £125 for a 20% tax payer and £167 for a 40% tax payer where the employer deducts pension contributions from gross pay. Any employer-matching will then increase contributions further. Failing to consider these will lead to further underestimation of how much future value each contribution creates.

Years in the future

Actual

Estimate

Figure 1

Underestimating the power of compounding

Source: Mckenzie, C.R.M., Liersch, M.J. (2011) Misunderstanding Savings Growth: Implications for Retirement Savings Behavior, in Journal of Marketing Research: November 2011.

2 Banks, J., Oldfield, Z. (2007) Understanding Pensions: Cognitive function, Numerical Ability and Retirement Saving, in Fiscal Studies, Volume 28, Issue 2, pp.143-170.

3 Mckenzie, C.R.M., Liersch, M.J. (2011) Misunderstanding Savings Growth: Implications for Retirement Savings Behavior, in Journal of Marketing Research: November 2011, Vol. 48, No. SPL, pp. S1-S13.

4 Assuming a 4.7% rate (indicative for level rate with no guarantee at age 55) means USD$250,000 will buy an annuity of USD$979 per month.

7

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ian

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(in d

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2,500,000

1,500,000

2,000,000

1,000,000

500,000

10 20 30 400

2,500,000

1,500,000

2,000,000

1,000,000

500,000

10 20 30 400

When attempting to alter behaviour we have a range of options: deliver education, provide a subtle nudge, or provide a strong shove in the right direction.

The government response: a landscape of nudges

For years government, the pensions industry and financial advisors have attempted to educate people on the benefits of saving more for their retirement but with little success. It seems inertia trumps education.

In the physical world, inertia is the resistance of an object to any change in its state of motion. This concept of moving in one direction unless a force is applied has parallels to the way we behave in decision-making, and is often called the ‘status quo bias’. The number of consumers who stick with products and services despite poor outcomes has been shown through numerous studies. These studies suggest this is largely because making any change requires an amount of effort, mental or otherwise, deemed too high to overcome. This inertia, which often defines how we behave and make choices, has significant consequences for pension scheme members.

The government’s approach to overcome this inertia and address the increasing shortfall in DC pensions has been, increasingly, to legislate rather than educate. The first part of this legislation was auto enrolment, leaving employees automatically enrolled into a pension scheme which is subsequently invested into a default fund. Here, the power of inertia is being harnessed in people’s favour. The status quo bias makes it likely that most will remain contributing

into the default fund, and the early results from companies that have staged auto enrolment support this observation: they show a marked increase in the participation in workplace pension schemes5. Enrolling employees by default is a good first step to help people provide for retirement. However, the current one-size-fits-all levels of saving may not be sufficient for most.

The government, by introducing auto enrolment, is attempting to help employees overcome behavioural barriers, but this does not mean that employers can absolve themselves from thinking closely about pension provision for their staff. We examine some interventions which employers could use to counteract these barriers to saving in our guide Steps Towards a ‘Living Pension’.

5Automatic enrolment opt-out rates: findings from research with large employers, https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/227039/opt-out-research-large-employers-ad_hoc.pdf

I haven’t got time now, I will do this

another day

8

Auto enrolment brings many benefits: the largest is to society as a whole because more people save, thus improving retirement lifestyles.

Unintended consequences

This is followed by the individual benefit to those who wouldn’t otherwise save for their retirement. However, auto enrolment is not necessarily a silver bullet. Greater participation and, due to the same inertia, greater numbers invested in the default fund increase the importance of having an appropriate strategy. But default funds are designed for the average, and to safeguard those worst off. This means that, while they may be roughly appropriate for many, they are not a perfect fit for most, with those who are very different from the average getting a particularly bad fit.

As with most interventions or nudges, auto enrolment will have a positive effect for those who would otherwise be unengaged. However, it may actually discourage further engagement by leading people to take the position that ‘someone else has thought about this for me’, taking us even further away from the goal of ‘confident and informed’ decision-making.

Nudges are an essential safety net to improve outcomes for those who can’t or won’t engage, but need to be supplemented by other measures to promote engagement, or they might have unintended negative consequences – including feeling overly-comfortable with an inadequate solution.

