(featured photo: Bill Reynolds/Flickr CC BY 2.0
Even if we know we cannot avoid uncertainty, we continue to pursue certainty.
Retirement planning. It’s one of the classic topics in behavioural economics: most people realize they should be saving (more) for their retirement, but the utility of spending the money now seems so much higher. Retirement is so far in the future that we find it hard to picture ourselves in that position. The technical terms used, myopia and present bias, exemplify what it is about. If you manage to resist these tendencies and put money away in a pot to fund your eventual retirement, you get some welcome peace of mind. But unfortunately, that is temporary. Once retirement is no longer in the distant future, a new dilemma presents itself – not between spending and saving, but between two very different ways of securing an income from that pot.
Simple and certain
In the UK, until 2015, prospective pensioners could take 25% of their pension savings as a tax-free lump sum, but they had to purchase an annuity with the balance – hand it over to an insurance company, which then pays you a regular amount of money, for as long as you live. Consequently, the advice that was widely given to pension savers was to derisk their portfolio by shifting investment from stocks to bonds in the last few years before retirement, to avoid a sudden stock market crash annihilate your fund just when you’re about to buy an annuity.
Annuities are the perfect solution for the risk averse person. You know exactly how much you will get, without having to worry that the money runs out or about interest rate or stock market performance. The only remaining worry is inflation, and hey, you can inflation-proof your annuity too.
But peace of mind does not come for free. Annuity rates are linked to long term bond rates, and generally, certainly over longer periods, these have been consistently several percentage points below to stock market returns. This was not an issue when the purchase of an annuity was mandatory and there was no other choice, but since 2015, this obligation has been lifted. It is now possible to choose to keep your pension invested and draw it down over time, which would give you a more generous retirement income. You draw the market return gains from your investment, and top them up with a slice of capital to fund your living costs. In good years, you may be able to leave the capital untouched, and not deplete it at all. But even if you need to withdraw capital, that will, initially at least, be at a low rate. However, if you are unlucky, and the stock market falls, you may need to take out a sizeable chunk of capital to pay the bills, so much that the absolute return in the next years will never again be enough to give you the income you need, thus forcing you to keep on drawing more and more capital… until it is all gone. Oops.
As a would-be pensioner, you now need to choose how to provide for your ageing self. Until now, my retirement fund has a moderately high-risk profile, which has served me well, even across a few downturns in the last few decades. I have not de-risked it, as the old advice would have been, because there is no longer an obligation to buy an annuity. I am well aware of human cognitive biases, and so the draw-down option, leaving the pot invested for the long term and living off the proceeds would seem the best choice. But I sense some cold feet. The lure of the apparent certainty of the annuity seems irresistible. Why might I have suddenly become more risk averse?
Reasons to be risk averse
Risk aversion seems to be literally in our genes. A recent systematic review by Francisco Molins, a neuropsychologist at the university of Valencia, and colleagues concluded that risk aversion may have a genetic basis. Variations in our DNA that relate to the regulation of two key neurotransmitters, serotonin and dopamine, appear to be associated with different degrees of risk aversion in individuals. In particular, a lower sensitivity to dopamine (associated with, among others, pleasure and reward, learning, and behaviour and cognition), and higher levels of serotonin (associated with mood regulation, memory and also learning) would be linked to higher risk aversion. But that does not quite explain why anyone would be less risk averse while saving, and more risk averse when choosing how to live off the proceeds.
For that, prospect theory, developed by Amos Tversky and Daniel Kahneman (who recently died) offers several complementary explanations. According to this theory, we are more risk averse for gains than for losses. The decision at the point of retirement is one between a certain gain (the annuity) and an uncertain gain (the draw-down pension). That is a different reference point compared to the person still saving, when contributions not only continually add to the fund, but also, should the overall value drop significantly, would buy more assets, and hence increased potential for more growth over time. Irrespective of the reference level of retirement income we might determine, we are also loss averse. Literally running out of money before we die is pretty catastrophic, and not outweighed by the potential of a more comfortable retirement when we’re lucky. And prospect theory also holds that we overweight small probabilities (such as that of a dramatic fall in the stock market that would mean we outlive our savings).
Other reasons for feeling a preference towards the annuity option might be that several decades of assuming an annuity was the only option has worked as an anchor, and turned it into a default that does not need justifying.
Dueling regrets
But perhaps the most important underlying cause for the dilemma is the prospect of future regret – of having made the wrong decision. The annuity option avoids ever regretting that a big chunk of your nest egg is wiped away by the kind of post-dotcom bubble and 9/11 stock market slump (when, for example, the S&P500 index ended down three years in a row, with a total cumulative loss of over 38%), or the precipitous crash in 2008 (when the S&P500 lost 37% in a single year). But it also embodies the lingering ‘what if’ regret of missed opportunity. Currently the rate for a joint life annuity, increasing by 3% per year to protect against inflation, is around 4.5%. That is distinctly mediocre compared to the annualized return of the S&P500 which, even including the two major downturns in the last 25 years, was around 7.5%.
These regrets are embroiled in an duel. If I opt for the drawdown pension, and there is a dramatic downturn that slashes my investment, I will regret not having chosen for the security of the annuity, even if the income would have been more modest. If I choose the annuity, over time I might find that inflation is eroding my purchasing power, and I will regret missing out on the market returns that would have made my retirement a lot more comfortable.
Perhaps the best way to resolve the dilemma is a hybrid solution: ensure there is a floor underneath any potential losses that eliminates the catastrophic risk of running out of money before I die, and leave another part of my investment in place to capture market upsides and provide protection against inflation.
If only I could get rock solid certainty about how I should split the pension pot between the two options to maximize peace of mind in my old age…
Koenfucius 