My kingdom for a set menu
The life-cycle option as a solution to the “poverty of choice”.
Maynard Keynes characterised economics, in a nutshell, as a problem of scarcity. Increasingly, however, consumers at all levels are faced with a problem of abundance – an abundance of choices and an abundance of information. Paradoxically, a rich set of choices doesn’t necessarily translate into either easier or better decisions. In fact, it leads to suboptimal selections.
The same is true when it comes to decisions about savings and investments. Cash-strapped consumers are prompted by foresight or regulation to put aside money for their pension pot, but they are further constrained by the “poverty of choice” – when too many options result in poor decision-making, or worse, no decision at all, leaving the consumer decidedly worse off.
I profess to being an eternal menu-ditherer – when faced with a myriad of options, I invariably ooh-and-ah, before throwing up my hands in despair and settling on a burger and fries (or the high-end equivalent thereof). The impressive, flowery descriptions do little to help me make my choice – the mélange of mousses, jus, reductions, froths and foams leave me baffled.
I therefore appreciate the concept of a set menu. The chef determines the menu de jour, based on expertise, experience and current circumstances. They’ve done their time in hot kitchens, crying over onions; they’ve prodded and poked the avocados and listened to the melons, and seen what is appropriate to the season, what is available at a reasonable price, and what is of good quality.
A closer look at the lifecycle model
One can extend the metaphor of a set menu to retirement options, and in particular, a default investment plan, determined by those who are better equipped, for those who are unwilling or unable to decide. The chefs in this case are the elected board of trustees, guided by regulations and sound, impartial guidance from industry bodies and specialists.
The majority of defined contribution pension plans allow their members some degree of choice as to where their contributions should be invested. Yet the majority of pension plan members do not actively engage with the process.
A default fund has become the typical solution for members who do not make an active choice, and a high proportion of members worldwide typically end up in the default fund (percentages range from 42% in Australia to 60% in Chile).
The same is likely to hold true in South Africa, where a vast majority of pension funds’ member-base is hamstrung by the daily financial grind and inadequate financial education. It is a double whammy; poverty, and the “poverty of choice”. In SA, it is therefore not surprising that nearly 42% of pension fund members end up in their scheme’s default option. The design of default options is therefore of critical policy relevance.
Well-designed and suitable default funds ( judged in terms of attaining an appropriate replacement ratio, taking risk and return considerations into account) are increasingly in the spotlight, as they determine whether a broad-based section of South Africans are adequately provided for on retirement.
Studies have concluded that life-cycle strategies are able to provide superior replacement rates, versus alternatives such as fixed portfolio strategies (which can include all bond, all cash or fixed asset allocations. Balanced funds, for example, typically maintain a fixed allocation to a mix of asset classes). One of the key aspects of life-cycle funds is that they can effectively take mortality characteristics into account.
Life-stage approaches focus on replacement ratios at retirement, allowing assets and liabilities to be matched over life stages or cohorts to adjust for increasing longevity (or other demographic risks) and inflation risk. They are intuitive as the majority of members can recognise that life consists of phases, and that their needs, abilities and wants change as they age and progress in their working lives.
The typical profile for a life-cycle model is to implement a decreasing allocation to equity between the different stages (growth/ accumulation, consolidation, and preservation phases) with a rotation toward fixed-income assets (bonds, property and inflation-linked bonds). Empirical evidence suggests that lifecycle strategies typically reduce the variability of wealth outcomes, though there may be some sacrifice of upside risk. In other words, in certain markets, the mean of outcomes may be higher for a fixed/balanced fund default than for a life-cycle default. The median, however, will be lower than the life-cycle outcome, with more members clustered at the lower end.
Life-cycle models have typically also proven better at weathering extreme market conditions, providing more protection against downside risk. Interestingly, this is particularly true for shorter contribution periods. Many
A vast majority of pension funds’ member-base is hamstrung by the daily financial grind
and inadequate financial education. It is a double whammy;
poverty, and the “poverty of choice”.