To highlight these risks consider the results of a study in the US which showed the effects of auto-enrolment on contribution rates (Figure 2): employees anchored strongly on the 2% default contribution rate, with few deviations. Under auto enrolment more employees joined. However, there had also been a reduction in the number of employees contributing more than the default. The power of inertia is plain to see here, but actually works against those employees who would otherwise have thought about how much to contribute. Removing the decision to join removed the need to think about the right level of saving.

1% 2% 3-5% 6% 7-10% 11-16%

3 16

20

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7

26

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14

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18

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10

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70

60

60

40

30

20

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ticip

ants

Contribution rate

Figure 2

Unintended consequences of auto enrolment

Source: Choi, J.J., Laison, D., Madrian, B., Metrick, A. (2001) For better or for worse: Default effects and 401(K) savings behaviour, in Wise, D.A. (2004) Perspectives on the Economics of Aging. University of Chicago Press; p.81-121.

Hired before automatic enrolment

Hired during automatic enrolment: 2% default

Hired after automatic enrolment

9

After April 2015 retirees will have huge amounts of flexibility over how they take their pension benefits, which most did not have previously. This newfound freedom of choice raises some important behavioural issues.

The new DC landscape: how much choice is dangerous?

People will face some of the same issues discussed in the previous section with regards to the spending-versus-saving trade-off. The importance of self-control and retirees’ ability to delay gratification will be increased and will have a large effect on retirement outcomes.

It is perhaps worth highlighting the extreme dichotomy between the behavioural assumptions underpinning auto-enrolment versus those underpinning the new freedom of choice model. Auto-enrolment is based on the behavioural assumption that savers cannot individually make the choices that are best for their future selves, so we must legislate to protect them. The latest changes in regulation, providing choice at retirement, are based on a different assumption entirely: that by retirement investors have somehow acquired the ability to assimilate large amounts of complex information and make optimal decisions for their finances in retirement.

Clearly, there is a degree of inconsistency here in the behavioural assumptions underpinning these two legislative changes, and recognising this can help us understand the potential pitfalls of each.

To begin with there are fears that putting the decisions and hence the risks in the hands of employees will lead to many making poor choices, which could result in very unfavourable outcomes. The biggest concern is that people will not balance the spending-now-versus-spending-later trade-off, and spend their pensions too quickly, finding that they do not have enough to fund their standard of living in the longer term.

The risk of too much choice There is also the risk that too much choice could overload people and put them off finding a good solution. Given more options, people are less likely to make a decision at all, let alone an informed decision6.

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AUTO ENROLMENT

‘Someone else has thought

about this for me.’

?

There will now be a huge number of choices available at retirement. As previously discussed, there will be three broad ways to access your pension funds but any combination of these will probably be available, in many variations, hugely compounding the problem of knowing what to do. All these potential problems stem from the risk that, due to auto enrolment, most employees will simply not be engaged enough with their retirement planning to make the sort of decisions required without assistance.

Free guidance The government has announced that there will be free guidance available for everyone at retirement. This service is branded ‘Pension Wise’ with the slogan Your money. Your choice. and will be provided by impartial third parties. Behavioural Finance can give us some insight into how the mechanism for receiving the guidance, and the way it is delivered, will affect 1) people’s likelihood of accessing the guidance and 2) the actions they will take.

It is an effect of inertia that people take the path of least resistance and are therefore unlikely to change behaviours easily. This is what makes imposing default options an appealing behavioural intervention. As the guidance is

not mandatory, merely receiving it already requires effort to move away from the default of doing nothing. Providers are required to ‘signpost’ members to the guidance, but unless appointments are made on behalf of members or they are pro-actively contacted, the action sits with the retirees and this will reduce uptake. Therefore, the real impact may depend strongly on the details of how these sessions are organised.

The delivery of the guidance then is crucial as, if not appropriate, it will further reduce the likelihood people will actually use it. It has been revealed that the guidance sessions will take place in person or over the phone, and there will be online delivery to support this. This proposed multi-channel delivery will allow people to engage at a level they feel comfortable with, which may help address the issues of retirees not wanting to seek face-to-face consultations to avoid perceived embarrassment about their pension savings. Employees expect employers to help and support their journey to a comfortable retirement7, so it may be incumbent on employers to promote access to the guidance or advice not only at retirement, but also earlier in the pension life cycle.

