Pension freedoms and the trend away from secure income will lead towards more restrained spending as investors hedge against market downturns, the head of the Financial Conduct Authority has warned.
In a speech on the macro-economic impacts of pension saving at Gleneagles, FCA chief executive Andrew Bailey also cautioned against over-exposure to housing for retirement saving, reminding investors that the Financial Policy Committee of the Bank of England, of which he is a member, sees the increased indebtedness of home-purchasers as a risk it is seeking to manage.
Bailey explained how he believed the ‘lifetime saving model’ or ‘life-cycle’ hypothesis, the economic theory that argues people plan their spending over their projected lifespan by accumulating when they work and decumulating when they retire, remained valid, but is challenged by behavioural finance factors such as hyperbolic discounting, whereby individuals attach greater value to money today over money to spend in the future.
Without specifically referring to pension freedoms, the decline in annuitisation and the switch to DC, Bailey suggested that greater volatility in likely income meant individuals would have to be more cautious in their spending.
He also argued that people creating long-term savings products faced challenges as interest rates, and therefore the discount rate on assets in which savings are held, was subject to significant change. He pointed out that annual GDP growth in advanced economies is around 1.2 per cent, 57 per cent lower than the 2.8 per cent average growth of a decade ago.
Bailey said: “I want to talk today about the macroeconomic aspect of pensions, something that I think requires more attention, as well as how that macro picture reflects into the challenges for the FCA.
“Changes in the volatility of income are likely to affect views on lifetime resources relative to assumed need. More volatile income will tend to restrain spending… greater uncertainty generates a demand for greater precautionary saving.
“Social security systems and defined benefit pension schemes tend to reinforce the life-cycle model of saving by prescribing saving, and doing so – through its compulsion – in a way that neutralises quite a bit of the variable discount rate argument. I offer no judgement on whether this is a good thing or a bad thing, but the shift is certainly happening, and therefore the relevance of the behavioural argument in terms of discount rate assumptions is if anything likely to grow.
“There is an argument that pension saving would be assisted by people holding more housing in their stock of pension assets, based on the real appreciation in the value of housing. I don’t subscribe to this argument. Why? First, because given the scale of uncertainty over long-run real returns on assets, I would not favour over-weighing to any one asset class, while recognising that a balanced investment portfolio can be exposed to property. But, increasing the weight on housing investments could be self-defeating. In the FPC we have been concerned about increasing levels of household indebtedness. If the effect of increasing the demand for housing as an asset to own is to push up the cost of ownership, an increase in holdings of housing as pension assets will tend to increase the real cost, and thus household indebtedness.
“To borrow the phrase of St Augustine – which is translated often as “make me chaste, but not yet” – individuals heavily discount tomorrow. Behavioural economists have used the term “hyperbolic discounting” to describe time inconsistent preferences in which, given similar rewards, individuals will save less today than the lifetime model would predict because they overestimate their ability and willingness to save tomorrow and at all points in the future. To borrow another phrase, does tomorrow ever come then? The answer from the models is yes-ish, but considerably later in life.
“The weight given to such variances in the discount rate over time matters substantially when judging the value of additional long-term saving for retirement and thus the design of savings products. It matters more in an environment – as we are seeing in the pensions world – where the responsibility for such saving is increasingly transferred from the state and employers to individuals in society.”