Behavioural economics, the study of how humans operate and make decisions based on psychological, cognitive and emotional factors, offer some interesting insights to the brave new world in pensions paved by George Osborne in March’s Budget.
As of April 2015, at retirement age people will have the freedom and flexibility to take all the money accumulated in their pension and do with it as they wish – once the tax has been paid. At face value it might seem like a financial liberation and as a consequence of these freedoms, many believe we will all save more for the future. But the opposite outcome is quite probably more likely if we listen to behavioural economic theory it might mean that by focusing on large lump sums of money for retirement, we will feel less inclined to save.
Research from Goldstein, Hershfield & Benartzi (2014) sought to assess how middle-aged people would assess the adequacy of retirement savings when expressed in two different ways: as a lump sum and as equivalent regular monthly payments. Goldstein, Hershfield & Benartzi predicted that the perceived adequacy of a pension would vary depending on how it was presented. They anticipated that savers at lower levels of accumulated funds would be more sensitive to changes in monthly sums than to changes in lump sums.
So whereas a £50,000 lump sum appears a satisfying amount for someone retiring, the same amount expressed in monthly annuity-style payments spread over an expected lifetime in retirement appears less satisfactory. Interestingly, there is a tipping point when pension pots expressed as monthly amounts are viewed as having greater adequacy than their lump sum equivalent. In this study, the figure is around the £200,000 mark – which seems roughly the amount at which most people’s living costs are met when expressed as monthly amounts.
As a consequence of people appraising their pension pots as less adequate when presented in regular monthly amounts, become inclined to save more. Therefore, the benefits of increased saving are greater when pensions are presented as monthly amounts rather than a lump sum. If you are trying to decide how much and what to do with your pension savings Enables IFA’s in Bishop’s Stortford can help you consider your options.