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6 Iyengar, S.S., Gur Huberman & Jiang , W. (2004) How Much Choice Is Too Much: Determinants of Individual Contributions in 401k Retirement Plans, in Olivia S. Mitchell and Stephen P. Utkus, eds, Developments in Decision-Making under Uncertainty: Implications for Retirement Plan Design and Plan Sponsors, 83–95. Oxford: Oxford University Press.

7 Financial Well-being: The Last Taboo in the Workplace? Barclays, April 2014.

Guidance standards The FCA has been tasked with creating standards for the guidance and, while the standards are not yet finalised, the details released, by HM Treasury in January 2015 provide good insight into the likely content of the guidance. Some of the original objectives are:

• “It is intended that the guidance will signpost people to additional specialist help where appropriate, including, for example, regulated financial advice or debt advice.”

• “To be effective the guidance will need to be tailored, providing consumers with sufficient personalised information, so that they can understand their options and make confident, informed decisions about their retirement choices.”

• “The guidance is not intended to stray into areas such as specific product or provider recommendations, which would be better handled by an authorised IFA. Therefore, the guidance will not tell consumers which option to choose or recommend a particular product, provider or adviser. Ultimately, consumers will be responsible for the decisions they make.”

Guidance, then, will clearly consider what the available options are for retirees. But without giving any financial advice, it will be difficult to personalise the description of these various options and tailor guidance to specific circum-stances. This implies that retirees will need to be directed to regulated financial advisors who can provide this specialist tailoring, leaving a very small area in which the guidance will operate and a danger of minimal personalisation. So, while guidance should help people avoid very bad outcomes, we think the question of what is the best solution for retirees still remains.

In the next section we discuss the options and behaviours of different groups and how these decisions may be influenced independent of the guidance.

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DON’T FORGET

Make your own informed

decision.

GUIDANCEONLY

Regulated advice

More information

Debt advice

In order to examine the effects of the new freedom on behaviour it is best to split the choices into two distinct issues: firstly the choice between one lump sum payment and a stream of payments, and secondly the choice of how to provide the stream of payments.

Potential behaviours

We will take a further look at each of these issues before discussing our expectation of behaviours across UK retirees.

A bird in the hand is worth two in the bush Framing is an important factor affecting people’s choices, as decisions can be strongly influenced by how information is presented. This choice of how to present information will be very powerful in determining the choices made. When comparing a lump sum versus an annuity (a stream of income payments over time) that is financially equivalent, humans exhibit preferences that are not always optimal8. At lower values, lump sums are generally assessed as being better than annuities; but at higher values of wealth the assessment reverses. This may lead those who are retiring soon, the generation with smaller DC pension pots, towards choosing the lump sum rather than an annuity, even where this is the worse financial choice for them. This attraction of ‘cash in the hand’ may also lead to suboptimal behaviour when choosing between a lump sum now versus the income from drawing the portfolio down over time – causing investors to downplay the capital and potential appreciation in a portfolio over time. Framing effects could work to counteract or magnify these effects and change the outcomes for retirees.

Many comparisons have been drawn with the Australian system where the flexibility in pensions is well established and the DC market is significant, making up 84% of total pension assets9. Attention has been drawn to the fact

that close to half of those who accessed superannuation funds (the Australian equivalent to DC funds) in 2012 opted for a lump sum withdrawal and 25% will exhaust their superan-nuation funds by the age of 70. This dash for cash is predictable and a potential issue for the UK, which we will discuss in more detail. However, this comparison is not completely reliable as there are some key differences between the UK and Australian pension land-scape. Primarily, Australian state benefits are asset-based means-tested, so they provide some incentive for people to consume their DC pension savings, whereas the UK will operate more like a fixed level state pension.

How will members take their income? After April 2015, if members want to receive income in retirement they will have the choice to annuitise or withdraw income gradually from their pension fund to meet expenditure (drawdown). In drawdown there is a risk both with respect to the amount of income provided and the length of time it will last for. The exact risks will depend on the investments in the fund.

