Pensions: Making pension plans the default option
Studies have found that making the choice to enrol in a pension the default one for workers has a dramatic upward effect on participation. Can it work here? Liam Delaney, Colm Harmon and Keith O’Hara report.
Economics has long grappled with the question of why people do, or do not participate in pension plans. For most of the 20th century, economists viewed this problem through a model known as the life-cycle hypothesis, which suggests that people, using available information, rationally forecast their future income, then save and invest in a way such that their consumption will be smooth over their lifetime. A popular vehicle for this consumption-smoothing saving is participation in a pension plan, usually set up early in an employee’s career.
Work in behavioural economics, a field that combines economics and psychology, has been questioning this account. Contrary to life-cycle theory predictions, consumption seems to fall too much after retirement; people, in general, seem unaware of their options; and most importantly, many of us appear simply too lazy and prone to procrastination to achieve an optimal consumption-saving trade-off.
A seminal paper by two U.S.-based researchers, Brigitte Madrian and Dennis Shea, investigated what happened when employees were “autoenrolled” into pension plans, but were also given the choice to opt out. The results are quite striking. Despite no difference in the financial aspects of the plans, such as employer contributions, autoenrolling employees had dramatic effects on employee participation. Among groups who traditionally did not take out pensions (women, low-income groups, and ethnic minorities) the results were particularly pronounced; a near-quadrupling of enrolment numbers over self-selected entry for some cohorts.
This research has been followed-up by numerous other papers and the auto-enrolment feature seems a robust way of increasing participation in company contexts. In general, the active setting of default options is being debated across a wide range of policy areas. The question is whether such altering of default options can be a solution to low pension participation across whole populations.
In the next couple of years, based on this research, both the British and Irish governments will embark on ambitious programmes of changing the pension default options among private sector workers. In Ireland, as part of the 2010 national pensions framework, all private sector employees not currently covered by an employer-sponsored pension plan will be autoenrolled into a defined-contribution plan. Employees will contribute 4 per cent of income within defined income bands, the employer will contribute 2 per cent on a mandatory basis and the government will contribute a 2 per cent tax break.
The programme will begin in 2014, with the contributions being collected through the PRSI system.
There is a lot to be welcomed about this policy. Successive attempts at increasing pension participation throughout the Celtic Tiger period largely failed. Programmes, for the most part, targeted awareness and generally tried very soft tactics to address what is a more ingrained behavioural issue. Auto-enrolment has a strong evidence base and can, in the right conditions, change behaviour in a way that will ultimately benefit employees without coercing them or removing freedom of choice.
However, there are a number of issues that need to be thought through before implementation. Firstly, this is a forceful policy. In Ireland, employees who opt out will be re-enrolled after two years. In essence, this makes the policy more of a shove than a nudge, and sets a precedent that government policy in this direction will be on the hard side.
Secondly, it is fully mandatory for employers to participate. There are obvious political reasons why the government would do this, but the necessity of employer contributions is not obvious at a time of tough labour market conditions. The potential knock-on effects to wages and to hiring should be given more thought, including any additional administrative burden placed on small employers arising from auto-enrolment.
A further issue is the potential that this scheme will target those who are already saving or would have saved anyway. The evidence is not yet conclusive from New Zealand, but early papers on the similar KiwiSaver initiative make it seem likely that a large degree of substitution took place from other savings sources rather than an actual increase in net savings.
Still more serious is the possibility that the 4 per cent contribution rates set by the government will be seen as tacit advice by the people being enrolled. 4 per cent is a small savings rate, even with the employer and government contributions. Recent evidence suggests that a whole cohort of employees enrolled at low-levels may rigidly stick to them, despite the fact that they would have contributed more had they been left alone. The Government should give serious consideration to enrolling at higher contribution rates and giving the option to reduce contributions, as well as devising mechanisms to encourage scaling up, particularly via pre-commitments from future pay increases, something that hopefully will be a feature of a post-2014 Irish economy.
When the mechanism is designed, the issue of how the funds will be presented to participants and, in particular, the allocation of the default fund will be the most pressing issue to decide. Evidence from Sweden suggests that employees, given more choice tend to diversify less and move, in particular, into domestic equities, achieving lower returns than if simply assigned a default well-diversified portfolio.
This is a major national experiment with implications for many other aspects of policy. There is much evidence that, conducted correctly, this policy can fix a major problem facing us in years ahead. But there are also many pitfalls and it is important that the roll-out be accompanied by a seriously conducted pilot-phase.
Liam Delaney is a research fellow at the Geary Institute and Professor of Economics at Stirling University. Colm Harmon is Professor of Economics and Director of Geary Institute. Keith O’Hara is a researcher at the Geary Institute.
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