Remarks by Ross Jones
Global Financial Literacy Summit
17 July 2009
Ross Jones
Deputy Chairman, Australian Prudential Regulation Authority
To give some idea of the extent of the problem for the future, this survey found little support for more generous social security funded by higher taxes, nor for compulsory savings or auto enrolment. Fewer than 20% of those surveyed supported such reforms. Voluntary saving supported by tax concessions generally garnered the highest levels of support.
However, if the majority of people in most countries are not well prepared for retirement, yet see voluntary savings as the preferred option for retirement income, there is a very strong need for individuals to understand long term risks and manage for them.
At the same time as demographic trends will lead to a substantial increase in people over 65, those same people will be expected to take greater responsibility for their pension provision. A most significant factor in this is the global shift in pension supervision from defined benefits structures to defined contributions structures.
Essentially in defined benefit funds, the employer guarantees a certain retirement income and assumes the risk of providing such income. In defined contributions models, retirement income depends on investment returns and contributions and thus the risk is passed to the worker. In many such schemes the fund member also has some ability to make their own investment decisions. The extent to which members make their own investment decisions varies considerably from country to country but generally there is a trend to allowing fund members more choice.
As a consequence the level of financial education needed by individuals has increased considerably in recent years. Pension fund members are often required to make sophisticated investment choices. But it goes beyond that. Not only do individuals need financial knowledge to help them in the accumulation phase, but they also need to handle the risk of asset volatility at the point of retirement and the subsequent longevity risk and inflation risk during what may be a long retirement.
Many individual fund members may be unaware of these risks and even where they have an awareness, they may lack the financial skills to address such risks.
Consequently financial literacy is of critical importance in retirement planning and retirement income. Poorly informed investment and pension decisions will make it very difficult for consumers to plan and save effectively for their retirement as well as placing them at greater risk of suffering financial loss.
Many studies of financial literacy around the world find similar results. They tend to show that there is generally a low level of financial literacy among consumers and that such literacy is correlated with income levels and education. They also tend to show that people over-estimate their financial knowledge and skills.
In many countries financial literacy is strongly associated with a person’s age, gender, education and socio-economic characteristics. It is not surprising to find that poor financial literacy is more common in both the young and the elderly (particularly people over 70 years), more common in females (and especially in females over 70 years), more common in poorly educated people, and more common among those with high levels of socio-economic disadvantage (for example the unemployed and those whose main source of income is a government benefit or allowance).
A significant consequence is that many people in developed economies with sound and effectively regulated financial markets make decisions with regard to their finances which are detrimental to their post working life standard of living.
However, improving financial literacy for retirement planning and retirement income is a very complex task. The types of skills required go beyond basic levels of financial literacy and provision of information. In Australia, a 2008 study of people’s understanding of investment fundamentals found that, a significant proportion of people did not read the financial statements sent to them by their pension fund.
Of those who received annual statements from their fund, almost one third of the people found them difficult to understand. Many others indicated bluntly that they couldn’t be bothered reading the statements. Of course, a significant reason why they couldn’t be bothered was possibly that they were difficult to understand.
This probably shouldn’t come as a surprise when another study in Australia indicated that around 50 per cent of pension fund members didn’t even know if their scheme was defined benefits or defined contributions. Given that Australia has had a compulsory system, largely based on defined contributions individual accounts for around 20 years, it is an alarming outcome.
Similarly, a Japanese study found that more than 70% of adult respondents had no knowledge about investments in equities and bonds and more than 50% had no knowledge of financial products in general. But Japan introduced DC plans in 2001 and consequently Japanese consumers are now required to make financial decisions that require more extensive knowledge than previously.
One particular problem with financial education for retirement saving is the complexity of the system in many countries. For example, many countries provide a wide variety of tax concessions to encourage individuals to save for retirement. However the range and rate of these concessions are often subject to change by government. When making these changes many governments grandfather previous arrangements on equity grounds. However the outcome is that over an individual’s working lifetime, different elements of his or her retirement savings are subject to differing tax regimes. The subsequent complexity of the arrangements decreases the ability of individuals to understand the detail of their pension plans.
It is very difficult to encourage younger people to consider their retirement savings. In the first instance, competing demands for savings such as home mortgages and costs associated with educating children limit capacity to save for retirement even where there is a sound understanding of the benefits. But in circumstances where there are numerous changes in the design and tax effectiveness of retirement savings, many younger people lose interest, arguing quite reasonably that given the large number of changes to the system likely to occur over their working lifetime, there is little to be gained from having an understanding of the current system. If it is expected to change many times before retirement, why consider retirement income schemes until you are much closer to retirement? Consequently, a specific decision not to invest time and effort into understanding financial matters related to retirement by a young person may be completely rational.
At the other end of the age spectrum, one of the crucial issues for pre-retirees is to have an understanding of how much they need for retirement. In many economies pre retirees have higher levels of financial knowledge than that of the general population. They typically have an interest in receiving financial information relevant to their post retirement income. But again system complexities can limit the effectiveness of such information provision. In many OECD countries post retirement income for many individuals comes from a range of sources e.g. a government pension supplemented by some private pension or a public pension plus employer related pension plus products from private savings. Surveys in Australia show that more than 75% of pre retirees are not aware of how much retirement income they will receive from any particular source.