CASHLUMPSUM

ANNUITYvs?

13

14

Despite the risks, many are likely to find the drawdown option preferable to annuities, with the possible exception of those with very low risk tolerance. This is partly because annuities have had a great deal of bad press, largely due to their perceived high cost, that will be in the front of people’s minds. Furthermore, annuities don’t provide the flexibility for individuals to leave a bequest, which many will find off-putting. The trends in countries which have already made pension reforms similar to those proposed further support this view.

Entering into drawdown also requires a high level of engagement and knowledge from pensioners that their relative disengagement with the auto- enroled savings phase has not prepared them for. Any drawdown strategy can only be appropriate given an individual’s attitude to risk and capacity to take risk10. In the retirement phase this capacity depends heavily on future expenditure and income – if you have high spending plans for

your retirement, your capacity to take risk could be very low. Barclays, in its capacity as a pension consultant and manufacturer of a best-in-class11 default strategy, along with others may provide sensible drawdown strategies. However, as plans change and unforeseen circumstances arise those strategies will need to be reviewed and perhaps adjusted.

The choices examined Despite not knowing the exact content of the guidance guarantee in the UK we can hypothesize as to the likely behaviours of those reaching retirement. Given the pensions regime post April 2015 we think that there will be a few distinct groups of retirees who will behave in different ways. At either end of the spectrum, in terms of wealth, behaviours will be unlikely to change. People who find themselves at retirement with small pots previously had the same flexibility called ‘trivial commutation’, and will be likely to draw their entire pension as a lump sum.

Beware of the tax consequences of taking your pension in one lump sum

CAUTION LOSS OF PERSONAL ALLOWANCE CAUTION LOSS OF PERSONAL

CAUTION CAUTION CAUTION CAUTION CAUTION CAUTION

CAUTION HIGHER TAX RATE CAUTION HIGHER TAX RATE CAUTION HI

Those with significant amounts of wealth had greater flexibility previously, were probably paying for advice and already had access to a larger range of products. The biggest effect will be for employees who have pensions over the trivial commutation limit of £30,000, but who aren’t extremely wealthy. They will now also have the flexibility to take this amount as a lump sum, though there will be some barriers as a result of the disincentives from taxation.

The first barrier will be the boundary of higher rate tax, where any further sum will be taxed at 40%. It is likely that those below this threshold will find taking the lump sum an appealing option, given the value of any annual income, from either annuity or drawdown portfolio, will feel negligible. This may be used to pay off debt, provide a cash buffer, or increase retirement living standards. Above this level, however, the choice becomes more difficult as retirees will be losing more of their pension in tax payments if taken as a lump sum. This group are still likely to see withdrawing the whole pension as a lump sum as more valuable than any income stream it can provide, but may withdraw it over more than one year to reduce the tax burden. It is worth noting that some of those with pensions of this size are likely to continue to work past retirement age in order to supplement their retirement income. This could push them into higher rates of tax earlier, and change the thresholds for decision-making. The next barrier is the level at which you start to lose your personal allowance which is currently £100,000 and finally, those with taxable lump sums over £150,000 will have to start paying the additional income tax rate of

45%. It is unlikely that these groups will take the entire pot as a single lump sum, due to the tax bill. At this level the income produced by annuity or drawdown becomes more meaningful and we are likely to see the benefits of the income stream being perceived as more valuable than the lump sum. So, for those with greater wealth, and thus generally greater risk capacity, a combination of lump sum and drawdown strategy could well be the dominant choice. Annuities could be used with part of the pension pot to provide a secure standard of living on top of the state pension, and the rest could be drawn down as and when needed for other discretionary expenditures.

Lessons to be learnt Some lessons can be learnt from looking at the Australian system, by examining the issues they have faced and what they are trying to do to improve of outcomes. There has been a trend towards increased levels of debt leading up to retirement to boost living standards, with the tax-free lump sum used to repay the debt. This is understandable given the consumption-now-versus-future-consumption trade-off.

