The title is Steven Landsburg’s four-word summary of economics. It is a quote[1] I have used for years to explain why things are as they are. The quote offers hope – we can make positive change by changing the incentives – and it offers despair – if we can’t change the incentives no amount of new thinking or goodwill will be enough. This latter thought brings to mind a second quote, this one by Upton Sinclair: “It is difficult to get a man to understand something, when his salary depends upon his not understanding it!”[2] And this leads us to Jeremy Grantham: “The central truth of the investment business is that investment behavior is driven by career risk.”[3] Because I am old enough to have been sent to Sunday school, my mind throws in “what shall it profit a man, if he shall gain the whole world, and lose his own soul?”[4] However, because this has become rather heavy, rather quickly, I should explain what sent me down this path.
It was a conversation with an Australian who pointed out that everything that was great about their defined contribution (DC) system (participation, adequacy and preservation) was due to legislation. Impressive proportion of the population with DC savings? Contribution payments by employers are compulsory[5]. High account balances relative to other countries? Mandatory minimum contribution of 9.5% of earnings – and that is under-pinned by a generous pillar 1 state pension. No leakage from the system? Check – legislation prevents individuals accessing their accounts until at least age 60. As a consequence of this legislation, and a regulatory environment that encourages competition and consolidation, Australia has one of the most admired investment industries in the world. Large and sophisticated asset owner organisations? Check.
However, there are a couple of big holes in the Australian DC system. The first is the absence of ‘pot follows member’ or consolidation legislation which means individuals typically end up with more than one account, paying too much in fees and insurance premiums (administration is typically a fixed A$ amount per account per week – so no incentive for superfunds to consolidate as that would reduce revenue). Happily for the end saver, a new law comes into effect on 1 July 2019 allowing the Australian Tax Office to consolidate their accounts for them – another example of best practice being imposed from the outside.
The second hole in the system is that it doesn’t provide retirement income. It is an accumulation system that is happy to retain and manage an individual’s assets after they have retired, but it is not willing (at least to-date) to tackle the longevity risk problem on the retiree’s behalf. We have asked Australian attendees at two recent Institute events whether a fit-for-purpose DC product MUST include a form of longevity protection[6]. Averaged across the two events, 62% of respondents voted for ‘in the default’, 36% for ‘as an option’ and only 2% for ‘not at all’.
Given the strength of this opinion from industry insiders, shouldn’t we expect to see a number of retirement income solutions being launched in the near term? This is where we hit the gap between saying and doing, and we are forced to circle back to career risk and incentives. The recent Productivity Commission in Australia has increased the peer comparison pressure[7]. In this environment, where is the incentive to do the hard, costly and risky product development to deliver what the member needs but isn’t asking for – and which no-one else is offering? We could summarise that the Australian legislation has created an admirable asset management industry, but not a retirement income provision industry.
In case it looks as though I am having a go at Australia, I am simply using that (very good) system as an example. How many examples could we list, across all countries, where the investment industry has done the right thing for the end saver without legislative encouragement? People respond to incentives after all. And they have career risk to manage. So the task becomes to lower career risk and shift the incentives. A colleague has written a previous post on these issues as they relate to DC fiduciaries[8].
In general terms we can address career risk and incentives via three routes:
- Compensation: this refers back to the Upton Sinclair quote, if our difficulty with understanding is correlated with the level of our compensation then lowering pay may help. Clearly that won’t happen. A slightly more practical option would be to maintain pay at the same level but remove the variability (ie remove bonuses). I have written about this before[9] so won’t rehearse the arguments here – the key point is to redirect the effort an individual spends on managing their compensation towards performing their role. Again, this is unlikely to happen – because of the incentives!
- Sticks: these options are typically fear based. We would need to find a way to portray the consequences of not acting as greater than the fear of disrupting the status quo. This doesn’t look like the best route as it raises the stakes in what is already a difficult situation.
- Carrots: reward-based options. Assuming that moving the status quo would involve some combination of effort, cost, risk and uncertainty, what rewards could we offer? I see three possibilities: (a) profit – ‘doing the right thing’ offers a more profitable and sustainable future, (b) enlightened self-interest – a degree of restraint in the short term to avoid pain in the long term, and (b) purpose – a reason for operating that is bigger than making money.
To me ‘carrots’ is the way to go, and I see the three suggested possibilities as overlapping. In fact, I see sustainable profit as a subset of purpose. The question then becomes whether the Institute can find and socialise new thinking on sustainable profit, enlightened self-interest and purpose that is powerful enough to shift the prevailing incentive system…
[1] The full quote is “Most of economics can be summarized in four words: “People respond to incentives.” The rest is commentary.” From Steven E. Landsburg’s book The Armchair Economist [2] Source Wikiquote https://en.wikiquote.org/wiki/Upton_Sinclair [3] Various sources are available, this was copied from a column written by Grantham in Finanz und Wirtschaft https://www.fuw.ch/article/jeremy-grantham-career-risk-is-likely-to-always-dominate-investing/ [4] Mark 8:36 King James Version [5] Once gross earnings reach A$450 per month [6] DC summit, Melbourne, 29 November 2018 and Investment organisations of tomorrow, Sydney, 28 March 2019 [7] This website contains the report and a useful summary: https://www.pc.gov.au/inquiries/completed/superannuation/assessment/report. Competition is described as superficial given the presence of 93 sub-scale (<A$1bn) regulated funds, and the ‘best in show’ idea would entrench peer comparison of net returns to enter, or remain in the list of top, historic, performers. [8] Wanted: good defined contribution fiduciaries. Cowards need not apply. Bob Collie, April 05, 2018. [9] To bonus or not to bonus? Thinking Ahead Institute, January 26, 2017