Topic 2: Pensions as Intertemporal Choice
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Learning Objectives
After reading this topic, you should be able to answer these questions
- What is intertemporal choice?
- How are intertemporal choices made?
- Classical rationality
- Bounded rationality
- Ecological rationality
- How do intertemporal choices impact pensions?
In the previous topic we learnt about the World Bank’s ‘five pillars’ typology of national pension systems. The five pillar typology is the outcome of global overview of national pension systems. However, to have a consistent response to pension reform it is important that we develop a rationale about choices and emphasis that individual countries make in their pension plans and pension systems.Two constructs; intertemporal choice and rationality are central to the development of an analytical approach to pension plans and pension systems. We discuss these two concepts and explain their significance in this and the next topic in this module.
Conventional wisdom is that we start saving early to benefit from from compounding. Reality is that few of us have the discipline to work for a goal or an outcome that is 30 to 40 years away. Household data suggests that we are not saving enough today for our retirement needs in the future. Canadian household indebtedness is among the highest in the World. Household savings are low and indebtedness high in Canada (and other developed countries). With increasing life expectancy including for those in their 80s we can expect greater expenditures on old age care in the final years of their life (Schillington, 2016). This gap between savings expectations and behaviour is a global phenomenon with very significant consequences for old age financial security around the world. Intertemporal choice is central to our understanding of how we take long term decisions.
Intertemporal Choice
Pension decisions span the lifetime of an individual and have multi-generational implications for society and the economy. This class of decisions are called intertemporal decisions.
In economics, the study of decisions are required because of relative scarcity. Decisions or choices must be made because human wants (being expressions of ones thought processes) are unlimited, while resources required to meet them are relatively scarce or limited. This relative scarcity gives rise to opportunity cost. Choosing A implies that the limited resource cannot be used to meet choice B hence the potential gain from choosing B is the opportunity cost of meeting choice A. All choices, either in the short term or in the long term have opportunity costs.
Intertemporal choices are also made under a resource constraint and have an opportunity cost; however, we study them as a distinct category of choices. The primary reason for this is that the opportunity costs of intertemporal decisions can be deferred to the future or shifted to a different stakeholder. Policy level examples of intertemporal choice are saving for retirement, levels of public debt, or healthcare expenditure. For each of these policy choices there is a possibility of shifting the burden from the current generation to future generations and this raises serious concerns about intergenerational equity and sustainability of such policies. For example, if the active workforce does not save enough for their retirement, the future generation will be faced with the serious implications of having to provide for retirees out of their current earnings.
The management of this trade-off in intertemporal choice, as in pension decisions is growing in scope and complexity due to increasing human longevity, rising healthcare costs and changes in labour markets because of globalization and technology. We will explore the consequences of these in subsequent topics.
Not only do pension decisions have intertemporal implications, but they are also unique among the three most important financial decisions we make over a lifetime. The three major financial decisions that an individual has to take over a lifetime are education; the purchase of a house; and retirement. Unlike education and home purchasing decisions, the pension decision is the most challenging, as the order of cost and benefit are reversed. In the case of education and house buying, you can borrow under contracted terms to pay back the money and start enjoying the benefits almost immediately. Saving for retirement or provisioning for pensions, represents unique challenges to our decision capabilities as the costs or sacrifice of current consumption is known; voluntary and immediate. However, the reward or potential benefit of pensions in retirement is distant and uncertain as no one is sure of the length of their individual lifespan. The benefit and cost structure is flipped when compared with the other two long term financing decisions for education and house purchase.
Thus the pension the decision is complex. First, the decisions have intertemporal implications as the consequences of the decision can be shifted to future generations or other stakeholders . If the current workforce does not save enough from their current earnings, the workforce of the future will have to pay for your retirement from their current earnings. Second the cost of the savings is immediate and certain. Savings for retirement implies reduced consumption in the present. This is entirely voluntary and unlike in the case of education or home purchase where the costs are contractual and cannot be deferred. However, future payoffs of savings are uncertain not only because financial returns are uncertain but also because longevity and future healthcare and old age requirements are unknown in the present.
How Do We Make Intertemporal Choices?