8 Goldstein, Daniel G. and Hershfield, Hal E. and Benartzi, Shlomo, The Illusion of Wealth and Its Reversal (January 28, 2014). Available at SSRN: http://ssrn.com/abstract=2387022 or http://dx.doi.org/10.2139/ssrn.2387022

9Global Pension Asset Study, Towers Watson, February 2014.10Capacity to take risk or risk capacity is defined by an individual’s financial circumstances.11Employee Benefit Awards 2014: Best DC pensions default investment – Winner, Jobs and Business Glasgow (JBG Retirement Plan).

15

DRAWDOWN

IncomePensionFund

Can youhelp me?

Yes

As the guidance standards suggest, seeking financial advice will be the right answer for many people. Only then will they get the tailored discussion that most will require in order to fully understand the consequences of different options and have confidence in their retirement plans.

What is the right answer?

Advice makes sense for many retirees: those with only small amounts can’t afford to make bad decisions and risk their future income; while for those with larger pension pots, using their pension in the most efficient way, keeping some flexibility for future expenditure but not taking too much risk, will be a complex balancing act.

There is no universal right answer, and the most appropriate solution will depend on a combination of individual preferences and financial circumstances. People will need to find an appropriate balance in their trade-off between risk and growth versus income. The choice now afforded to retirees will change the ‘at retirement’ allocation that is most appropriate for the default strategy significantly.

Withdrawal of the funds as a lump sum may appear low risk but may have considerable consequences. It may even be popular as a way of making the savings pot, which hasn’t been accessible before, feel tangible. Annuities will still provide a good answer for many, and could play at least a part in the best solution for everyone as insurance against longevity risk. As life companies innovate in a changed market and interest rates increase, we may see a second dawn for the annuity. On the downside though, neither of these options offers the potential for growth, which may be important for those who wish to bequest assets. Having the option of leaving a bequest is a highly emotional issue, and for many this will reduce the desire to purchase an annuity where the money no longer forms part of your estate at death.

A drawdown strategy may appear to be a suitable option as members would stay invested at retirement, but in a portfolio aiming to deliver an appropriate level of income, either generated by the investments themselves, and/or by selling the investments over time. Due to high fixed costs these types of investment portfolios have been prohibitive for retirees with smaller pension pots in the past. For drawdown to become a feasible option it requires low-cost products and portfolios.

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The first steps towards cheaper drawdown strategies have already been taken. For example, ‘retirement-bridging’ products that provide a drawdown strategy up until a certain age, after which an annuity is purchased. A plethora of other options exists, and no doubt we will see more product development in the near future. For most people, using the combination of an annuity along with any state benefits to provide a certain critical level of income, with the remainder in a drawdown strategy, will likely be the best solution, particularly if the annuity can be deferred to a later date. The exact combination depends strongly on levels of risk tolerance and risk capacity.

Collective defined contribution schemes Finally, it is worth mentioning collective defined contribution (CDC) schemes. These are already used in countries such as The Netherlands and Canada, and the UK government appears keen to support their use. These schemes, referred to as ‘defined ambition’, are a halfway house between DB and DC. Members’ contributions are pooled and invested collectively, aiming at a target for what they will receive at retirement. They potentially reduce costs, due to their size, and can help those with smaller pension pots spread their risk over a broader range of investments. They are also claimed to provide better and more stable returns as they distribute investment and longevity risks over a large population. However, returns and benefits are not guaranteed, and the exact returns depend on the time period observed. It is important to note that target amounts (indicative amounts anticipated as retirement income) can, and have been, reduced in times of economic difficulty. In The Netherlands there has been a generational divide on CDCs recently as the young feel they are subsidising those currently retiring and missing out on potential growth on their own contributions. As the UK has an aging population we may also suffer the same reaction.

There is a relationship between the level of unionisation of a country and its use of CDCs, as these sorts of schemes work best if the members share some common features, such as demographics and wage growth. This is because they are treated as a collective with limited options for individuals to choose contribution level, risk profile or investment strategy. There are many barriers to CDCs, including whether they are better than DC products from a sponsor’s point of view, as well as concerns around flexibility. If CDC members are allowed to take their benefits in one lump sum, this may have an adverse effect on the remaining members. We believe it unlikely that employers would support the seeding of these schemes in the foreseeable future; employers haven’t been keen to sign up for them thus far, and they are disillusioned by the damage done to them from the combination of uncertain pension liabilities they can’t control and the several tranches of DB legislation which have had retrospective impacts.

