Behavioural Economics & The auto-enrolment revolution
The United Kingdom is one of the first countries to mandate auto enrolment of employees of businesses of all sizes to auto enroll employees into pension funds.
They also mandate employer contributions, and tax refunds into the allocated accounts.
Recent papers analysing this policy has proven that it has been very effective in increasing the amount of people who now have pension savings.
The UK has vastly increased the rate at which they enrol employees into these funds, compared to economies like the US & EU.
Does this mean the UK is headed to great retirement outcomes for its citizens in 50 years' time? Unfortunately, forecasting data still says, no it isn’t.
Is it the outlook better than say, the United States? Yes.
But is it enough for a comfortable retirement? No.
What is going wrong?
While this problem is being tackled by the UK government by increasing the minimum contribution levels (The most recent revision being in April 2019), the problem doesn’t end there.
The rise in auto-enroled pension funds has sparked a question within another type of financial product, and that is the case of passive investing / ETFs / index funds.
A higher amount of pension companies today are investing into ETFs as compared to the past, seeing their passive investment style & low fees as a secure long-term option with better returns as compared to government bonds or alternative long-term investments.
The problem with this passive investment strategy is that it is prone to financial instability in the event of a financial crisis.
Furthermore, the exact risks and long-term tradeoffs to passive investment are not clear.
How can behavioural science provide an insight into this?
From a behavioural perspective, applying social herding theory, it’s clear to understand the choices of customers who choose to invest nearly 50% into passive investing strategies today as compared to only roughly 24% a few years ago.
People feel safer trusting the decision of the majority to guide their investment choices, it’s the law of low effort.
We choose the action that requires minimal energy for maximum payoff.
But this form of passive trading could prove dangerous in the long run. It provides no valid reason for index tracked companies to innovate.
A large percentage of their stocks are purchased by algorithms investing in the index - uncorrelated with company performance.
Behavioural finance has strongly questioned the efficiency of markets, and other fundamental questions, but research hasn’t looked at a scenario where a majority of investors are investing passively, with no knowledge of what they are investing into.
This resembles in many ways people throwing money into a pot, hoping for companies to do better with their money, and create better outcomes while not actively checking or holding them accountable – it’s creating a hotbed for a lack of corporate governance.
So, how does auto enrolment tie into this?
Auto enrolment enables an even more passive investment, into passive investment.
People auto-enroll into pension funds, who place some of their money into passive investment funds. Is there a problem that is compounding here?
While this may seem like a complicated financial markets issue, what it really boils down to again (as frequently evident) is human behaviour.
Passive investment directly into ETF’s or via your pension funds is slowly becoming the default.
Default options drive social norm creations. Having any financial product as a social norm is inherently dangerous to global financial safety.
Disrupting these social norms by interventions into a maximum cap on pension funds that can be passive investments is a good strategy.
Encouraging employees to make an active choice in the future, that is more in-line to their retirement goals, or auto-enrolling employees into funds proportional to risk criteria based on age is another good option, this taps into our basic instincts to be more risk seeking while we are younger and risk averse as we get older.
Knowledge, while tempting to be a radical solution has proven to be mostly useless as people are quickly overwhelmed by the plethora of information.
We know that when people face a cognitive overload, they tend to shut down and not make any decisions at all, rather than make an optimal one. So clearly, knowledge does not seem to be the solution.
Instead risk prompts about passive investment vs active investment are important to ensure those who would be willing to actively invest (those whose behaviours are such) see it as a viable alternative to passive investment and feel empowered to do so.