Designed defaults – Introducing the Backstop State

I am working on a Progressive Essay. I am basing it around some ideas on superannuation that I have elaborated in my Courier Mail Columns here, here and here.

As the essay burgeoned to over 8,000 words, I decided to break it into two. The first essay is oriented around the theme of the management of complexity. The second is oriented around the themes of the management of risk, and improving the flexibility of regulation.

The first essay has five sections:
1 An introduction to both essays
2 A discussion of complexity
3 The Backstop State – or a state that tries to optimise ‘default settings’ for its citizens in superannuation.
4 Improving the regulation of information disclosure and investment advice
5 The role of an Opposition regarding this agenda.

Below the fold I have posted the first two parts of the first essay and I would be grateful for any reactions and suggestions. I have not reproduced all footnotes as I have simply transcribed the text from my word processor.

Designed defaults: How the Backstop State can failsafe Australians’ superannuation.

I. Introduction
The implementation of the deregulatory wave of microeconomic reform is largely complete. Some industries could still do with deregulation including the postal, taxi, pharmacy and news-agency industries. But just listing them illustrates their relative unimportance.

Economists have recently turned their attention to both the health and education systems as new fields of reform, as well they might. Nevertheless I think there are fine new vistas for microeconomic reform, but to see them we must see our economy afresh. This claim can be put in context alongside another claim: that before deregulation we thought of the economy as a giant mechanism for making things. As early as the 1930s, Friedrich Hayek, one of the intellectual architects of the wave of deregulation of the 1980s and 90s emphasised the incompleteness of this picture, arguing that the skills of the merchant and the trader were as indispensable to a well functioning economy as those of the mechanic and the engineer.

In many respects the National Competition Policy” represented a culmination of deregulation involving as it did a systematic stock-take of our economic institutions with one question in mind: “how can we intensify competition in the interests of economic efficiency?”.

We need only nominate some other critical theme of economic organisation to provide ourselves with fresh perspectives on economic reform. Once identified such themes could motivate their own systematic through the economy a l¡ competition policy. For an economy is more than a giant apparatus for producing goods and services, and for trading them (both internally and with other countries). It must also facilitate appropriate decision making despite the bewildering and growing complexity of our world. And it must do so by generating information and expertise and getting it to where it is most useful.

It must also bear and manage risk. Further, as the web of red tape grows slowly, inexorably denser year after year, as our Tax Act passes the 7,000 page mark and the financial sector groans under the weight of wave after wave of Financial Services Reform, it is hard to believe that except where regulation can be swept away with the stroke of a pen (as it was in the case of shopping hours) regulatory reform has been anything but a disappointment. If we are to tackle these new vistas of reform without repeating the mistakes of the past, we need to find more effective ways of regulating to improve outcomes.

Our burgeoning superannuation system provides a worthwhile microcosm within which to demonstrate these ambitious claims. Note also that where deregulatory reform typically involved the maximisation of competition wherever and however possible, reform of our systems of information, risk management and regulation can only be done well by those who are truly seek to refine and optimise the complementary roles of government and markets, of collective and competitive action in a mixed economy. More than with deregulatory reform, partisanship for competitive or collective action and the endless ritual battles between those positions is likely to obscure worthwhile possibilities for improvement.

This is the first of two essays addressing the themes introduced above. This essay addresses complexity and information whilst a subsequent essay will focus on regulation of risk within superannuation and increasing the flexibility with which people can access their superannuation for long term non-retirement savings needs.

Before proceeding a word of clarification is in order. These essays contain what I hope are worthwhile discussion and proposals but no claim is made to comprehensiveness. Any pretensions of comprehensiveness would have required me to deal with taxation. Given something close to a flat tax regime in superannuation implemented mysteriously enough by the ALP in collaboration with the union movement it would be strange if could not be made more equitable. But this is an area that is well worn, and one in which I can claim few original insights.

II. Complexity
As Adam Smith explained, our society and economy’s growth in ‘opulence’ is also a growth in complexity. In an age of terrorist bombings it might sound academic to suggest that addressing the complexity of citizens’ lives might be a worthwhile political project. But complexity is already a talking point of some significance amongst the hoi-polloi and on talk-back radio. Our lives have grown remarkably more complex in the last few decades.

Regulation including the rules governing the tax system – is now much more complex and pervasive. More noticeably the deregulation of a range of utilities and other service industries (like banking) has led to an explosion of complexity for consumers. In industries with relatively high fixed costs, price discrimination is pursued vigorously. Though price discrimination is frequently regarded by today’s policy advisors as intrinsically efficiency enhancing (because in principle it allows efficiency gains through the extension of the market) this analysis ignores the consumer inconvenience that will often be entailed in practice (See Appendix One) and the way in which price discrimination increases sometimes massively consumers’ costs in searching for the right product.

People agonise over which mobile phone plan, and which bank loan will minimise their costs. Some despair of ever knowing. Whole new industries like mortgage broking and specialist phone marketing have arisen to address consumers anxieties and frustrations with the complexities and vast variety of choices they face. Jokes circulate about such subjects as the vast variety of different fares one can book on a Qantas’ flight. Of course, as John Vickers has recently said, “market imperfections do not necessarily call for public policy solutions” (2003: 2) and any very direct government regulation of price discrimination would almost certainly generate outcomes that were foreseeable only in their perversity.

But though we should be rightly wary of cures that could be worse than the disease, we should proceed in the understanding that complexity has its costs and chastened by the knowledge that they have received much less than the attention they have been due in most economists’ education.

