Get your hands out of my pockets!

This is a topic that came up in my Behavioural Finance class this last week. It actually aggravated me a great deal, and as Laura can attest, I have spent much of the last week musing over it. So, since it's been on my mind, I thought I would share my thoughts on the subject.

A number of countries, including the US and the UK, are in the process of rolling out auto-enrolment of employees in company pension plans and set non-zero initial levels of investment in the pension plan. This would not require individuals to remain enrolled in the company pension plan, or at those savings rates, but would enroll all employees automatically and allow them to opt-out rather than the prevailing system, where individuals can opt-in.

This is a soft paternalistic approach to solving a behavioural problem that contributes to a perceived social problem. The perceived social problem is that individuals tend to save too little for their retirement. This is somewhat surprising in the case of employees of firms offering pension plans, especially given the company pension plans often offer substantial inducements to participation (like contribution matching). This seems to be caused by a number of behavioural problems; like inertia - that individuals often do not respond to the incentives before them, or time-inconsistency - that they are exponentially impatient, extremely unwilling to give up what they have now for what they expect to receive in return in the future.

Auto-enrolment in pension funds is a soft paternalistic approach, as there are other agents who think that they know what is best for the individual and then act upon those opinions. The approach is 'soft' because it allows the affected individual to change how this action affects them (unlike hard paternalism).

I was suspicious of this approach from the start, but it has taken me some time to consider my objections. I admit that I think individuals should save more for their retirement - I would even advise young workers to start saving for their retirement as soon as they start work (first, they won't get used to a higher spending rate and have to make a painful adjustment later on, and second because of the simple appeal of compound interest). However, I am uncomfortable with auto-enrollment; a contractual relationship is being created between the individual and the pension fund without the individual so choosing. Even though the individual has the ability to cancel that relationship, it does not seem right for it to be assumed that the individual would want that relationship.

Let me give some similar examples to help consider this. Consider a scenario in which you work for a bank, and it brings out a new credit card product, for which it is going to charge a non-negligible annual fee. The bank thinks that this product is really in the best interests of all its employees, and signs them all up to a new credit card account. I suspect that, were you one of the employees, you would be pretty miffed. (Actually, this has happened... and the employees were in uproar!)

Or another example, in a different context; let us suppose the government passes a new law where it assumes that it is in the best interests of voters to vote for the incumbent government, and as such all electoral abstentions will be counted as votes for the incumbent government. Voters can vote for other parties, or even spoil their ballot paper, but if they fail to show up it will count as a vote for the incumbent government. Again, I expect there would be outrage!

But how are these scenarios different from the pension fund auto-enrolment? The main difference seems to be the acceptance of whether the other agent's actions are in the best interest of the the individual - but that is a very subjective question.

However, I am not sure I would rule out all soft paternalism. My real objection is, I think, the violation of pre-existing rights. Let us take an alternative example of auto-enrolment in pension funds. Were the company to create a pension plan account for its employees - without setting any level of investments and permanently without charge until there are investments in the account, then I don't think I would object to this. Whilst it is creating a contractual relationship with the individual, it has not committed the individual to anything, and as such the individual's pre-existing rights have not been violated. In fact, I might even go so far as to say that I would applaud such an approach, as it provides a non-intrusive means of reducing the individual's behavioural problem of inertia. (n.b. for the credit card example, removing the card's annual fee would not remove all violations of the individual's pre-existing rights, as the mere creation of the credit card account would affect the individual's credit score.)

What about the individual's time-inconsistency problem. Here, it appears there also ways of helping the individual to overcome their behavioural problem; allowing the individual to enter an agreement to pre-commit some proportion of any future pay-rises to their pension plan investments. This allows the individual to make a better choice for the future investments without the high cost of their exponential impatience, and don't feel worse at the time they increase their savings rate, as they never experience a drop in their take-home pay.

So I think that there is much that behavioural finance can offer to help individuals to make better choices. However, I think that we need to be careful about the approaches that are used - the end does not always justify the means!

I would be very interested in your thoughts on the topic, and your reflections on the examples I have included.

My friend Max...

Here's a little puzzle - I'm indebted to my colleague Nick for sharing this with me:

In computer programming, it's common to have a function that returns a maximum. For example, in Java, there's a function Math.max(double a, double b), which returns the higher of the values a and b. (If you're not familiar with programming, don't worry about the doubles, a and b are just numbers.)

So here's the challenge. Write a function that returns the higher of two values, using standard algebraic operators - i.e. addition, subtraction, multiplication, division, powers. You cannot use conditionals (if x, then y etc) or comparators (e.g. >, < or = ).

You don't even need to answer in programming code; an algebraic function that returns the higher of two numbers is sufficient.

Answers on a postcard?

Start at the very beginning...

So, this is the blogosphere... and here I am.

Inspired by Laura's blog, Dreaming Spires, and having had the opportunity to do a guest post (Anthony's Book Game) I thought I would join this crazy world that is. It's an opportunity to share my thoughts and musings on whatever topics interest me. If I'm fortunate, they will interest you too, otherwise they may just serve to reveal my eccentricities.