My king­dom for a set menu

The life-cy­cle op­tion as a so­lu­tion to the “poverty of choice”.

Finweek English Edition - - COLLECTIVE INSIGHT -

ohnj

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”.

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