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Irrationality about DB transfers: 3 cognitive biases to expect in your clients

DB transfer

Two weeks ago we considered the role of present bias in the temptation to take up a DB to DC transfer offer, even when it is not in our long-run best interests. Of the other cognitive biases at play in these types of decisions, there are three of particular relevance to the DB transfer context: the endowment effect and loss aversion, the scarcity effect, and anticipated regret aversion. This article explores how these can influence your clients’ decisions, and how you can support them to adopt a more “rational” approach.

Of the plethora of cognitive biases which permeate our thinking, the phenomenon of overvaluing immediate rewards at the expenses of our long-run interests (present bias, please see the previous article), tends to have the strongest impact on DB transfer decisions. Here we consider several others, all of which tend to bias our decision in favour of the immediately available CETV option.

1. Endowment effect and loss aversion

When approaching a financial adviser about a DB transfer opportunity, some clients may already have in mind to take it up and are looking for facilitation and even support of their decision. Particularly for the over-55’s, who can access 25% as an immediate cash lump sum, these clients are likely to consider the available CETV as “mine”. A wealth of behavioural economic evidence shows we tend to place additional value on those things we perceive as ours. Known as the “endowment effect”, this leads to a relative reluctance to give up our own things. Of course, this presents no issue when taking the CETV is the financially sensible option, but it can bias clients’ decision making towards a sub-optimal choice when it is not.

The endowment effect is in large part driven by “loss aversion” – the pain of losing (or giving something up) is psychologically about twice as powerful as the pleasure of gaining. Experiments have shown that compared to making a decision in isolation, loss aversion is much reduced when people are asked to explain their choice to another person. The impact of this accountability appears to be in part due to the additional cognitive effort required to think through and articulate a justification of their choice. These findings offer us an insight into how advisers can support their endowment affected, “it’s my money, I’ll take it out”, clients: encourage them to clearly talk you through their rationale, as not only does this provide you opportunities to counter any errors in their financial logic, but the very process of doing so will help de-bias them.

2. Scarcity effect

Digital marketers make good use of a cognitive bias known as the “scarcity effect”, by highlighting “low stock” items and “online only” offers, and offering only limited timeframes for fast delivery. Scarcity often operates as code for uniqueness and exclusivity, and so relative to products that appear abundant, we place higher value on items we perceive as scarce (and as experiments have shown, this holds even when the scarce and abundant items are identical).

Clearly then, the common positioning of a CETV offer by pensions providers as “one-off” and “time-limited”, serves to increase the attractiveness of the opportunity to cash out. However, research shows that the impact of scarcity varies depending on whether people consider the product has utilitarian or hedonic value, whether they adopt a positive (“playing to win”) or defensive (“avoid losing”) mindset, and also whether they perceive the source of scarcity to be supply-generated (rather than demand-generated, due to high popularity). So while much depends on the mindset of each client, in general the best approach to tackle the scarcity effect is to point out to clients that their pension provider is likely deliberately positioning their offer in this way (especially those who restrict the number of pension valuations available annually). Moreover, despite marketing DB transfer options as a rare opportunity, numerous pension providers have bettered their offers over time.

3. Anticipated regret aversion

Everyone is familiar with the pain of feeling we’ve make the wrong choice, and the accompanying regret, especially when the decision we got wrong was an important one. The impact of regret is so powerful that in addition to simply just trying to make the right life decisions for ourselves, we also actively seek to avoid options which we may be particularly likely to regret if things don’t pan out. When it comes to DB transfer decisions, the choice is often structured in a way to amplify the “anticipated regret aversion” associated with failing to take out the offer, particularly because of the social influences at play.

As a general rule, we take what others are doing as a guide, and this “social normative” tendency is especially powerful when we perceive others as like our-selves, or (even better) how we aspire to be. Clients will likely know of colleagues who are planning to take the CETV (who may openly encourage others to do so too, in part to boost their confidence in their own choice), and will thus be aware that not taking up a DB transfer offer might not only be objectively the wrong choice, but if so, one they will acutely regret because others they know well profited from the opposite decision. Pension providers may seek to exploit this by commissioning employees in leadership positions to advocate taking the CETV, and even encouraging “informal” employee gatherings to spread the word about the available offer.

How you can help

To help your clients counter their innate (and any provider-amplified) tendencies to avoid regret, the best approach is twofold: first, help your clients understand that due to life circumstances, what is a good offer and good decision for one employee may not be appropriate for everyone else; and two, clearly articulate the risks and regrets associated with taking up the offer, which they may not have adequately considered due to their cognitive biases at play.

By Dr. Laura Haynes

Hear Dr Laura Haynes speak at the Great Pension Debate III



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