What are the challenges we face when we take an intertemporal decision? First, intertemporal decisions have implications that go beyond the current generation. Second, the implications of the decisions cannot be completely specified today with probabilities attached to these outcomes as in conventional uncertainty. Significant insights into intertemporal choice are provided by the different interpretations of rationality. We will discuss three of the more relevant interpretations of rationality. These are: classical, bounded and ecological concepts of rationality. Classical rationality is central to the economist’s approach to intertemporal choices, emphasising the maximization of the utility from savings and consumption either from a lifetime of income or expected lifetime permanent income levels. Bounded rationality is grounded in the behavioural perspective and emphasizes the cognitive and computational limits of human decision capacity. Ecological rationality is based on evolutionary fitness. According to this view of rationality, the brain makes choices that are specific to every environment with the purpose of ensuring survival of the species. The focus is not on decision optimization or goal maximization but on survival.
Classical rationality
Economics & intertemporal choice – homo economicus
Economists have been interested in intertemporal choice behaviour in their attempt to explain the recurrence of business cycles. Business cycles are cycles of booms and busts that are characteristic of market economies and are apparently triggered by economy wide behaviour of savings and consumption. It was observed in the 1950s that contrary to the Keynesian hypothesis to explain booms and busts, consumption as a share of income does not fall and savings does not correspondingly increase with rising income. A few different hypotheses on how we make intertemporal choices, were proposed by economists, to explain how individuals allocate income between consumption and savings. We will not go into the details of the hypotheses as our focus is not the analysis of business cycles. Our interest is in the assumptions that economists make about the individual and the environment in which intertemporal choices or choices of consumption and savings are made over time, as these choices have implications for pension decisions.
Common to all hypotheses of the intertemporal choices between consumption and savings that have been proposed by economists is the assumption of Homo Economicus, or the figurative human being who is rational because they boost self-interest by utilizing all available information to maximize utility to attain the highest possible consumption or profit. Irrespective of the hypotheses, the economists view is that intertemporal choices involving trade-offs between consumption and savings are made with perfect foresight and the decision maker takes a computational approach that incorporates all relevant information into the decision. In all hypotheses of intertemporal choice, the economic decision maker (the consumer), is attributed with perfect foresight. The consumer seeks to maximize satisfaction by comparing the marginal utilities of savings and consumption, trading one over the other to equalize the marginal utility from each (Fisher, 1930). Consumers form a subjective assessment of their permanent (life) income and consumption (Friedman, 1957); through smoothing their consumption by taking a lifecycle (young adult, middle & retirement years) view of their income (Modigliani, 1966).
A formulation of this rational computational approach is the time value of money that connects the present value (PV) with the expected future value (FV). A fundamental tenet of the time value of money is that a dollar today is worth more than a dollar at some point of the future. The time value of money also provides us with an exact representation of the FV in terms of value today or PV in the discounted cash flow model:
PV = FV/(1+D)t
Where D is the discount rate and t are the number of time periods. The rational economic decision maker can assign a discount rate for the future dollar for a specific period, which may be a week, a month or a year. This discount rate is applied to the expected future value and goes up exponentially for every period the future is deferred. The expression gives us a very calibrated and exact value of future dollars in terms of present dollars. Thus, the expression can be used to work out the equivalence between consumption and savings to the last (marginal dollar). In addition to the assumptions about the cognitive and computational capabilities of the decision maker and the relevance and completeness of the information available, there are important assumptions made about the discount rate used to calculate the equivalence between the present and the future. The decision maker, according to economics, assumes exponential discounting. The discount rate captures both the waiting or the extent to which consumption of the income is deferred or postponed as well as the risk or uncertainty of the future expected payoff or cash flow. Thus, the actual future value may not be what it is expected to be. The exponential discount rate is constant per period and is not sensitive to the extent of the separation between the present and the future. Therefore, the future value is discounted at a constant rate irrespective of how far it is in the future. So, a year difference between PV & FV, for example between 2017-2018, will attract the same discount rate as a year difference twenty year from now, that is 2027 -2028.
Bounded Rationality
Insights from psychology have also been used to explain intertemporal choice in behavioural economics/finance. Behavioural economics does not question the pursuit of the goal of greater satisfaction by the figurative economic decision maker – the homo economicus. However, the bounded rationality, is approach, as distinct from classical rationality acknowledges cognitive and computational limits of the economic decision maker. The decision maker’s rationality is ‘bounded’ by the biases and procedures used in the implementation of the decision. The economic decision maker in behavioural economics pursues ‘satisficing’ and not maximizing behaviour. Satisficing implies the pursuit of greater satisfaction but given the cognitive and computational limits it is recognized that a decision will not likely result in maximum satisfaction.
Behavioural economics proposes several alternative frames and benchmarks that have implications for intertemporal choices between consumption and savings. Some of the relevant alternative frames and benchmarks in behavioural economics/finance that are useful in understanding intertemporal decision behaviour are discussed next.
