Analysis of US pension take-up suggests auto-enrolment will only work by making people aware of the options available, not expecting them to become pension pros, writes Henry Cobbe of BirthStar.
The incoming pension freedoms will give people much more choice at retirement. The knock-on effect will be a change in the way people invest their workplace pensions in those vital last years before work ends.
The retirement date point is less likely to end pension accumulation in an annuity purchase but will open a new phase of decumulation investment.
The key priorities in accumulation for the millions of workplace scheme members remain the same however: contribute as much as possible and have investments that perform as well as possible.
Given that the success of auto-enrolment depends on inertia, is there a danger of giving savers too much choice?
Workplace pensions will have to cater for the retirement freedoms by offering more investment options.
For example, the National Employment Savings Trust (Nest), which uses target date funds that derisk as the member approaches their chosen retirement date, is reviewing its investment prices.
It would be wrong to automatically and totally derisk members who plan to stay invested post-retirement. But what is the answer?
It might be easier to dispense with the target date fund altogether and let people manage their own pension investments, assuming they are one of the many group pension scheme members who advisers will not be able to service – though I personally would not agree with that.
Making it complicated
While choice may be appealing for the financially savvy, we need to be conscious that not everyone wants choice.
Evidence suggests those who do want greater choice are in the minority. For many, the prospect of having too much choice can trigger inaction, resulting in the overall effect of discouraging people to save at all.
Research carried out on 800,000 employees in the US has found that when just two funds are offered in workplace pension schemes, participation is around 75%.
Yet when up to 59 different funds are offered, participation falls to around 60%. So less choice could be better in getting people saving, which means the appropriateness of what is offered is essential.
With auto-enrolment, membership levels might not seem such a problem, but the prospect of high numbers of people opting out is still a danger.
Once enrolment is complete there is the further challenge of encouraging people to contribute a greater proportion of their salaries and ensuring members are not stuck in underperforming funds.
Too late to educate
Financial education is often cited as a solution for encouraging a savings culture, however some research suggests the impact of financial education is negligible.
For example, a large US employer monitored the impact of its financial education drive on its 70,000-strong workforce.
The programme included online resources, seminars, personalised illustrations and promotional materials.
A very basic test on financial awareness before and after this multi-million dollar effort showed little overall improvement.
While financial education should be accessible and promoted at school, for working adults it is not a savings panacea.
Attempts to educate adults on things they have to rather than want to do tend to go in one ear and out the other.
Pressure to perform
While a diligent saver keeps well informed on how their respective investments are performing, the concept of ‘information overload’ can also come into play.
For example, it may be assumed that people would like to know how their investments are doing, but being constantly updated on the ups and downs of their investments can give some people the jitters.
Performance updates and day-to-day information on a portfolio can prevent long-term savers from pursuing the appropriate level of risk to achieve their required outcomes.
It has been shown that aversion is asymmetric. An individual saver is likely to experience greater pain when made aware of losses than pleasure received from portfolio gains.
Additionally, constant reminders of market changes can sidetrack savers from the benefits of the traditional buy-and-hold strategy.
Avoiding information overload
As a way of mitigating the risk of portfolio drift, savers are encouraged to review their investments regularly to ensure they remain appropriate to their circumstances and objectives.
Yet research has found that an individual’s innate bias towards maintaining the status quo makes key decision-making around change difficult.
Despite best intentions, reviews are rarely regular for most retail investors who do not have access to a financial adviser.
Nowadays you do not need to understand cars to enjoy driving them, if they are expertly designed.
The same should apply to investing. We want to invest workplace pension scheme members for the long-term but that does not mean turning those people into investment experts.
We need to challenge traditional thinking on how to make it easier for everyone to save for the long term and, equally importantly, how to save well.
Henry Cobbe is managing director of BirthStar Target Date Funds.