COLLECTIVE INSIGHT: HOW DEFAULTS CAN CHANGE YOUR PENSION POT
If you are an employee who receives some form of employee benefits, your pension fund probably already uses a default investment option.
be honest – when you saw that this edition of Collective Insight was all about defaults, which of the following dictionary explanations of that word was the one that first popped into your head? dɪˈfɔːlt default noun
1. failure to do something required by duty or law – such as pay financial debts
2. a selection made usually automatically or without active consideration due to lack of a viable alternative Given our hypersensitivity around our financial well-being these days, my bet is that your mind first raced to “credit defaults” or “failure to pay financial debts”. In fact, this edition of Collective Insight is dedicated to understanding the latter definition of “default” – with specific reference to the kind of defaults National Treasury feels we need to introduce if South Africans are going to achieve the level of savings that they require to ensure that they do not become a financial burden on others.
On some level it would seem that this debate might be best suited for trustees of retirement funds or policymakers. But we believe this edition should be essential reading for any employee who receives any form of employee benefits from their employer. And that covers most of us.
Defaults will be coming to the employee benefit plan and retirement fund nearest you – if they haven’t already. Most likely your pension fund already uses a default investment strategy.
But National Treasury would like to see defaults being used in relation to decisions about preservation and annuitisation. And the logic for applying defaults easily extends to such decisions as your contribution rates to your pension fund; the automatic escalation of those contributions over time as your salary increases (auto-escalation); and the shift in your risk benefit coverage as you progress through different life stages.
The link between defaults and saving
Why has this concept of defaults become so important to your financial welfare? At the heart of this debate (and it’s turning into a particularly contentious one) is the welldocumented observation that we members of the human race (not just South Africans) are not particularly good at formulating the right long-term savings and financial protection strategies to ensure that we do not become a burden on others over the course of our financial journey.
When South African employers began shifting their employees out of defined benefit funds, where the employer made all the decisions on behalf of their members, and into the defined contribution model of retirement savings, suddenly this financial planning responsibility was shifted directly to the shoulders of the savers.
As Olivia Mitchell and Stephen Utkus pointed out in their seminal piece on pension fund design and human behaviour, “getting this decision-making right meant that the human brain would need to have the capacity to solve many decade-long time-value of money problems with massive uncertainties as to stochastic cash flows and their timing” i.e. we humans weren’t likely to figure this one out on our own.
Enter the concept of defaults. On some level the concept of defaults is brilliant. Get the professionals to work out all the complex modelling required to make sure that members of retirement funds get the strategy they require to meet that retirement income funding; embed this thinking into a series of processes and funds (pre- and post-retirement) and then set it as a default
Suddenly this financial planning responsibility was shifted directly to the shoulders of the savers.