Individual Capability and Effort in Retirement Benefit Choice

• Author: Christine Eckert,Hazel Bateman,Stephen Satchell,Susan Thorp,Fedor Iskhakov,Jordan Louviere
• Published date: 01 June 2018
• DOI: http://doi.org/10.1111/jori.12162
• Date: 01 June 2018

©2016 The Journal of Risk and Insurance. Vol.85, No. 2, 483–512 (2018).

DOI: 10.1111/jori.12162

Individual Capability and Effort in Retirement

Benefit Choice

Hazel Bateman

Christine Eckert

Fedor Iskhakov

Jordan Louviere

Stephen Satchell

Susan Thorp

Abstract

Weinvestigate the role of individual capability and effort in the management

of retirement ruin. In an experimental setting, we analyze how 854 defined

contribution (DC) plan members reallocated wealth between a lifetime an-

nuity and a phased withdrawal account when we increased the risk of ex-

hausting the phased withdrawal account before the end of life. We find that

more numerate individuals who put effort into understanding product fea-

tures chose more longevity insurance at higher ruin risks. Financially literate

members were more likely to show understanding of the product features,

but general financial literacy did not directly improve ruin risk management.

Initiatives aiming to help DC members understand income stream products

at the time of the decision are warranted.

Hazel Bateman is at the School of Risk and Actuarial Studies, UNSW Australia.

Christine Eckert is at the Business School, Marketing Discipline Group, University of Tech-

nology Sydney, Australia. Fedor Iskhakov is at the Research School of Economics, Australian

National University and the ARC Centre of Excellence in Population Aging Research, UNSW

Australia. Jordan Louviere is at the School of Marketing, University of South Australia, Aus-

tralia. Stephen Satchell is at TrinityCollege, University of Cambridge, U.K. and at the Discipline

of Finance, University of Sydney, Australia. Susan Thorp is at the Discipline of Finance, Co-

drington Building, The University of Sydney,2006, NSW Australia. Thorp can be contacted via

e-mail: susan.thorp@sydney.edu.au. The authors acknowledge helpful comments from three

reviewers, and generous assistance with the development and implementation of the Inter-

net survey from PureProfile, and the staff of the Centre for the Study of Choice, University of

Technology Sydney. They also appreciate research assistance from Edward Wei. Funding was

provided by the Australian Research Council DP1093842. Parts of this work were also sup-

ported by the Chair of Finance and Superannuation, University of Technology Sydney, via the

Sydney Financial Forum (through Colonial First State Global Asset Management), the NSW

Government, the Association of Superannuation Funds of Australia, the Industry Superannu-

ation Network, and the Paul Woolley Centrefor the Study of Capital Market Dysfunctionality,

University of Technology Sydney.

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484 The Journal of Risk and Insurance

Introduction

Around the world, governments have been reducing public pensions in favor of pri-

vate savings plans (OECD 2013). At the same time, defined benefit (DB) plans are be-

ing superseded by defined contribution (DC) arrangements (Bateman and Kingston,

2013; Vernon, 2013). Most DB plan members enjoy natural continuity between labor

income and retirement income, but retiringDC plan members have to transform lump

sums into income, managing liquidity,longevity risk, and volatile investment returns.

Researchers and policy makers have recognized that unsophisticated plan members

often lack the skills and knowledge they need for this task. However, efforts to im-

prove financial capability have had mixed results (Fernandes, Lynch,and Netemeyer,

2014; Lusardi and Mitchell, 2014). This raises questions about what ordinary retirees

need to know when choosing retirement income products, as well as questions about

what government and industry interventions can do to improve retirement welfare.

We hypothesize that plan members will need more than basic financial literacy to

manage decumulation. Good decisions will depend on individuals’ cognitive ability

and on the effort that they put into learning about the important features of retirement

income products. In the words of Fernandes, Lynch, and Netemeyer (2014, p. 13),

“just-in-time” learning about products enables “consumer expertise.” We test this

hypothesis in an online choice experiment. Most studies of retirement benefits assume

that individuals already know what products are available and understand how they

work. By relaxing this assumption, we show that the participants in our experiment

who have a firm grasp of the product features are less likely to choose higher exposure

to the risk of retirement ruin as that risk rises. In other words, moderately numerate

people who direct timely effort to learning about products are more able to manage

the risk of running out of money in retirement.

Retirement benefit products often have complex and irreversible features, and pre-

retirees may not know about them or understand how they work. We conducted

a preliminary survey showing that only one-third of 920 respondents (aged 50–74

years) had heard of a life annuity, only 20 percent knew that it lasted until death, and

only 8 percent knew that it guaranteed an income. Respondents were also ignorant

about other retirement income products such as phased withdrawals. In fact, objec-

tive measures of retirementincome product knowledge are much worse than objective

measures of financial literacy (Agnew, Bateman, and Thorp, 2013), and poor knowl-

edge of pension arrangements is common, leading to unwitting mistakes (Mitchell,

1987; Gustman, Steinmeier, and Tabatabai, 2009). At the same time, opportunities for

the current group of retirees to learn from peers or elders have been restricted by the

relatively rapid switch to DC plans (Bernheim, 2002; Beshears et al., 2008).

Retirees who want to make sound decisions about retirement income products have

to make the effort to acquire specialized financial literacy. Investment in financial lit-

eracy can be modeled in a life-cycle setting where individuals incur direct and indirect

investment costs to build financial human capital (Lusardi and Mitchell, 2014). The

investment pays off through access to more sophisticated financial strategies that earn

higher rates of return, and tends to increase with wealth and education. The indirect

costs of investing in financial literacy are akin to the concept of employee effort in ef-

ficiency wage models (Shapiro and Stiglitz, 1984) and processing effort in psychology