How to manage our cognitive biases to boost private pension savings

The public pension system, a fundamental pillar of the welfare state, presents a set of significant challenges both in Spain and in Europe in a context characterised by the retirement of the baby boom generation. In fact, almost 60% of adult European citizens admit to being concerned about whether they will have enough money in retirement.1However, there has not been a significant increase in savings rates in recent years: the savings rate in the euro area in the period 2010-2019 was 12.5% (7.4% in Spain), below the 13.3% of 2000-2009 (9.1% in Spain). Germany is an exception to this trend, as not only is it the euro area economy with the highest savings rate but it has also seen an increase in this rate (17.5% in 2010-2019 versus 16.8% in 2000-2009).

Moreover, the composition of European households’ financial savings reflects a conservative profile in most countries, with a clear preference for deposits, which represent between 20% and 40% of total financial assets. In contrast, the proportion of total financial assets made up of savings in private pension funds and retirement insurance policies is rather uneven from country to country and is determined by the replacement rate of public pensions.2 It is observed that the higher the replacement rate for public pensions, the lower the percentage of workers with private pension plans: in Denmark and the Netherlands, public replacement rates are among the lowest in the EU, yet between 93% and 100% of working-age individuals have a private pension fund. This is because it is practically mandatory to have this type of savings instrument and, as a result, they contribute around 60% of the total pension which people receive in retirement. On the other hand, in Spain, which has one of the highest public pension replacement rates in Europe (around 74%), it is observed that the percentage of the working-age population with pension plans has barely changed since 2005 and is below 30%.3

The automatic mechanism generates a series of biases within us (whether cognitive or emotional) which make it difficult for us to make «rational» decisions. Behavioural economics incorporates this idea that agents do not make their decisions in an entirely rational way (as has traditionally been assumed in economic theory), but rather their decisions are driven by emotions and different types of biases.

Certain biases are decisive when it comes to planning our savings. These include our lack of self-control (too many temptations in the present which prevent us from saving); our aversion to loss (if an investment incurs losses in a particular year, that affects us more than the gains which that same investment had accumulated over the years); the creation of mental accounts (we organise our money into different categories of expenditure or income, which are not interchangeable), and the status quo and inertia (our preference to remain in the current situation). These biases lead to the erection of three major barriers which prevent us from «activating» our rational brain to think about retirement: we struggle to imagine a time when we will be old and to identify with our future self; we value our present needs much more than our future ones, and we suffer a certain short-sightedness when assessing what our needs will be as we age.

However, these behaviours that are inherent in our human condition can be modified, or adapted, as demonstrated by the findings of behavioural economics which confirm that individuals’ decisions are highly conditioned by the way in which the available options are presented to them. It is therefore a question of «taking advantage» of the cognitive biases we have as human beings in order to give individuals a nudge so that their final decision is the right one, while at the same time respecting their freedom of choice, as the available alternatives are neither removed nor blocked.4 Behavioural economics therefore presents methods that can be used by government institutions to guide citizens’ decisions.5

The UK pension system had been mixed since the mid-20^th century: it had a public redistribution system and a private pension system. However, the demographic trends and projections were raising warning signs regarding the sustainability of the public pension system. In addition, the private system could not compensate for the situation, since the level of contributions and savings had been gradually declining.

For this reason, in 2008 a new pension law was approved which included the adoption of so-called automatic enrolment. Under this mechanism, employers must automatically enrol their staff in a private pension plan6 (so-called company or employment pension plans, which supplement the public pension) provided they meet certain requirements,7 although the employee has one month to withdraw from the system. In addition, every three years companies must automatically re-register those workers who had chosen to withdraw. The system was activated in 2012 and gradually implemented across all British companies over the next six years.

The figures confirm the initiative’s success: whereas in 2013 only 32% of British private-sector workers had a company pension scheme, by 2019 this figure had risen to 75%. As a result, the total replacement rate for pensions reached 49% in 2021, compared to 22% counting public pensions only. In addition, the volume of assets in private pension plans has more than doubled, amounting to over 120% of GDP in 2021, compared to 73% prior to automatic enrolment.

The United Kingdom is just one example demonstrating that behavioural economics techniques work. Other success stories can be found in the US with its Save More Tomorrow (SmarT) programme, which managed to boost pension savings for some 15 million people;8 in Brazil, which got 80% of public-sector workers to have a supplementary pension fund through automatic enrolment, or in the Netherlands, which raised awareness among workers at the individual level of the status of their public pension by sending them what became known as the «orange envelope».9 These cases can serve as inspiration when designing public policies to promote private savings for retirement, although there are no magic formulas and they must be adapted to the idiosyncrasies of each particular culture, because what works in one place may not necessarily work in another.

Ensuring that private company pension plans become widespread is an important first step, but achieving a significant increase in the level of savings depends on the tax incentives offered for doing so – in most countries, contributions made to pension plans can be deducted from one’s taxable income, up to a certain limit, and the taxation on this portion of income and its returns is deferred until it is collected in retirement. It also depends on the profile of the affected savers10 and, as we have seen, on people’s cognitive biases. In Spain, where from 2022 the combined tax-deductible contribution limit for workers and employers in company pension schemes is raised to 10,000 euros,11 the available estimates suggest that every euro saved in company plans has historically increased the level of gross private savings by around 66 cents (i.e. a portion is offset by the reduction of other forms of savings, but on balance there is a substantial increase in total savings).12 An alternative way to boost aggregate savings would be for the state to supplement contributions to individual pension plans. This policy has been followed, for example, in the so-called «Riester plans» in Germany or in the case of Lifetime ISAs in the United Kingdom.13 The evidence suggests that supplements to contributions increase the ownership of retirement savings vehicles, but that the majority of taxpayers fail to make any contributions despite the incentive.14 Once again, we come face-to-face with human irrationality, dear Sancho: as human beings we struggle to see the tax benefits of saving for retirement, unless someone explains them to us well.15