Much of what has happened in financial services in the past three decades has been the result of the implementation of policies based on economic theories. These have encouraged the belief that humans are sufficiently rational and self-serving that removing restrictions and giving them greater choice will usually result in better outcomes than forcing them do so something.
In relation to long-term savings I contend that this is untrue and that no amount of tinkering will fix it. My conclusion is that only compulsion will result in individuals saving enough for their retirement.
Behavioural finance has shown that we heavily undervalue tomorrow’s pound versus today’s pound. Many BF commentators assume that since we are fundamentally rational we can be educated out of this and nudged to do better but this conclusion is not based on any evidence that a scientist would take seriously.
On the contrary, the evidence in favour of the proposition that hyperbolical discounting outweighs rational self-interest continues to pile up. I prefer the evolutionary biology explanation – during our millions of formative years on the plains of Africa, the bird in hand was worth four or five tomorrow.
A trait like this, so deep-wired that it is run by the limbic system, can only be overridden by the prefrontal cortex with an effort. To make that effort, we need strong incentives. For example, faced with a life assurance salesman telling us our children will starve and be miserable without our support, we reluctantly part with the £40 per month to pay the policy premiums. It is pretty well established that threat/fear works better in this context than greed.
Incentives based on greed have not worked in motivating long-term savings. The fact that the vast bulk of tax relief on pension premiums has gone to people who did not actually need to save more for their retirement (or did not need the tax break) is convincing proof, unless you are wearing the industry blinkers.
In all societies people have a model of the social compact. In the UK, the compact that created the welfare state included a state pension at a level that someone on average earnings could live on. I think a lot of people still assume that this is how it is or ought to be.
In most other developed European countries, the state pension is a much higher proportion of average earnings. The citizens of those countries and their employers pay higher taxes, especially payroll taxes, to finance this but you do not hear people complaining and demanding lower taxes so they can pay for their own retirements. Most economists would say they are irrational.
On the contrary, I think it is entirely rational for people not to want to have to make their own retirement savings decisions. You do not have to think for long to understand that it is very complicated and that even if you work at it really hard you could still make decisions that turn out badly because of unpredictable events.
Why wouldn’t you prefer to pay a bit more tax and get a bigger state pension? And despite what the financial services industry says, this is a cheaper, more efficient solution for society (state plus individuals).
It is only a matter of time before we get compulsion, but it would be better if it comes as an upgrade to the social compact.
Chris Gilchrist is the author of the Taxbriefs adviser guide ‘The Process of Financial Planning’ and edits the investment newsletter The IRS Report.