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Behavioural Finance for Pensions Actuaries Arthur Els 11 October 2010 How many new CERA’s over past year? Behavioural Finance for Pensions Actuaries Arthur Els 11 October 2010 With thanks to: Agenda • Human traits • Scheme design • Service providers • Members/Trustees • Conclusion 1. Human Traits We humans have built-in biases • Anchoring • Loss aversion • Regret avoidance • Framing • Hindsight bias • Rules of thumb Human Traits - Anchoring No of new CERA’s = 195 Anchors = 80 310 Peer pressure – how we eat! • Alone •2 +35% •4 +75% • 7+ +96% Emotions are a MAJOR factor Pensions Actuary: Your fund membership has all the following: ? But mostly: Human Traits - Conclusion Your fund members are subject to: • Bias • Fear • Manipulation As Pensions Actuaries, we need to care for them! 2. Scheme design Scheme Design - 1 1. Never underestimate the power of inertia! 2. Greater the choice, less the chance of member choosing 3. Take care when communicating to members (“framing”) Which is longer? Identical but perceived differently! Scheme Design - 2 4. Member’s attitude to risk: • Increases with frequency of monitoring • After a loss, often becomes reckless • Markowitz – 50/50 – “to minimise future regret” Scheme Design - 2 5. Members (and we) have less self-control than thought 6. Pain from a loss >> pleasure from a gain (250%) Pensions Actuary (us – aloof) Member We need to be involved - understand the biases, fears of our clients!!! Scheme Design – Conclusion Good scheme design: • Applies “Libertarian Paternalism” i.e. allow choice but nudge in right direction • Has sensible default portfolios • Caters for member biases, inertia • Minimises member regret • 3. Service providers Service Providers - 1 • 2006 Harvard University research for a major lender in South Africa: “By American standards the interest rates being offered were high – between 7,75% and 11,75% per month – though in line with the South African market” • Embarassing! *Ref: Why we make mistakes Page 101 Service Providers - 2 The quandary facing service providers: “Despite all their virtues, markets often give companies strong incentives to cater for (and profit from) human frailties, rather than try to eradicate them or to minimise their effects”* *Ref: Nudge Page 73 Service Providers - 3 Examples of exploitation by service providers: • Anchoring – “Buy 4 and get …” • Inertia - Sell gift vouchers that are never redeemed. • Peer pressure – “Everybody else is …” Service Providers - 4 Exploitation in retirement funds: • Greed – “Come to us – we choose best of breed of manager so that ….” • Availability bias – “Remember the recent credit crisis? - our structured product fund is what you need…” • 1st impression – …. Two politicians – Who is more competent? Most choose him Princeton University study Service Providers - 5 Exploitation in retirement funds (ctd): • 1st impression – – A good 1st impression often decides the issue! – Service Providers use this power to exploit funds • Lack of financial discipline – “With our daily unit pricing you can trade frequently and make a fortune ….” Effect of frequent trading* • Bull market in 1990’s Average US Market Return 17,9% Return of frequent trader 11,4% “Gain” from frequent (5,5%) trading • Frequent traders are overconfident of own abilities – leading to losses * Wall Street Journal Service Providers - 6 Smoothing of investment returns: • PFA does permit smoothing [S14B(1)(b)] “…, provided that the board may elect to smooth the fund return” • Is appropriate in some funds e.g. blue-collar • Beware of advice to contrary from purveyors of daily unit pricing systems, guaranteed funds. Service Providers – Conclusion 1. Service providers are out to make a profit 2. Protect your client against exploitation 3. Are these service of real value: a) Daily unit pricing? b) Many portfolio choices? c) Ability to trade often? 4. Members/Trustees Members/Trustees - 1 Powerful drivers: 1. Regret aversion – someone else is to blame! Regret is more than being sorry – it is feeling responsible – thus to be avoided 2. Regret aversion (ctd) Warren Buffett’s biggest mistake: 1993: bought Dexter Shoe Company a) “One of best managed companies we have seen in our lifetime” (Buffett) b) Paid $433m, issued 25 203 Berkshire shares 2008: a) Value of: Company ?, Shares $3,5bn b) “To date Dexter is the worst deal I have made. I gave away 1,6% of a wonderful business …. to buy a worthless business” (Buffett) Members/Trustees - 2 Some powerful drivers: 2. Hindsight bias – member wears rose- coloured glasses when recalling own past actions Genuinely believes the rose-coloured view occurred! • Picasso – “The Dream” • Sold for $139m 29.9.2006 • Following day holed by Steve Wynn’s elbow • Insurance claim for $54m • His recollection: “I just turned and said …’How could I have done that?’” • Observer’s recollection: “#@$#, Look what I have done!” Members/Trustees - 3 2. Hindsight bias (ctd) After recent credit crisis, some members: a) “Recall” giving instruction to invest in money market, but no record found b) Have taken funds to Adjudicator because not warned about pending crisis! Members/Trustees - 4 Some powerful drivers: 3. Endorsement – Member assumes default portfolio has Trustee endorsement - thus suitable 4. Apathy – Only 18% of those receiving information act on it Members/Trustees - 5 Some powerful drivers: 5. Myopic loss aversion – Concentrating on short term volatility rather than long-term returns 6. Loss aversion – Becomes risk taker in order to recoup losses Gambled bank assets in order to recoup losses • Societe General Rogue Trader, Jerome Kerviel • Sentenced to 3 years, must repay Euro 4.9 bn Members/Trustees - Conclusion The Pensions Actuary must understand that Members are: • Subject to powerful sub-conscious biases • Emotional beings • Fearful of making a loss • Are capable of taking inappropriate risks 5. Conclusion Dear Pensions Actuaries: Giving financial advice is more than just cold figures You are dealing with real people There is a behavioural aspect to financial advice – understand this and become involved This is an exciting extension to our work – enjoy it and make a difference! Yours Arthur Els Thank you!
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