A nudge and a wink

ALBERT EINSTEIN IS said to have described compound interest as the eighth wonder of the world. It should also be a boon for workers planning their retirement. Start saving early enough and a pension becomes much more affordable.

Unfortunately young people are often unable or unwilling to take advantage of this miracle. Their wages are low and their main priority may be to pay off their student debts or to save for a deposit on a house. Moreover, they may find it difficult to defer gratification or, as economists like to put it, they use hyperbolic discounting. Most of them would much rather have money in their hands today than put it aside for a retirement which they can barely imagine. “People worry about sacrificing their liquidity by putting money in a pension,” says Alex Waite of Lane Clark & Peacock, a benefits consultancy. “They may have money to save now but think they might need it next year.”

But people may change their behaviour if the problem is explained to them in the right way. In one academic study college-age students who were shown digitised pictures of themselves as they might look in old age allocated more than twice as much of their income to retirement savings as students who were shown contemporary photos.

Most countries use some form of tax incentive to encourage saving for pensions, usually by making contributions tax-deductible and allowing pension pots to accumulate tax-free. In a survey by the Investment Company Institute, more than 80% of pension-plan members said that the tax break acted as an incentive, and 40% said that without the 401(k) concessions they would not be saving at all. But tax incentives are likely to be of most benefit to the rich, who have more money to save; and those on lower earnings may find the tax rules too complicated. A survey of British savers by Aegon, an insurance company, found that few understood the concept of tax relief. It concluded that participation in pension plans would increase if the government were described as “matching” the amount of money put aside by workers.

The easy option

These days the pensions industry is calling on the wiles of the behavioural school of economics. Governments are trying to “nudge” people into doing what is good for them, as described in the eponymous book by two economists, Richard Thaler and Cass Sunstein.

The most popular nudge to do with pensions is auto-enrolment, which takes advantage of people's inertia. Traditionally, workers have been offered the chance to opt in to a pension scheme; this involved filling in a form and making a number of difficult decisions. Many could not be bothered. Under the nudge principle, workers are automatically enrolled in the scheme and actively have to opt out if they do not want to join. This has duly boosted participation.

In America auto-enrolment was approved in the Pension Protection Act of 2006 and was used by 57% of private-sector companies in 2010, with a further 15% planning to introduce it this year, according to a survey by Aon Hewitt, a consultancy. David John of the Brookings Institution suggests that the concept could be extended to small employers via an auto-IRA (individual retirement account), allowing businesses to offer employees a pension scheme at low cost.

In Britain auto-enrolment is at the heart of a new national pension scheme, the National Employment Savings Trust (NEST). Due to start in 2012, it is designed to deal with the 45% of workers without a private pension plan. In future all employers will have to offer one, and NEST offers them a low-cost option if they do not want to set up their own scheme. Economies of scale and limited investment choice will keep down charges.

The man behind NEST is Tim Jones, a former retail banker. He sees it as a technological and administrative challenge as much as an investment one. “Our aim is that if you can shop online at Sainsbury's, you can set up an account with NEST,” he says. The new rules may persuade perhaps 5m-9m Britons to save for the first time, he reckons. The number that join NEST could range anywhere from 2m-6m.

However, auto-enrolment raises questions. Saving for a pension may not always be the best use of an employee's income. People with credit-card debts who are paying interest of 15-20% would be better off reducing their balances. In some countries (including Britain) means-tested benefits for low earners may be reduced in retirement if a pension is being paid.

Another problem is that the amount of money going into NEST may not be enough to generate a decent pension. Total contributions will be 8%, of which 3% will come from the employer, 4% from the employee and 1% from the government, in the form of tax relief. But that is less than the average contribution rate of private-sector DC schemes. The danger is that employers will be tempted to “trade down” to the new levels.

Saving for a pension may not be the best use of an employee's income. People with credit-card debts would be better off reducing their balances

“It has been relatively rare for companies not to slash their contributions when they move from DB to DC,” says Alan Morahan at Punter Southall, a consultancy. “There is a danger that auto-enrolment may exacerbate the trend as companies realise they have to make contributions for more people.”

Moreover, the new system is being phased in very slowly, with contributions reaching their full level only in 2017, so employees now in their 50s will not get much out of it.

