Monday, 31 March 2014

Pensions and present day bias

In the UK budget a week or so ago the Chancellor surprised most by announcing a radical shake up of the UK pension system. According to the old system retirees, with a private pension plan, were essentially forced to buy an annuity that would smooth income over their remaining life. Under the new system retirees can withdraw the money and spend it as they wish. So, if they want to splash out on a Lamborghini sports car then fine (according to the pensions minister). 
           What has interested me most about the pension changes is the public reaction. Immediately, people began questioning whether it made sense to let retirees have freedom of choice. Are pensioners capable of make informed rational decisions about how to spend their savings? Will they not blow it all and be left to live out their lives on state support? To most people it seemed obvious that some might make dumb, inappropriate choices. And, for me, this illustrates how divorced from reality economic theory has become.
          Thankfully, we now have a theory of why people may make inconsistent choices over time (see, for example, the article 'Doing it now or later' by Ted O'Donoghue and Matthew Rabin). The theory points towards time-inconsistent preferences with a present day bias. The bias basically means we treat today as 'special' relative to the future. And that means we may be unable to stick to long term plans. For instance, on Friday you might plan to clean the garage on Saturday, on Saturday you think 'maybe next week', and on Monday you regret not cleaning the garage. The present bias in this example manifest's itself on Saturday: From the perspective of Friday or Monday, Saturday is just any other day. But, when Saturday is today it's special, and you do not want to clean the garage!
          Everybody is surely familiar with the consequences of time-inconsistency - planning to do something, but then not wanting to do it when the time comes. The idea that pensioners might blow all their pension money unwisely seemed common sense to most. Standard economic models, however, take no account at all of time-inconsistency. And even though we now have simple models of time-inconsistent preferences it is very rare to see them applied. A fundamental part of human behavior is, therefore, completely neglected by standard economic theory! That's weird, and frankly, makes economics look silly.
         This divorce between reality and theory is a consequence of economists becoming trapped in a world where people are assumed rational, even though we know people are systematically biased in many ways. To date, behavioral economics has done nothing more than chip away at the edges of this monolith. Hopefully, things will change in the future.
       But, what of the liberalization of the pension rules? Some argue that because of time-inconsistent preferences the changes will be harmful. And, no doubt there will be some who blow their pension money in a way they subsequently regret. The old system, however, forced everyone to buy an annuity despite their being many for whom this was not the best option. Trading off the interests of some against others is always difficult. But, I think the old system was clearly weighted too much on the side of those likely to blow the money. Many were having to choose bad options for the benefit of a few who could not be trusted to spend the money wisely.
          Present bias does exist, however. And so it is still important to try and nudge pensioners to spend their money wisely. Note, though, a fundamental characteristic of a good nudge - it should not limit the options available. The pension reforms announced by the government fit this model - they liberalize choice while still nudging pensioners in the direction that will be sensible for most.

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