Behavioural economics has applications in all walks of life not least pensions, says the National Employment Savings Trusts Graham Vidler
'Nudge theory', developed by US academics Shlomo Benartzi and Richard Thaler, considers the way choices can be presented to gently guide people into making better decisions. The theory has been applied in situations ranging from increasing organ donation to improving recovery rates for fines, and from reducing road accidents to making life easier for the cleaners in the men's toilets at Schiphol Airport. But one of the largest practical applications of nudge ever attempted started in October here in the UK. It's better known as auto-enrolment.
Auto-enrolment relies on harnessing the power of inertia. Rather than having to make an active choice to join a pension scheme, eligible workers will be automatically enrolled into schemes by their employers. The government estimates that as a result there will be between 5m and 8m people saving for the first time or saving more in all forms of workplace pension schemes.
As a new, low-cost and easy-to-use scheme that has been set up by government to help employers fulfil their auto-enrolment duties, NEST has taken behavioural economics very seriously. For us, it's all about using academic insights to help deal with our members as they actually are. That way, we're much more likely to be able to help our members get better retirement outcomes by making better decisions about their savings. Auto-enrolment takes the first step towards tackling the UK's problem of under-saving, but one of the biggest questions for the whole pensions industry is how to keep people saving.
If you met your future self today, what's the one thing you hope you'd be able to say to them? Thanks for keeping up with the gym membership? You were right to go to that party after all? Well done for putting some money away?
At NEST, our research and work with leading behavioural economists has led us to conclude that harnessing a connection to a member's future self can be a powerful tool in helping people make better decisions for a better tomorrow and understanding the value continuing to save. This is an insight we've included in our 'Lives of Brian' video, where young Brian considers his lot with various versions of his future self (bit.ly/livesofbrian).
The challenge of connecting to future selves also underpins the awareness campaign that NEST ran earlier this year across social media, with the slogan 'tomorrow is worth saving for'. It was designed to encourage people to think about what they do today and will still want to do in years to come - such as going to the cinema or enjoying a meal out. The campaign material set out the basics of auto-enrolment and where NEST fits into that picture.
Loss framing
You can also see the lessons of behavioural economics at work in the way we have constructed our opt-out process. We believe a good opt-out process means enabling members to make an informed decision. Our research told us that members want to feel in control, have enough information to make an informed decision, and for the process not to be too onerous if they decide to opt out.
We turned to behavioural economists for an answer to the question of how to support workers in making decisions, while being clear that we are not promoting opt out, yet helping members to avoid bad decisions.
One way is through a technique known as 'loss-framing', which involves helping enrolled workers to understand what they stand to lose out on in terms of employer contributions and the government's contribution in terms of tax relief if they opt out. Many people perceive pension contributions as a loss, particularly when they see a deduction from their payslip without any explanation. Showing the loss that would be incurred if someone were to opt out helps to counter this behavioural bias and produce a better informed decision.
Keeping people saving once enrolled is, of course, vital to their retirement incomes. We need to manage our members' exposure to risk to encourage them to save and build up retirement savings over their working lives. Behavioural economics also underpins the design of our investment approach.
For our members, there are three areas of risk in tension with each other - the risks that people want to take (their risk appetite), the risks they can take (risk capacity) and the risks they need to take to deliver a retirement income. The challenge for developing the investment approach has been to balance these three factors.
Our approach may look a bit different from that taken by many workplace schemes, because the people that NEST is designed for are not the typical target market for pensions. People automatically enrolled into pensions are likely to be younger, have less familiarity with financial products than existing savers and have lower earnings - median earnings in the target group are around £20,000, while those contributing to a pension are around £30,000.
Balancing risk
Our research shows that our target group is more risk-averse than risk-seeking, with a large proportion (37%) favouring taking no risk whatsoever with retirement savings. Risk preferences are linked with income, with those on lower incomes being more likely to be risk-averse than those on higher incomes. Our research also showed that younger people have some of the strongest reactions to investment loss.
The research showed that the target group was likely to have negative and emotional responses to investment loss, such as disappointment, anger, surprise and incredulity. They felt loss with a sense of immediacy and didn't consider it within the context of a long-term savings vehicle. Loss aversion was observed most strongly among the young and those on low incomes.
For its default option of target-date funds, we therefore created different investment phases, including a foundation phase, which is expected to last for around five years for a 22-year old, and targets inflation after charges to preserve the value of savings in real terms. The foundation phase provides a lower-risk start for younger members and is designed to minimise volatility and avoid negative reactions, such as stopping saving. By the age of 30 at the very latest, members will be in the growth phase, with an objective of delivering consumer price index plus 3% after charges.
Automatic enrolment is a once-in-a-generation chance to change the savings culture of the UK for the better and help people realise the kinds of retirements they would like. NEST stands ready to play its part and has been built from the ground up with the principles of behavioural economics at its heart. While we've worked with global experts and taken best-practice examples from around the world, our work is only just beginning.