The importance of the accumulation stage Ultimately, choices made pre-retirement in the accumulation stage may be just as, if not more, important than those made at the point of retirement. Yet the current guidance is not designed for this accumulation phase, and there is a danger that for those who haven’t saved enough during accumulation, it will not be able to help no matter how good it is. The combination of lack of appropriate planning and individual difficulty in saving enough, early enough, means that those relying on Defined Contribution schemes to provide income above and beyond the state benefits may find them-selves short of what they need at retirement. Getting employee pension provision right can have substantial benefits in the workplace.

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Robert joined Barclays in February 2011 and has been a part of the Behavioural Finance team since 2013.

He bridges the gap between the behavioural finance and quantitative finance members of the team. Recently he has spent time working on mathematical models of individual risk capacity and how, together with psychological risk tolerance, this forms the basis for determining investment suitability. Rob also accompanies private bankers to client meetings to help explain our behavioural approach to wealth management, and presents frequently to internal and external audiences on the Barclays Investment Philosophy.

Prior to joining Barclays Wealth, Robert completed a two-year graduate management programme at Standard Bank, a South African Investment Bank, in London. He graduated from Warwick University with a bachelor’s degree in mechanical and manufacturing engineering.

About the authors

Robert Smith Behavioural Finance Specialist Barclays Wealth and Investment Management

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Peter Brooks joined Barclays in March 2007 as Behavioural Finance Specialist. In this role, Dr Brooks works with a team of experts to develop and implement commercial applications drawing on behavioural portfolio theory, the psychology of judgment and decision making, and decision sciences.

In his career with Barclays, Dr Brooks has spent over two years based in Singapore providing specialist support to the private banking business across Asia. He supported the launch of the firm’s unique Investment Philosophy across all key global wealth management markets and now contributes that global understanding to clients. He also provides research commentary on how investor attitudes are affected by prevailing market conditions and how this links to investor behaviours. His current work focuses on bringing the best of behavioural finance to self-directed investors.

Dr Brooks’ expertise in behavioural finance stems from his strong background in academia. He holds a MSc in Economics and Econometrics, and a PhD in Behavioural and Experimental Economics, from the University of Manchester. His PhD thesis focused on experimental research into individual attitudes to monetary gains and losses.

Dr Peter Brooks PhD Behavioural Finance Specialist Barclays Wealth and Investment Management

Following his PhD, Dr Brooks worked as a Senior Research Associate in Behavioural and Experimental Economics at the University of East Anglia, where his research involved designing and running experiments on the ability of repeated market outcomes and experiences to “teach” individuals to overcome psychological biases.

Dr Brooks has also contributed research articles to the Journal of Risk and Uncertainty, Theory and Decision, and the Wiley Encyclopedia of Operations Research and Management Science. He has been a regular contributor to the leading print and television media on topics related to investing private wealth.

Barclays is not a legal or tax adviser. Accordingly, nothing contained within this document nor any other material produced by or on behalf of Barclays should be construed as constituting legal or tax advice to either you (as the employer) or your employees. Tax rules can change and the benefits and drawbacks of a particular tax treatment will vary with individual circumstances. We recommend that you, as the employer, take professional advice where required. Both you and your employee’s have sole responsibility for the management of your respective tax and legal affairs including making any applicable filings and payments and complying with any applicable laws and regulations.

Barclays offers wealth and investment management products and services to its clients through Barclays Bank PLC and its subsidiary companies. Barclays Bank PLC is registered in England and authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Registered No. 1026167. Registered Office: 1 Churchill Place, London E14 5HP.

February 2015.

DC Pension & Investment Consulting.An enlightened approach from Barclays.

Chances are your workforce is made up of employees from multiple generations, at different stages of their careers. As such, their needs and priorities will vary greatly too. With the insights from our Behavioural-Quant Finance team and the expertise of our DC Consultants you can help your members to invest in a way that best reflects their needs and helps them achieve their retirement goals.

The full report, Humanising pensions: Understanding the behavioural effects of freedom in pension choice is available from Barclays:

employersolutions@barclays.com

www.barclays.com/employersolutions

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