Hyperbolic versus exponential discounting
According to behavioural economics experimental evidence shows that the intertemporal decision maker uses hyperbolic discounting and not exponential discounting in working out the equivalence between present value and future value. What this means is that we tend to apply a larger discount rate to decisions with payoffs in the nearer term, while we apply a smaller discount rate as the payoff gets farther away. Thus unlike the assertion in classical rationality; the discount rate applied to a decision outcome for 2027-2028 will be higher than the discount rate applied to a decision outcome in 2017-2018.
The discount rate increases at a decreasing rate, rather than increasing at a constant rate, as in exponential discounting. Hyperbolic discounting is modeled as follows:
V = A/(1+kt)
Where V is the value of the reward, A is the reward amount, t is the delay, and k is a discount parameter accounting for the slope.
Commitment, reward magnitude and attention
Some important concepts from behavioural economics that help us understand intertemporal choices and decision behaviour are commitment, reward magnitude, and attention. Commitment refers to the use of external devices that force the individual to choose the delayed option. Reward Magnitude refers to the impact that the size of the delayed reward has on one’s decision as to accept it or not. Logically, only the relative size of the immediate and delayed reward should matter. If the choice was whether to take $5 now or $20 in a month, and the person chooses $5 now, we might expect a person to make the same decision as if the choice were between $500,000 now or $2,000,000 in a month. However, research (ref) indicates that people are more careful in decision making when large sums of money are involved. A person is more likely to wait for one month to take the $2,000,000 than the $500,000 now. Therefore, it appears that the absolute magnitude of rewards is important in intertemporal decision making. Attention has a role in intertemporal choices and has yielded some interesting results. When attention is drawn to the subject of the decision, people tend to take the immediate rewards over the delayed option. When the immediate reward is hidden, people will wait much longer for a delayed reward. This view of human rationality was recognized in the 2017 Nobel Prize in Economics awarded to Richard H. Thaler, a behavioral economist at the University of Chicago, IL, USA. It has led to many recommendations or “nudges,” that aim to change human decision behaviour including some decisions which are relevant to pension planning (Thaler & Sunsten, 2008).
Organ donation program. How does it help design retirement policy?
Ecological Rationality
The neuroscientific approach to intertemporal decision analysis is based on the findings and analysis in biology. According to neuroscience, decisions and choices are guided by ecological rationality. We follow Stevens (2010) use of the term ecological rationality as behaviour that is consistent with evolutionary fitness that is decision behaviour which promotes the survival of species. Ecological rationality requires decisions to be consistent with the evolutionary fitness of the decision maker. Evolutionary fitness is the success of the species to survive and reproduce in an environment. Whether a species is successful or not in its survival enterprise cannot be assessed by the optimality, or the maximization of the outcome of a decision, as in classical rationality. According to ecological rationality, no decision can be evaluated independent of the environment or the context of the decision. In ecological rationality the decisions are rational if they entail the wise selection of decision strategies that ﬁt speciﬁc environmental attributes and thus promote the long-term survival and reproduction of a species in the context of the environment where it belongs. The very same outcome may be ecologically rational or irrational depending on the environment. The focus of ecological rationality is on the environment and the process of decision making and not on the decision outcomes.
These insights have implications for decision making beyond biology. At a a more generic level, according to Mata, Pachur, von Helversen, Hertwig, Rieskamp, & Schooler (2012), decisions consistent with ecological rationality have three tenets. First, decision strategies are adapted to particular environments. Second, decision strategies are not good or bad per se, but have to be evaluated relative to the environment in which they are used. Finally, the decision maker responds to task and environment characteristics in formulating a decision strategy.
Of the three interpretations of rationality that we have discussed here only ecological rationality has been corroborated by evidence from direct observation of human behaviour. Classical rationality is based on deductive logic as a construct of homo economicus. Behavioural rationality on the other hand relies on indirect evidence from experiments. Neurobiology studies based on direct observation of cerebral activity using imagery tools like fMRI have revealed several key insights into human decision behaviour. The evidence from direct observation of the brain lends support to a process theory of human decision making where decisions are made based on anticipations like expectancy, fear etc., and a result of various emotional reactions to outcomes such as elation, regret, and envy (Bossaerts, 2009). Imaging experiments show that decisions are the result of a process and not exclusively goal driven. Thus, for a decision, different outcomes may emerge depending upon the triggers in the environment. Evidence from neurobiology and brain research also suggests that the sensitivity of decision differences in utility is greater when it is difficult to predict the consequences of the decisions in precise terms, as in financial decisions. Studies also find evidence that human brains are good at strategic decisions but not at incorporating mathematical computations in their decision-making processes.These findings are more consistent with ecological rationality and not with assumptions of classical or bounded rationality. In a goal maximizing framework, differences in expected utility and experienced utility are dependent on what the individual decides. However, in a neurobiological approach, the differences in expected utility and experienced utility is not a function of the individual’s decision but dependent on what others decide.
