A couple of entries down I posted a draft Progressive Essay I’m working on. I said the next post would contain another large slab of text with two sections – one on investment advice, the other on a role for the Opposition.
Well the first of those offerings is being held over until a subsequent essay so that the first retains its focus on the “backstop state”. However I wanted to post and get comment on my comments on a role for the Opposition. Because I’ve been through the whole essay improving expression here and there and tightening it up, I have posted the whole essay as currently drafted.
But if you’ve read it before, please skip to the last heading – A role for the Opposition. I’d be interested in comments.
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 with 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 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” was 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 trawl 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, the web of red tape grows inexorably denser, 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. Except where regulation can be swept away with the stroke of a pen (as it was with import quotas and shopping hours) regulatory reform has been 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 deregulatory reform typically involved the maximisation of competition wherever and however possible. Thus although ideological zeal either for competitive markets or against them is rarely the friend of good policy, enhancing competition within our economy was a worthwhile project and one which was not fundamentally compromised by the pro-market ideological zealotry of some of its protagonists.
By contrast reform of our systems of information, risk management and regulation can only be done well by those with a feel for the mixed economy. For if commonsense does not tell us, economic theory does that these areas will be best handled by those who truly seek to refine and optimise the complementary roles of government and markets, of collective and competitive action. More than was the case 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. It addresses the issue of complexity whilst a subsequent essay will focus on Risk, regulation and results within superannuation. These essays contain what I hope are worthwhile discussion and proposals but no claim is made to comprehensiveness.
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 appear rather academic to suggest that addressing the complexity of citizens’ lives might be a worthwhile project not just in public policy but also in political advocacy. In fact complexity is already a talking point amongst the hoi-polloi and on talk-back radio. Our lives have grown remarkably in complexity 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 rife. 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 consumers’ costs in searching for the right product sometimes massively.
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 choices they face. Jokes circulate around the internet about all the different fares for the same seat 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 those costs have received much less than the attention they have been due in most economists’ education and in much of the economic literature even to day.
III. Complexity and uncertainty: Decision making and procrastination
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. Indeed, even if we did we would could never banish uncertainty. And so rather than optimise we ‘satisfice’ or use rules of thumb to help us make decisions. The new field of ‘behavioural economics’ adds to this picture, particularly by fleshing out some of humanity’s more systematic ‘bounded irrationalities’. It has some important things to say about savings and superannuation particularly in the presence of complexity and ignorance.
In situations of great uncertainty like deciding how much we should save now to fund a retirement that is decades away we look around to see what others do. We are influenced by what seems ‘normal’. (Lusardi, 2000). We also procrastinate, often irrationally. 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.
IV. The ‘Backstop State’
The phenomena explored above disclose a role for a highly beneficial kind of collective action which is nevertheless not coercive. 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 their right to choose, they would fall back on a default option that reflected expert opinion about what was the most beneficial possible.
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 far better savings and investment options than are set by current ‘undesigned 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 with so little coercion or risk of harm. It offers a remarkably painless way to 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 not really knowing where to begin. Only slightly more 45 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. In getting experts to design the best default they can the state is setting up a highly efficient form of delegation of decision making which citizens are then free to use or not to use as their inclination takes them. Absent the small fixed costs in setting up such defaults, this is as close to the textbook Pareto improvement where some people are better off and no-one is worse off as one is likely to find in our fallen world.
V. A default superannuation infrastructure.
Apart from lower income earners (ACOSS, 2002), there is little debate that higher super contributions are in order from most Australians. This suggests that, 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.
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Box One: the mechanics of increasing the default level of superannuation
Opinions will differ about the mechanics of how best to increase the default level of superannuation. The points below are intended to be illustrative rather than definitive.
On the introduction of a scheme to bring about changes to the ‘default’ level of superannuation a target level of contributions would be set. Some would argue that the default level should vary with income.
On a certain date say one year after the introduction of a default scheme employers would be required to deduct an additional one percent above their compulsory 9% contribution. The less perceptible was the increase in the default rate of super contribution the fewer people will opt out of it which would be consistent with long standing policy goals to increase saving in the Australian economy. Accordingly the increase in the default rate would be most felicitously introduced with annual wage rises. I envisage that the additional one percent contribution be in the form of a salary sacrifice by the employee, rather than an increase in the employer contribution. There would be no change where the employee was already salary sacrificing above some declared target contribution rate say 15%).
Employers would be required to increase the salary sacrifice by default with employees receiving a form with;
1. a simple explanation of what had happened along with
2. some simple advice explaining that the government advised by experts considered that it was usually prudent for people to save more than the 9% compulsory level. The statement might suggest the target level of savings (which we’re assuming for the sake of illustration is 15%) and indicate that over the next five years their salary sacrifice will be increased by default by one percentage point per year to achieve this target.
3. an invitation to elect a lower (or higher) level of contribution than the default that had just been introduced.
The process would be repeated yearly.
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I will propose means of improving investment advice in a subsequent essay. But be that as it may, 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 substantial exposure to 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 allow the trustee to prevent too large an amount of money depressing the returns of a single fund manager.
I would also like to see the ‘default fund’ charge its members a small fee to receive independent investment advice (supplied by providers who have no incentives to recommend one investment or strategy over another and with a track record of successful advice. ). In keeping with the theme of this essay, members would be able to forego the advice and have the fee returned should they wish.
VI. A role for the opposition
We are taught that there are three arms of government the executive, the legislature and the judiciary but it is useful to remember a fourth. As the events of the last few decades have shown, politicians are persuaders. And as society becomes more complex ‘soft power’ the power of mores and expectations grows in relative importance over the ‘hard power’ of black letter law. Persuasion grows progressively more powerful relative to the other, more coercive arms of government. Indeed, the potential of ‘designed defaults’ in superannuation is an illustration of the phenomenon of soft power itself.
This provides an Opposition with opportunities to offset some of the natural advantages of incumbency that its political opponent enjoys. Whatever else might be said about him, Mark Latham mobilised the suasional arm of government from the Opposition benches of the Parliament to secure much needed reform of Parliamentary superannuation. His actions carried a double dividend. One dividend for his community in the form of better, fairer policies and another political dividend for himself and his party.
The agenda set out above presents an Opposition with the opportunity to make a difference even if it cannot influence Federal Government policy. Precisely because ‘designed defaults’ so much gain at the cost of so little pain, simply bringing the issue to prominence could be surprisingly influential.
But the Opposition has other powerful resources. ALP State Governments could adopt designed defaults for those on their direct payrolls, use their influence to promote the idea more widely and also consider in what other areas designed defaults might be worth pursuing. And the union movement could advocate and/or negotiate for designed defaults with employers and also through industry funds. In addition to those firms that implemented such policies out of a sense of community spirit, one would hope and expect such an agenda to be strongly supported by firms and industry associations in the financial services sector whom it would benefit.
As a result, real progress could be expected even in the absence of holding office. We could move towards the backstop society – even before we established the backstop state. Such an achievement would be a proud one for an Opposition. But at a time when the party has difficulty being heard amid the crises and clamour of the moment, it would also help demonstrate the ALP’s capacity to forge positive change at the same time as it was pursuing the necessarily largely negative and generally thankless role of holding the Government to account. Whatever its political fortunes in the next few years, initiating the establishment of designed defaults in Australia’s superannuation system would enable the ALP to continue the process it began in the 1980s. That process will end when we can say that anyone who has saved too little for their retirement, has done so by design, and not by default.