Workplace Pensions – The Value of a Nudge

The new financial year has brought the continuing rollout of the UK Workplace Pension scheme and an increasing number of employees will see a new deduction on their payslip each month. Indeed, this month marks the launch of Dectech’s very own workplace pension scheme.

The Workplace Pension scheme is, psychologically speaking, well designed. It begins by harnessing the status quo bias: automatically enrolling employees so they have to spend time and effort to opt-out. And, with very small monthly contributions, the initial payslip deductions are relatively painless so loss aversion does not incentivise leaving. Over the next few years the percentage contribution increases but inertia and habituation to the scheme will ensure employees keep saving.

Why are these “nudges” necessary? Put simply, people aren’t saving enough to adequately fund their retirement, while life expectancy is increasing. There are many underlying causes of the pension gap, but we know, from behavioural science, that people are inherently biased to not save enough for the future. For example, our present bias means we often choose to irrationally forgo a larger future return (a good pension) in favour of an immediate, smaller reward (spending the money).  Furthermore, our exponential-growth bias means that we neglect the power of compound interest, failing to appreciate the extra value of investing in a pension while we are young.

These effects aren’t trivial. A recent behavioural economics research paper from the National Bureau of Economic Research found that people who exhibit these two psychological effects have retirement savings that are up to 70% lower than people who don’t. Thus, pension schemes are a worthwhile intervention. However, the most interesting insight (for us) from this research is that self-awareness of behavioural biases can somewhat mitigate their negative effects.

At first, this finding surprised us: our own research on financial decision-making for the European Commission found that warning people about biases has little effect on the quality of their investment decisions. How might we reconcile these two findings?

We suspect that the overconfidence bias leads people to ignore general information, assuming that they personally don’t exhibit those biases. Instead, to increase self-awareness of behavioural biases it may be necessary to provide people with personalised information, such as a test for behavioural biases. Better yet, showing people how they compare to a relevant peer group may educate and motivate those most in need of help. However, such an intervention on a national scale would be costly, so for the time being automatic workplace pensions seem like a good start.