Another alarming feature of the Australian survey was that despite more than 75% of pre retirees believing that their financial knowledge was average or above average, about half of the survey respondents did not know how much money they would need to live comfortably in retirement. Just as interesting was the response that more than half of the people in the survey confessed to procrastination when it came to planning their finances for retirement and one in four admitted to procrastinating for more than 10 years. A decade of indecision can have a huge effect on post retirement income.
Financial literacy with regard to retirement income issues is made more difficult by the complexity of language. For example, in many countries the terms default funds, lifestyle funds, growth funds and so on have no generally agreed meaning. Further many DC funds offer a large range of options within funds which also are given generic terms such as default, growth and so on.
Watson Wyatt recently estimated that global DC pension assets make up around 40% of global pension assets and the worldwide trend to DC is continuing. In many countries, members do not actively choose and so they are placed in the default option. But there is enormous variation both around the world and sometimes within countries, as to what constitutes the default option. Given that so many people do not make active decisions, poorly designed default options can have a major negative impact on retirement income.
For example, in Hong Kong where the majority of funds are DC, some default options are described as balanced with assets allocated 70 per cent to equities and 30 per cent to bonds. In the UK, stakeholder funds introduced in 2001 must offer a default option and since 2005 this had to be a life cycle strategy. However life cycle asset mix is allowed to vary widely.
In Australia most DC members are in the default option. Many of these options are described to members as a balanced fund. However there is no definition of balanced, and in many cases the balanced fund consists of around 60 per cent growth assets (which tend to be higher risk). In the current financial crisis, it has become clear that many fund members who were in so called balanced options had no real idea what balanced meant.
The fact is many fund labels have little meaning for consumers. There is no agreement even within the industry on how assets come to be labelled as growth or defensive, or what mix of these assets should be in a so-called ‘balanced’ portfolio as distinct from one described as a ‘growth’ portfolio. So when a person receives financial information to assist them in their retirement planning it is ambiguous and not always very useful.
One of the purposes of financial education for retirement savings in DC funds is to allow members to choose a diversified portfolio based to some degree on their risk tolerance. When they are sold to members of funds they are typically described and labelled as growth or balanced or capital stable or some other fairly generic term. They are supposedly categorised according to the mix of growth and defensive assets they hold.
Now there is general agreement that listed assets and private equity would be classified as growth and fixed income and cash as defensive. But what about hedge funds and infrastructure assets which feature in many portfolios? Some analysts describe them as providing long run absolute returns and therefore growth assets. Other analysts see hedge funds as defensive because of their supposed negative correlation to equity markets and infrastructure as defensive because of the supposed stable income they produce.
Without going into further detail, if expert analysts are unable to agree on definitions of classes that go into portfolios, there is little likelihood that the fund member will understand, even a member who is reasonably financially literate.
A recent Australian survey by industry research group, SuperRatings looked at the mix of assets going into Australian pension funds. It found that with funds labelled ‘balanced’, the percentage allocated to growth assets varied from 20 per cent to 80 per cent. Funds that were sold and labelled as ‘conservative’ could have more that 50 per cent allocated to growth assets.
The global financial crisis has exposed significant gaps in financial literacy with regard to pension products and retirement saving. Many fund members have suffered financial losses in the past 12 months, and for many of them, the extent of the losses has been surprising. In part this has been because they were unaware of the levels of risks that they had taken on either through a deliberate, but uniformed choice, or by default.
The OECD publication Improving Financial Education and Awareness on Insurance and Private Pensions (2008) outlines the essential role of financial education in encouraging people to understand the range of retirement savings options pre retirement, and the range of post retirement plans. Many OECD countries currently provide or are planning to provide workers with information about pensions and investments.
However, financial education for retirement is a particularly complex area. It is not simply enabling people to understand the relationships between risk and return when making investments. While that is itself a very difficult task, there are fundamental issues such as how much is needed for retirement, what living standard relative to the living standard while working is required and how long does the person plan to work. Such questions are first order issues but influenced by culture, social factors and government policies towards the aged.
Finally it is important to realise that financial education alone is likely to be insufficient to solve the problems created by risk transfer towards the individual. Decisions to save or not save for retirement are not solely related to knowledge or lack of knowledge. Behavioural economics studies in a number of countries have shown that some individuals do not seem to have the ability to think about the future and make decisions affecting their long term welfare. Other studies have indicated that consumers are sometimes overwhelmed when they have many options and respond by doing nothing. In an environment of a large range of complex investment options that impact on welfare far into the future, it may be no surprise that people make no choice. As noted earlier, they procrastinate, they wait.
Already some governments have responded to such issues, not by financial education alone, but by a range of policies linked to compulsion. Automic enrolment into pension plans and default options are one such option.
In conclusion, the role of financial education in retirement income and pensions is only just being recognised, even in those countries which have long had a sound financial regulatory environment. The level of ignorance and indifference on the part of the consumer is both surprising and depressing. In the 2008 Australian study I referred to earlier, more than 40% of respondents did not know what factors resulted in a decrease in the final value of the pension fund balance. In an environment of compulsory contributions for almost 20 years into mainly DC schemes, it is a major cause for concern. Increased work needs to be done to increase the level of engagement between members and their pension fund and better and simpler communication and education. If the trend to greater worker responsibility for their retirement income continues, the need for better, but not necessarily more financial education on retirement income will only increase.
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