CEO, IEF & Executive director, EFPA Spain
Financial advice and the cognitive biases of pensions
When Richard Thaler, after winning the 2017 Nobel Prize in Economics for his work on the impact of irrationality and emotions in economic decisions, responded to journalists that he would spend the amount of the prize (one million euros) “irrationally”, he undoubtedly wanted to reassert his own academic work, but he also intuitively knew that the real remuneration from this award would come from the wonderful fees that are subsequently received for speeches or papers after having been proclaimed the Nobel winner. So, he could therefore allow himself a certain amount of frivolity in the use of those “initial” funds.
In that statement, Thaler included the conviction that certain cognitive biases would be inevitable in his decision-making, even for someone who had studied such biases, albeit with an adequate element of knowledge and foresight (the quasi-certainty of future earnings), which in this case would obviously also condition his expenditure and investment decisions.
For those of us who are financial advisers (promoting or orienting not only our own decisions but also those of others), there is special relevance in the combination of 1) knowing and mainly avoiding the most common biases of intuition and the “quick thinking” of not only our clients but also our own and 2) the knowledge and the assessment ability that come with experience and a rational analysis of the investment alternatives.
When considering the requirements for a sound financial advice, it is of course essential to become completely aware of the cognitive biases that have the biggest impact on decision-making related to the planning and execution of savings, expenditure and investment and of the techniques for mitigating such biases. The main technique – let us not forget – is information for investors, in addition to educating them and, above all, ensuring their financial literacy. However, first of all a financial professional should conduct a certain process of introspection and determine how many of those biases (cognitive or not) affect him or her directly, and therefore how those biases affect the advice it is provided to their clients. Obviously, we human beings (which include financial advisers!) tend to be too optimistic, and this leads to clients making decisions themselves that are too lightly weighed or induced by their advisers, due to over-confidence, over-estimation of the control over investments or of the opinions of the supposed experts or gurus, the “imitation” or “halo” effect and, above all, due to the excessive aversion to losses that cause so much harm to good financial planning. An adviser must provide a suitable offset to this tendency and must prevent its own biases from worsening client's decisions. This doesn't always happen.
The most relevant financial objective for a large majority of citizens, a comfortable retirement, is probably where the majority of biases are currently amassed. We over-estimate the government's capacity to pay pensions in the near future, we refuse to accept the changes derived from longevity, we ignore the financial pressure that will be borne by future generations, and we therefore refuse to understand the inevitability of delaying retirement and of supplementing public pensions. These are biases of pure emotional irrationality, and we furthermore stir them up with a profound disinformation. The current status of the pension systems in many western countries is very complicated: running deficits, no sustainable solutions, a taboo subject preventing an open debate and the lack of transparency that includes manipulated data. Above all the situation is condemned by the fact that political parties, always placing their electoral interests first, avoid dealing with the reforms of the system that are now essential. Clear examples include the recent frustrated attempts of reforms in France and Spain.
On this subject we find ourselves facing the active promotion of all imaginable biases by governments and opinion makers, but mainly facing a generalized complacence that tends towards insufficient supplemental savings. Fighting this situation, without fear of pointing out the crude reality of what lies ahead, has to be the responsibility of all of us who work professionally as financial advisers or consultants, and especially the responsibility of those for whom professional qualifications are not just a requisite to be met but rather a requirement of professional quality and ethics. Continuing to ignore this responsibility would be even harsher. “Behavioural finance” or “financial or economic psychology” – however you want to call it – must be used as an essential tool to understand and help clients, without forgetting how we are also affected as financial advisers.