The neurobiological studies of decision behaviour have important implications for intertemporal decisions. First, the bounded rationality that we observe may be an adaptive strategy not a cognitive outcome. When faced with intertemporal choices in complex and changing financial environments the appropriate response would be to evolve heuristics or simple decision- making rules than to implement optimum solutions requiring complete information. Second, the evidence from neurobiology is that emotions play a central role in decision making. Superior decisions are made when emotions guide reasoned choices compared to decisions made purely on reason. Another important finding that emerges from the neurological evaluation of choices and decision-making is that choices have a social context. Risk aversion changes depending upon what other people around you do. Social context as an attribute of the environment has important implications for choices and decision making.
These evidenced based findings, based on direct observations of neural processes in the brain, are quite relevant for long-term decisions such as savings for retirement. In his BBC podcast on savings (18:00), economist Dan Ariely (2018) makes a strong reference to the role of the environment in our savings behaviour (listen to the podcast for an overview of these ideas in the context of our ability to save for retirement). Ariely contends that the quarterly earnings performance monitoring of corporates and the preference of time with family for immediate gratification (such as gifts, holidays, etc.) creates an environment that mitigates against saving for long-term goals like retirement and overshadows long-term interests like buying life insurance to protect the family.
In designing a pension system, the mix and emphasis on the World Bank’s pillars should incorporate considerations of environmental fitness as recommended by ecological rationality. A pension system that is consistent with ecological rationality will have a greater impact on “survival” into retirement. Financial literacy programs and pension plans that focus on individual choice and responsibility have a poor prognosis in an environment that focuses on quarterly performance and immediate gratification in corporate and personal interactions. Given the rise of income inequality, the viability of a pension system in providing for rising longevity will depend more on mandatory universally funded plan designs. This will be consistent with ecological rationality and environmental fitness. We will discuss this in greater detail in the topic on operational aspects of pension design.
The ecological view of rationality moves the locus of decisions from the individual to the group and then to a collective. The rationality is expressed in terms of environmental fitness as measured by the survival of the group and its ability to successfully adapt to changes in the environment. So, are we individualists, or what has been termed as prosocial decision makers? Is the goal of a decision to maximize individual self-interest, or are we more likely to seek a balance between self-fulfillment and sharing with others in our quest for collective survival? Is there an intrinsic role for fairness and justice in our decision-making behaviour, or are these attributes an imposition that seeks to curtail our pursuit of self-interest?
Pension decisions are intertemporal decisions. They have multigenerational implications that cannot be specified today. Ecological rationality with its focus on collective outcomes like survival is distinct from classical and bounded rationality as the trade offs between the current and the future goes beyond a lifetime perspective. Decisions involving intertemporal choice have acquired a growing urgency in the context of today’s challenges. For an overview and an insight into discounted cash flow analysis; the classical and bounded rationality decision rule read: The Perils of Short-Termism: Civilization’s Greatest Threat.
So what do we make of these different interpretations of rationality? As reiterated earlier, the three different interpretations of rationality are mot mutually exclusive. We will learn in this module that ecological rationality will provide valuable insights into the design of pension systems. Classical and bounded rationality will be valuable in the design of individual pension plans within a pension system.
Next, we will explore social contracts that provide the context for the incorporation of our decision behaviour to the design of pension systems and pension plans.
Exercises
TOPIC REVIEW
- Classical rationality
- Bounded rationality
- Ecological rationality
- Intertemporal Choices
- Exponential Discounting
- Hyperbolic Discounting
- “Nudges”
Exercises
SAMPLE REVIEW QUESTIONS
- What is choice? Why are we required to make choices?
- What is intertemporal choice? Why do we need to study intertemporal choice?
- The three major financial decisions in a person’s life are financing education; home and retirement. What is special about pension decisions? Are pension decisions an example of intertemporal choice?
- How is rationality interpreted in decision behaviour? Are these interpretations of rationality mutually exclusive?
- Discuss and apply the three versions of decision rationality to pension decisions.