Pension freedom has resulted in people behaving in precisely the way behavioural psychologists would have suggested they would when faced with the choices it entails, writes Mike Morrison.
Over the last few years I have become fascinated by how behavioural science interacts with the savings world and the fact we do not act rationally in making financial decisions. Instead, we are subject to certain biases and this is particularly relevant in the retirement process.
In the FCA’s recent Retirement Outcomes Review, there was one paragraph that caught my eye and which I believe sums up much of what has happened since 2015: “Pension freedoms have switched the mental accounting of (the) pension pot from a future retirement income choice to a current consumption choice.”
It immediately brought to mind discussions from a few years ago of being able to access your pension fund via a cash point machine …
Behavioural finance defines ‘mental accounting’ as ‘the tendency for people to separate their money into separate accounts based on a variety of subjective criteria like the source of their money and the intent for each account’.
This is a difficult one to overcome. Up to the age of 55, life might be challenging with limited financial resources – in other words, few treats or holidays. Then all of a sudden, at the age of 55, under the pension freedom rules, all the money that has been saved immediately becomes accessible (unless one is in a defined benefit (DB) scheme with a value in excess of £30,000 – but that’s another story).
Add to that the feeling retirement is a long way in the future and that spending a little will not matter, and it is easy to see why people are inclined to cash in early.
Pension freedom has, then, resulted in people behaving in the way behavioural psychologists would have suggested they would behave when faced with such choices. Put this way, does it really sound so bad?
For people with small pension funds – perhaps around £50,000 – non-life-changing sums that would have had to be used for drawdown or an annuity purchase can now be used for outcomes offering greater ‘utility’, such as loan repayments or even holiday purchases.
More problems arise for the category of ‘medium-sized’ funds. It is hard to put an exact number on this as it is the ‘squeezed middle’ – those people who are more likely to have a defined contribution scheme than a DB scheme, perhaps still with kids at home. Understandably the ability to dip into a pension pot at age 55 to supplement expenditure becomes very tempting.
Illustrating differing outcomes
If pension freedoms are to continue successfully, then education and the illustration of differing outcomes will be important alongside the recommendation, where necessary, of specialist advice.
Subjects that really need to be flagged should include the following:
* Longevity and the fact retirement can be longer than expected.
* How to budget for retirement and save accordingly.
* Attitude to risk and capacity for loss – particularly for income drawdown over a period of time. This includes flagging the fact that drawdown is a specialist subject and that advice can be key when it comes to using cashflow planning and the calculation of ‘safe’ withdrawal rates.
If we also attempt to address some of the behavioural biases inherent in planning for retirement, then perhaps we start to get somewhere – a message that retirement is such a big issue that it necessitates keeping those ‘accounts’ and ‘intents’ separate.
If we do not get it right, then that ‘knight in shining armour’ – the pension dashboard – changes from being the intended one-stop-shop for pension values and savings encouragement to a simple indicator of how much money can be spent and when.
Mike Morrison is head of platform technical at AJ Bell