If you are fortunate enough to have a pension plan offered through your employer, you will most likely have a Defined Benefit Pension Plan (DB) or a Defined Contribution Pension Plan (DC).
DC plans do not get effectively incorporated into one’s financial picture. One reason, in my opinion, is that mutual fund advisors (which many Canadians tend to deal with) have no incentive to help manage an employee pension plan. An advisor focused on relationship-building and total client wealth should look at the whole picture.
Another reason why individuals may not end up effectively using their DC plan is they may unknowingly fall victim to certain behavioural biases that could deviate their portfolio from the ideal asset allocation of funds.
Let’s start with a couple of definitions and features of the DB and DC plans
Defined Benefit Pension Plan (DB): A DB plan gives an employee a certain amount of pension income based on some formula and terms in the plan, which varies for each employer.
A key feature of this plan is that it is up to the employer to ensure the pension assets are sufficiently funded and takes on the investment risks (the employer ensures there are sufficient funds available to meet pension payment obligations).
Defined Contribution Pension Plan (DC): In a DC plan the employee makes periodic contributions to an employee’s pension. The employee must choose how these funds are to be invested within the available choices provided by the pension plan sponsor.
With a DC plan, the employee is responsible for the investments and funding the retirement income from the pension. The only financial liability the employer faces is making the contributions to the employee.
A key feature of this plan is that it is up to the employer to ensure the pension assets are sufficiently funded and takes on the investment risks.
Trends And Implications
According to Statistics Canada, over the past 2 decades or so, more and more companies are moving away from offering DB plans and moving towards DC plans. Although the public sector for the most part still offers DB plans, the number of DC plans in the private sector has doubled from 14% in 1992 to 28% in 2011. See the chart below.
A move towards DC plans means the responsibility falls on the employee to make investment decisions, something most employees are either not interested in doing or lack the necessary knowledge to do so. Individuals, in managing their own DC plans, may unknowingly fall victim to some cognitive behavioral biases such as status quo bias, 1/n naive diversification, and the endorsement effect which will be discussed shortly.
From my personal experience, the investment choices offered to employees in a DC are primarily mutual funds, which is unfortunate. However, the fees charged are very low which is a good thing!
Let’s dive into the 3 cognitive biases mentioned earlier.
Status Quo Bias
The status quo bias refers to the DC plan participant’s tendency to never change the default asset allocation of their pension investments or to make an initial allocation and then never change it. Effectively, this becomes a buy-and-hold type strategy.
By leaving the initial choices as-is, the investor’s asset allocation over time will end up deviating from the desired allocation.
1/n Naive Diversification
In the 1/n heuristic bias, participants simply divide their contributions (almost) equally among all the available choices. As a result, the asset allocation participants end up with largely depend on the funds offered by the employer. For example, if there are 3 equity funds and 1 bond fund offered for employees to choose from, they will end up with approximately 75% equities. If there are 3 bond funds and 1 equity fund offered, employees will end up allocating 75% of their contributions to bonds. You can find more details in the study by Benartzi & Thaler, Naive Diversification Strategies In Defined Contribution Savings Plan.
This is not necessarily a bad thing as this approach can produce a well diversified portfolio. However, whether or not participants end up with their desired asset allocation depends on the the relative choices offered by the employer. An employee may end up with their desired asset allocation only by luck if they don’t actively make conscious decisions about the choices in the pension plan.
Somewhat related to the above bias, the endorsement effect is where plan participants believe all the investment choices offered by the employer are good investments (they are implicitly endorsed by the employer). Participants may end up investing in all the available choices as described in the 1/n behavior bias above.
Some suggestions on how an employee can mitigate these biases:
1. Work with a qualified financial professional. DC pension assets should be incorporated into your financial plan. If you have a financial advisor who has not asked if you have a pension plan, fire this person! (ok, kidding…maybe)
2. Take investment decisions into your own hands and actively review the pension investments at least annually.
Edited by Janet Ngo