Self-selection - a simple tool that allows individuals to identify their own optimal pension plan
Up to 80% of the value of a pension lump sum may be lost if communication between financial company and saver fails. Researchers at Cass propose a simple to use annuity product which cuts out the risk of miscommunication by allowing the saver to directly select their own optimal investment strategy.
Although of great importance to the majority of the adult population, the actual percentage of people who understand pension plans is very small. Poor communication from pension providers hasn’t helped improve this situation, and the complex nature of a pension product is difficult to relate to an audience with little or no technical understanding. Inadequate or inappropriate cover can result.
This paper proposes a solution - the facility for a pension saver to make their own investment decisions via a simple interface with a tool that carries out all complex calculations while removing any opportunity for confusing or contradictory advice.
This intuitive framework should allow a saver to select the optimal investment strategy based on their individual appetite or otherwise for financial risk. Where a pension plan adviser might interpret what it believes the saver’s requirements are, and possibly interpret them incorrectly, this framework design provides the pension saver with the exact investment strategy they ask for.
The proposed interface, available through a website or mobile phone app, would be of a format familiar to many people, employing sliders to set current age, retirement age, and the investment amount. The saver would then choose the number of years for which they wanted to have a monthly pension benefit guaranteed.
As a result of these decisions, the saver is presented with a Risk-Return Trade-Off slider. With this the saver can visualise the trade-off between the length of guarantee and the most likely size of the monthly benefit within that guarantee period. The saver will always be made aware that there is a 50% chance the benefit income will continue at a fixed high-level for the rest of their life, and a 50% chance it may be reduced once the guarantee period is over. In response to whatever setting the sliders are moved to, the tool displays a percentage which represents the probability of ending up with a zero pension once the guaranteed pension income period has finished. For example, if 22% is the figure displayed then 22% is the chance of a zero pension after the guarantee period, with 28% then being the chance of the saver experiencing some reduction in benefit income.
We believe this offers a simple and intuitive means for individuals to understand risk and set their investment strategy accordingly.
The paper introduces three innovations:
- A product so easy to understand that the saver can self-select the financial risk and design the financial investment strategy within minutes;
- Automatic mortality risk sharing between annuity customers;
- Automatic investment guarantee risk sharing between customers, meaning they do not have to pay for their investment guarantee and the pension company does not need to issue one.
The great advantage of this system is its flexibility and accessibility, as it enables a saver to re-examine or change their investment strategy periodically if required. Indeed, the framework proposed in this paper offers near endless possibilities for building a pension product. The final optimal design is something that still needs to be worked towards. However, the researchers believe this study offers the basis of a genuine solution for ameliorating the challenges of the pension crisis.
A pre-print version of the paper Self-selection and risk sharing in a modern world of life-long annuities is available for download. The necessary underlying mathematical financial hedging theory is included in the paper.
A presentation about the study, delivered by the researchers at Cass Business School on the 14th May 2018, is also available for download.