Investment planning or random guessing?

Members in DC plans behave inconsistently when given the same options

Canadians aren’t preparing for retirement. Survey after survey has shown that most of the workforce hasn’t thought enough about retirement and employees aren’t socking enough away to maintain a comfortable lifestyle.

The main reason for the lack of preparedness is procrastination. Many family needs are tangible and immediate. Retirement seems far off and saving eminently postponable. This tendency is reinforced by a lack of understanding about how much savings are really needed.

Can one assume that those who are saving on a regular basis are in the clear? Not necessarily. It is still important to invest appropriately. Unfortunately many observers have decried the low level of investment knowledge of pension plan members and the inadequate educational efforts available to remedy this situation.

While this may not matter much for a secondary school math teacher with a defined benefit pension scheme, it is likely to be very important for a middle-level manager at a pharmaceutical firm with a defined contribution plan.

When future retirees must actively manage a significant portion of their retirement funds, it is important for them to have a minimal level of investment knowledge. Specifically, how should retirement funds be invested to achieve a good likelihood of reaching goals while keeping risk to a minimum? How much risk should be taken on? What asset classes should be invested in? What is the appropriate asset allocation?

Thinking in terms of just equities and fixed-income securities, what percentage should be invested in stocks and what percentage should be invested in bonds? And how should it vary over time?

Some knowledge of the past is certainly useful. From 1957 to 2003, a broadly diversified portfolio of Canadian stocks earned an average return of 10.49 per cent, while a portfolio of Government of Canada bonds with a maturity of 10 years or more earned an average return of 6.86 per cent. Of course the risk in stock returns was greater than the volatility of bond returns, so it comes down to a balancing of return expectations and risk. Those who have studied modern portfolio theory are aware that combining asset classes can also lead to beneficial risk reduction, so for most both equity and bond exposure will be desirable.

But what is the best stock-bond mix? Though some practitioners pretend otherwise, the latter issue is not a simple problem. Informed researchers and practitioners can and do disagree. While pension funds have historically opted for a 60/40 stock-bond mix, some commentators now argue for a heavier equity share, while others argue for a higher fixed-income component. Virtually everyone would agree, though, that the mix should be a function of an individual’s proximity to retirement and stomach for risk.

Given that asset allocation and, more specifically, the stock-bond mix are both important and complex, the question is: Are future retirees equipped to handle such vital decisions?

2,000 Canadians test poorly

A survey of more than 2,000 Canadian DC plan members was recently conducted for SEI Investments, a provider of outsourced business solutions. One goal of the survey was to obtain information on the level of investment knowledge of this group of individuals. Several questions were designed to ascertain whether investors understand asset allocation and the stock-bond mix.

The first question told respondents to imagine they had $100,000 in their pensions, and had to allocate this money among three alternatives: a government bond fund, a corporate bond fund and a stock fund.

One’s answer to a question like this should reveal their preferred stock-bond mix. If a respondent favours a 60/40 stock-bond mix, she should put down $60,000 for the stock fund and $40,000 should be allocated between the two bond funds. There is no right answer to a question like this, it all comes down to a person’s risk attitudes and these can differ markedly for valid reasons.

It turned out that the mean share over the entire sample allocated to the stock fund was 43 per cent. Individual concentrations ranged from zero per cent to 100 per cent.

A second question on the survey was almost identical, except that the three choices were a bond fund, a growth stock fund and a value stock fund. Once again answers logically could differ depending on risk preferences. Importantly, though, investors should understand asset allocation and the stock-bond mix. One way to investigate someone’s understanding is to check to see if their answers to the two questions are consistent. Their risk attitude should determine the stock-bond mix, and there is no reason why this should change appreciably from question to question regardless of the menu of alternatives.

If respondents provide inconsistent answers to these questions, serious doubt is cast on their understanding. As it turned out, the mean equity share over the entire sample — that is dollars allocated to both stock funds relative to the pool of money available — was 69 per cent. Given the sample size, the difference between percentages (69 per cent versus 43 per cent) was well beyond the realm of a sampling error.

The clear implication of this is that many pension plan members do not adequately understand an issue as vital to their financial well-being as asset allocation.

It is natural to wonder why the answers came out the way they did. A relatively new branch of finance, known as behavioural finance, states that when individuals are unsure of their decisions they sometimes rely on heuristics or rules-of-thumb that allow them to make what to them seems a reasonable choice.

When the problem involves choice over alternatives, researchers have documented a “diversification heuristic.” People who are unsure automatically choose a bit of everything offered. In the present context, a diversification heuristic can lead to evenly spreading one’s money across all three alternatives. This would suggest an equity share for the first question of 33 per cent and an equity share for the second question of 67 per cent. Recalling that the shares implied by the two sets of responses were 43 per cent and 69 per cent, we see that the diversification heuristic probably was instrumental in the choices of many respondents.

Investing employees need guidance

What should be done? It is increasingly realized by observers that individuals with self-directed retirement accounts need guidance. This is highlighted by the fact that both the Ontario Securities Commission and the Canadian Securities Institute have recently rolled out websites for investor and pension plan member education.

There is dissatisfaction among pension plan sponsors with the current education programs offered by providers and litigation fears are also a worry. In such a climate, where members have to decide for themselves, it is critical to have a well-designed educational program that includes a solid understanding of asset allocation and why it matters.

Richard Deaves is a professor of finance and business economics at McMaster University’s Michael G. DeGroote School of Business at in Hamilton. He can be reached at [email protected] or (905) 525-9140 ext. 23976.

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