Retirees stumble at final planning hurdle

As member choice gains prominence, people are being given more responsibility for looking after their golden years. Recent research, however, raises concerns about just how well they are able to do this. Zilla Efrat reports.

As member choice gains prominence, people are being given more responsibility for looking after their golden years. Recent research, however, raises concerns about just how well they are able to do this. Zilla Efrat reports.

Retirement planning must surely involve some of the most important decisions many people ever make. And, as member choice hits Australia, getting these decisions right will become increasingly important.

Research in the United States, however, has highlighted the abounding lack of financial sophistication amongst those who have to make the decisions.

Indeed, a study by Richard H. Thaler of the University of Chicago's Graduate School of Business and Shlomo Benartzi, cast doubts on the asset allocation abilities of most people.

Their study shows that, as in most complex tasks, people turn to a simple rule of thumb when allocating assets in their retirement plans. And, one such rule is the diversification heuristic or its extreme form, what they call the "1/n heuristic".

People using this rule simply spread their contributions evenly across the investment options in a plan irrespective of the particular mix of options available. The result is that the array of funds offered can strongly influence the asset allocation investors land up with.

Thaler and Benartzi discovered that as the number of equity funds offered to the investor rises, so does the investor's allocation to equity funds.

The use of the "1/n heuristic" rule in asset allocation has a long history. For example, the advice from rabbi Issac bar Aha in about the 4th century was that "a man should always place his money, a third into land, a third into merchandise and keep a third at hand."

And, there are signs that similar rules are still in use. For many years TIAA-CREF, the world's largest defined contribution savings plan offered two investments - bonds and stocks - and the most common allocation was a 50-50 split.

Thaler and Benartzi's research found evidence of naive diversification strategies both in experiments using employees at the University of California (UC) and in the actual behaviour of participants in a wide range of plans.

The researchers' first asked UC employees to complete hypothetical questionnaires on how they would allocate their retirement contributions between two funds.

Different groups were given different sets of funds, but their responses showed that the pair of funds offered strongly influenced the asset allocation.

Thaler and Benartzi then compared a plan for TWA pilots with one available to UC employees and came up with similar results. The TWA plan offered five core stock funds and one core bond fund. And, participants in this plan invested 75 per cent of their money in stocks, which is well above the US national average of 57 per cent.

On the other hand, the UC's plan offered one stock fund and four bond funds. Yet, its participants invested only 34 per cent in stocks, well below the national average.

Turning to the real world, Thaler and Benartzi also analysed the choices of participants in 170 savings plans which, together, had 1.56 million participants and annual contributions of $3.23 billion. Again they found that the mix of funds in the plan strong affected asset allocation choices.

The researchers also studied whether other factors could be at play, such as the possibility that plan sponsors are choosing an array of funds to match the preferences of employees.

This was done by examining the choices of the employees at a company for which they were able to get quarterly time-series data. And, the results reinforced the conclusions of their previous work.

Another interesting finding of Thaler and Benartzi was a propensity for employees to invest in the companies that they work for.

In those plans that offer company stock as an asset allocation option, the company stocks captured nearly 42 per cent of the assets, more than any type of investment.

When comparing the investments of plans that offer company stock with those that didn't, Thaler and Benartzi found that when employees do invest in company stock, they still tend to split the balance of their investments between equities and fixed income investments.

"It appears that the mental accounting of these investments involves putting the company stock into its own category separate from equities," the researchers say.

"The diversification heuristic then pushes people toward the 50-50 split of remaining assets. The result is that employees in plans that offer company stock have over 71 per cent of their assets in equities while those in plans without company stock have about 49 per cent in stock."

Thaler and Benartzi's findings would seem to suggest that the rise in retirement funds' investment in equities over the past decade may be partly due to the abundance of new equity funds on offer, although the booming stock market has, no doubt, been a major factor.

The findings surely give plan sponsors and designers plenty to chew on. They should, for example, consider what impact they could have on asset allocation by offering a wider choice of equity funds in a plan.

As the researchers note, it is easier to segment equity funds into new product groups like Small Cap, international or resources funds. It is, of course, much harder to do the same for fixed income funds, other than by maturity or risk.

In addition, sponsors need to note that the mix offered in their plans could lead to either too conservative or too aggressive asset allocations being made, as well as ones that do not fit the age group of participants.