Edward Whitehouse, a pensions expert at the OECD, thinks that more time is needed to demonstrate that auto-enrolment actually works; the initial studies were based on just a small number of American companies. The success of New Zealand's KiwiSaver programme, which used auto-enrolment to boost participation, may have been due to the generous tax incentives being offered. In particular, Mr Whitehouse wonders what will happen when workers discover they can get a short-term pay rise by opting out of the system.

In America's corporate sector auto-enrolment is sometimes accompanied by auto-escalation. As workers earn more, their pension contribution goes up steadily. The hope is that they will barely notice the difference in take-home pay but that a higher contribution rate (perhaps 10-15% in total) will in due course allow them to earn a decent pension.

Make them pay

The alternative to auto-enrolment is compulsion, as practised in Australia since 1992. Employers there are required to contribute 9% (set to rise to 12% in 2019) of an employee's salary to a superannuation account. The system applies to all Australian workers except the very lowest-paid.

A report by the Brookings Institution found that about half the assets in the Australian scheme were held in self-managed or retail funds, which pushed up charges to an average of around 1.25% of assets. Members of the scheme are able to take all their benefits as a lump sum at age 55. There is no requirement to buy an annuity. Many people use the money to pay off their debts; some go on a spending spree. So they may eat up their savings and have to fall back on the state's means-tested benefit at 65.

In theory, being able to withdraw money from a pension scheme may persuade employees to contribute to it in the first place. But South Africa also offers access to pension savings, and research by Alexander Forbes, a consultancy, found that 70% of members were taking their benefits in cash before retirement. Ideally savers will not take advantage of that option. One answer would be compulsory annuitisation, which is what Britain imposed for many years. Pensions are subsidised through the tax system to generate a lump sum that can be used to buy a retirement income to prevent the elderly from becoming a burden on taxpayers.

If workers in DC schemes fail to buy an annuity, they face the risk that they may outlive their savings. Even those British workers who do buy an annuity tend to go for a flat-rate version, running the risk that inflation will erode their purchasing power.

The legal requirement to buy an annuity has been weakened in recent years. And British enthusiasm for annuities will have been dampened further by a European Court of Justice decision last month that stopped insurance companies from discriminating on the ground of gender. Traditionally, men have received higher annuity payouts because their life expectancy is shorter. In future, annuity rates for men—the main buyers of the product—will have to be cut, perhaps by 5%, to bring them in line with rates for women. In effect, men will be underpaid.

Employees in America do not like annuities. “People hate losing control of their money,” says Seth Masters of AllianceBernstein. If their capital is tied up, pensioners may not be able to meet sudden health-care bills; they will be exposed to the credit risk of the insurer, which the collapse of AIG in 2008 showed to be a real danger; and in some cases their heirs may get nothing.

The American insurance industry has tried to get around this problem by offering variable annuities, which they like to call a “living benefit”. The investor puts in a lump sum, which is guaranteed for repayment, and the insurer increases this guarantee at a set rate each year. The idea is to give investors both a level of security and some protection against inflation. But this market still attracts only a small fraction of DC assets.

That may be because investors suffer from a condition called “money illusion”. They prefer having a lump sum to an inflation-linked income. As Tony Webb of the Centre for Retirement Research in Boston points out, a pension pot of $1m will buy an inflation-linked annuity of just $45,000 a year. “Retirees would go from being a millionaire to barely being in the middle class,” he says.

This apparently low annuity rate reflects increasing life expectancy. If an American married couple both retire at age 65, there is a 50% chance that one of them will live to 90. But pensioners tend to underestimate how long they will live.

A further complication is that people's spending profile after retirement tends to be U-shaped. When they first leave work, they are still active and keen to travel and spend money. As they reach their mid-70s they stay at home more and spend less. In their 80s their costs may rise again because of higher health-care bills or because they have moved to a nursing home.

If workers are not required to use all of their pension pot to buy an annuity, it seems sensible to ensure they make provision for their basic needs. In a report on retirement design, Mercer suggests dividing the pension pot into three: one from which to draw income for the first 15 years after retirement, aiming at a 50% replacement ratio; a second to be set aside to meet the higher costs of advanced age; and the rest for discretionary spending.

But this will be possible only if workers learn to regard their DC plans as the basis for an income stream. According to Geoff Manville, head of government relations at Mercer, the Obama administration is looking into a policy change that would require DC sponsors to give members a rough idea of the level of annuity they might expect. That could be another nudge in the right direction.