Pensions, Prime and growing pains: Making saving the default for younger members

As humans, we make decisions based on limited knowledge and a mixture of experience and how we are ‘hardwired’. Our brains automatically filter what we see and use a series of shortcuts (or heuristics) to choose – otherwise we’d be overwhelmed by data. Generally, these shortcuts work well, but behavioural economists have shown they can lead to systematic biases and mistakes. Responses like ‘fight or flight’ are arguably better suited to encounters with sabre-toothed tigers than long-term investment decisions.

For most people, pension saving is the first time they’ve been exposed to assets like equities and bonds – so setting biased patterns at this early stage may chart the course for a financial lifetime. As such, the pensions industry and government worry about younger defined contribution (DC) savers’ responses to the ups and downs of markets. For example, if investment returns are negative in the short term, people might panic and stop contributing – underestimating the long-term benefits of saving.

Happy with apathy?

Hang on though, recently there’s been surprisingly little saver reaction to downturns, and certainly no stampede for the exit. Just think of the COVID pandemic in March 2020, and the cost-of-living crisis since 2022.

Most observers agree that’s due to apathy, rather than a good understanding of pensions. Behavioural biases play a role here, with people not engaging on their eventual retirement as it’s so far in the future (called hyperbolic discounting). Apathy helps protect savers from making panicked decisions in crises, when otherwise a lack of understanding and behavioural biases could lead to them stopping contributions or moving to cash.

Now though, the advent of technology in investing may change that. Firstly, digital access and apps are making it easier for people to check their investments’ value – and act if they are concerned. Secondly, ‘social contagion’ is changing behaviour in extreme and surprising ways.

Me me me

The rise and partial fall of meme stocks has been a remarkable example. Once considered relics of the shopping mall era, names like GameStop* and AMC* have been resurrected – via social media. Ironically, these companies’ share prices were driven to extreme levels by the same generation whose online spending habits had contributed to their low valuations.

And it’s not just the stock market. One of the weirdest episodes of 2023 is the Prime* energy drink craze. Once again, a social-media-driven frenzy led to scarcity. In this case, we’ve seen fights break out in supermarkets, and a 5000% markup in price.

These instances can be better understood when we factor in mental biases, like herd mentality and groupthink, which add a lot of uncertainty to predicting saver behaviour, especially during adverse events. Financial scandals are as old as the hills, and the collapse of crypto exchange FTX is a recent one. However, a key concern for the future is that negative viral posts may amplify bad news stories much further than we predict, severely damaging the already battered public trust in financial markets during crises. One adverse result could be that savers choose to lower pension contributions.

The temptation to lower contributions seems intuitively greater for younger people. As digital natives, younger adults are on average more engaged with – and influenced by – what they read online. Plus decision-making partly relies on experience and knowledge, which they have less of. Compounding this are other, more immediate financial stresses, such as student loan debt or the high cost of housing, which as mentioned above, may make pension saving feel like more of a ‘tomorrow’ problem.

Contributions contribute the most

So, how bad is it if younger savers reduce their contributions after a crash? And what might that imply for default strategy design?

Well, it turns out that contributions are the main driver of outcomes for younger savers, with their impact likely to be a far bigger than that of investment returns. We show this below, by comparing the impact of different investment outcomes against the impact of stopping contributions after five years.

Starting with no initial savings, the impact of new contributions after five years dwarfs that of doubling the investment return above cash, from +2% to +4%. So, we believe the top priority with younger employees should be to maximise contributions and try to mitigate the risk they stop paying in.

One stop shop, not one stock shock

Achieving the right balance between targeting higher investment returns and accepting a higher expected asset volatility and risk of extreme, negative returns is a tricky trade-off and there’s no industry consensus on the best solution.

It seems to me that emerging technology trends and the influence of social contagion should, at the margin, reduce our confidence about saver behaviour in future crises, particularly when basing our thoughts on past experiences. From a risk-management perspective, when we are less confident about the likelihood of a risk occurring, we believe it makes sense to be more cautious in our approach.

Diversification by asset class away from purely equities may lower the return potential of the investment strategy, but it may also reduce risk and create a smoother returns profile. Even for those who remain keen on an equity-only approach for younger savers, diversification by regional exposure and currency exposure can still be effective tools in our view.

Ultimately, decision-makers need to make a tough call about human behaviour. They must judge how much return potential to give up, in order to mitigate extreme outcomes and the potentially disastrous risk that people stop contributing.

*For illustrative purposes only. Reference to this and any other security is on a historical basis and does not mean that the security is currently held or will be held within an LGIM portfolio. Such references do not constitute a recommendation to buy or sell any security.

 **Sources:

KSI quotation and launch information: https://www.thesun.co.uk/money/20535616/ksi-logan-paul-prime-sports-drink-cost/.

£100 price claim: https://www.standard.co.uk/news/uk/prime-energy-drink-asda-aldi-expensive-wakey-wines-logan-paul-ksi-b1050816.html 

£10,000 price claim: https://www.thesun.co.uk/news/20894418/inside-incredible-rise-prime-energy-drink/,

Arsenal sponsorship: https://dailycannon.com/2022/09/arsenal-adds-logan-pauls-prime-to-their-sponsorship-deals/.

Other info: https://www.standard.co.uk/news/london/prime-ksi-logan-paul-aldi-sale-london-b1049997.html

Image of KSI: YouTube – View/save archived versions on archive.org. Author: Gymshark.Wikimedia commons. This file is licensed under the Creative Commons Attribution 3.0 Unported license. This file, which was originally posted to YouTube, was reviewed on 2 April 2021 by reviewer Lymantria, who confirmed that it was available there under the stated license on that date.