Tuesday, November 25, 2014

Retirement Savings Marathon

11:40 PM


The magic bullet

We try to learn about investing and become better at it, but too many of us cannot overcome being financially challenged, or more precisely being comfortable making investing decisions. To boot many have no time or interest in the topic.

To alleviate this state of affairs, the Canadian Government established a federal Task Force on Financial Literacy. The task force made several recommendations for improving financial knowledge and these will take time to be adopted by the public.

What should we do to improve our odds of success?

Our biases

Behavioural science tries to understand social, cognitive and emotional biases that affect and influence economic decision-making. When it comes to money decisions, we don't act in a rational way.

There are several factors that play against us:

  • Overemphasizing immediate rewards at the expense of long-term needs,
  • Procrastination and inertia: delaying decision and a difficulty to change course,
  • Preferring the status quo to making active decisions,
  • Complexity of making retirement planning decisions far into the future, and 
  • Choice overload: the sheer volume of choice causes "paralysis analysis".

Meeting the challenge

Maybe we can learn from how employers and stakeholders worldwide have met the challenge of encouraging pension plan members to save for their retirement. I am referring here to capital accumulation plans such as defined contribution pension plans or group RRSPs. One big problem has been the large number of employees lacking any interest in their pension plan and more generally the task of saving for retirement.

This negatively impacts the level of contributions and investment returns and is disastrous to retirement income adequacy. Too many employees  commonly continue to contribute at the rate they first chose when they joined the plan and remain invested in the portfolio they were defaulted into initially.

So the industry addressed this apathy by adding automatic features to savings plans: enrollment, escalation and investing.

With "auto-enrollment", employees don't decide whether or not to enroll in a plan, they are automatically enrolled but have the right to opt out. This address the concern of employees never joining a plan and not bothering to save at all.

"Auto-escalation" adds automatic increases to the contributions rate over time. An employee who joins the plan starts contributing at a low rate, and as time goes on, the contribution rate slowly rises over time until it reaches a level that improves the chances of providing a reasonable retirement income. This concept helps employees "ease in" to the plan in a financially manageable way, while maximizing contributions as retirement becomes closer.

The other popular feature is to "auto-invest" the contributions. Instead of defaulting to money market funds, which cannot provide the investment returns required to accumulate an adequate retirement nest egg, the default fund where contributions are invested is a "target date" fund appropriate to the plan member's investment horizon. For example, these funds invest younger employees in higher-risk portfolios that automatically glide toward a more conservative profile over time.

These features are beneficial in many ways. First, it gets employees to develop solid savings and wealth accumulation habits. Second, it reduces the likelihood of getting extremely low investment returns and making them disengaged with the daunting task of saving for retirement. Third, experiencing volatility in the early years - when assets are low - teaches the discipline of "staying the course" and riding fluctuations with a low impact on the long-term outcome.

Being young

Younger savers have very different priorities, and saving for retirement isn't at the top of their list. Retirement is a lifetime away, and getting started in the housing market, paying off debt, travel, sports, hobbies and having a safety net for emergencies leaves little room for the retirement planning savings marathon.

But living in the present, where spending trumps saving, does have very real implications on the ability to retire with adequate income. Building savings to provide retirement income for 30 or more years requires patience and discipline, and it starts with regular ongoing monthly contributions that increase over time and are invested in a portfolio appropriate for the investor's risk tolerance and investment horizon.

These auto-features are designed to address the shortcomings identified in behavioural science and steer investors in a direction that serves their long-term interests.

We can all learn from this by adopting these strategies and forcing ourselves to act rationally with our economic decisions.


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