III The Backstop State: Dealing with complexity, ignorance, procrastination in superannuation

Nobel Laureate Herbert Simon devoted much of his life to exploring the implications of our necessarily ‘bounded’ rationality. We have neither the time nor the cognitive capacity to find out and comprehend the significance of everything there is to know about things (and even here we would still be left in a state of considerable uncertainty) and so we make decisions according to rules of thumb. The new field of ‘behavioural economics’ adds to this picture, particularly by fleshing out some of our species more systematic ‘bounded irrationalities’. As a result it has some important things to say about savings and superannuation particularly in the context of complexity and ignorance.

In situations of great uncertainty like deciding how much we should save now to fund a retirement that is several decades away we look around to see what others do, what seems normal. (Lusardi, 2000). We also procrastinate, often irrationally. In economic jargon we make ‘time inconsistent’ decisions. Janet Yellen tells a story of a savings plan at Harvard which yields no return until the employee chooses between two investment options. Most junior employees delay choosing (and in so doing waste hundreds of dollars in interest payments) though making the choice requires less than an hour’s time (Akerlof, 1991: 6). Australia’s own ledger of over $7 billion in unclaimed superannuation accounts attests to a similar phenomenon.

Akerlof generalises to observe that we are prone to irrational procrastination or in economic jargon dynamically inconsistent decision-making where:

1. the time between decisions is short making each act of procrastination relatively trivial (“I’ll do it tomorrow”), and;
2. there is a small ‘salience cost’ to undertaking the job now rather than later (1991, pp. 3-4).

There is good evidence that savings decisions themselves fit this pattern generally (See eg Lusardi, 2003). However except where it compels saving, the panoply of bureaucracy involved in superannuation savings plans could be increasing procrastination substantially.

This discloses a role for collective action which can be highly beneficial and yet without the usual drawback of collective action coercion. In a world of complexity, ignorance and transactions costs, citizens will value what I will call the “Backstop State”. Wherever possible, and before it resorts to coercion either through regulation or monetary incentives, the Backstop State will seek to assist its citizens by setting ‘designed defaults’. Citizens would remain free to make alternative arrangements. But they could also rest assured that, if they did not exercise this right to choose, they would fall back on a default option that reflected expert opinion about what was the most beneficial ‘default’ possible.

These actions of the Backstop State would address the issue of procrastination and ignorance. The ‘designed default’ would address the problems illustrated by behavioural finance by influencing perceptions of what was normal and prudent and by lowering the transaction costs of much better options than current defaults. Paraphrasing Churchill it is not unreasonable to say that rarely before in the field of human policy making has so much improvement been offered at so little risk or coercion. It offers a remarkably painless way to dramatically improve outcomes and yet coerces citizens no more than reality itself does requiring them only to actively exercise their choice if they do not like the ‘designed default’.

The equity arguments are compelling. If the US is any guide, less than 40 percent of people seek even to make a reasonable determination of how much retirement savings they will require. Only slightly more forty five percent have even the rudiments of the knowledge necessary to make sensible investment decisions for instance the knowledge that equities have tended to outperform bonds over time. And nearly three quarters believe they have saved too little in the last two or three decades (Lusardi, 2003: 2). The evidence suggests that designed defaults can have a major impact.

Choi et al. (2003) studied three firms that used automatic enrollment for tax privileged 401(k) retirement savings plans in the US. When employees were automatically enrolled, only a tiny fraction opted out, producing participation rates exceeding 85%. By contrast, when employees at these firms were not automatically enrolled, participation rates were much lower, ranging from 26% 43% after six months of tenure, and from 57% 69% after three years of tenure.

The efficiency arguments are equally powerful. Few of us have a strong inclination or aptitude to plan our finances and it is inefficient for us all to acquire the expertise either to manage those finances ourselves, or even to choose and supervise others with that expertise. Of course we should retain the choice to take matters into our own hands. But if we do not choose to do so, it is efficient for experts to design a default which is as well suited to people’s circumstances as they can make it.

There is debate over whether those on low incomes should be required to contribute more than nine percent of their earnings into superannuation (ACOSS, 2002). But apart from lower income earners, there is little debate that higher contributions are in order. Thus, even without increasing the level of compulsory superannuation we should gradually raise the ‘default’ level of contribution. We should do so gradually, as we did with compulsory super, a percent or so every couple of years so that the change is incorporated into people’s lives all but imperceptibly.

I suggest ways of improving investment advice in the subsequent section. But good policy will take the world as it is complete with those without the aptitude and/or the inclination to manage or supervise the management of their superannuation savings. For these people there should also be a default fund. Lusardi reports that in the US less sophisticated and poorer households those who have no financial plan “are less likely to invest in high return assets such as stocks (2003: 3)”. A properly structured default fund would address this problem. This fund should be managed at arms length from Government, and should have a ‘balanced’ asset allocation with substantial exposure in both domestic and international markets to high return assets such as equities, property alongside some probably lower exposure to bonds and cash. In keeping with the principles of competitive neutrality, the fund should purchase investment management services from wherever it considers it can obtain best value for money whether this be with private sector managers and/or funds managers (whether active or index hugging), ‘industry funds’ or public sector fund managers such as those managing the PSS. This competitive structure would maximise competition in funds management and prevent too large an amount of money depressing the returns of a single fund manager.

I would also like to see the default super scheme charge its members a small fee to receive independent investment advice either individually or in groups something they could renounce for a return of the fee should they wish.