Don’t judge a pension option by its cover

blocks with question marks for Quietroom blog

This month, millions of people will be trying to get their heads round big changes to the way pensions work. The main change is that people over 55 have more options for what to do with their pension savings. One of the difficulties with thinking about these options stems from the words the pension industry uses to label them.

The three options are called cash, annuity and income drawdown. Most people don’t understand what the second and third of those options are. When we asked them to guess, they were usually wrong.

So how will people decide which option to choose from the list? Well of course they might ask for help from a service like Pension Wise. But, as students of psychology know, within moments of looking at the list, and before fully understanding it, many people will have identified their preferred option.

The branch of psychology known as behavioural psychology or decision theory says that when we make judgements, we are strongly influenced by a plethora of mental shortcuts (‘heuristics’) and biases. We have to be, or we’d continually be paralysed by indecision. These shortcuts and biases affect uncommon, complex decisions, like which pension option to choose, just as much as common, straightforward ones, like which pants to put on.

Imagine an average person – let’s call her Emma – thinking about retiring and faced for the first time with the question: ‘Which option do you prefer: cash, annuity or income drawdown?’

To produce a quick, intuitive answer, Emma’s brain is likely to put that difficult question to one side and substitute it with an easier one. Psychologists call this ‘attribute substitution’. This easier question could well be: ‘Which option do you like the sound of?’ People we’ve spoken to find annuities complicated and quite reasonably guess that ‘income drawdown’ must be bad news because it puts the word ‘income’ next to the word ‘down’. ‘Cash’, on the other hand, is a simple, feel-good concept. So Emma’s intuitive preference is disproportionately likely to be ‘cash’.

But once she gets some professional advice or guidance, won’t Emma put that intuitive preference to one side? Here are three more insights from behavioural psychology that suggest that she might not:

  1. When Emma hears about and then weighs up the risks and benefits of each option, she’s likely to be swayed by her positive feelings about ‘cash’. This is the ‘affect heuristic’ – if you feel good about something, you’re likely to rate the benefits of it higher and the risks lower.
  1. A specific risk with the cash option, where you take all your pension savings out in a big lump, is that you spend your money too quickly and so run out before you die. But Emma is likely to discount this risk, because of the ‘optimism bias’ – the common belief that bad things are less likely to happen to us than to others.
  1. Emma will also tend to do what we all do when we get information about something we already have an opinion on – give more weight to information which supports our existing view, and less to that which doesn’t. This is the ‘confirmation bias’.

None of this is to say the cash option is necessarily bad. Just that people are – at least in part – going to make important choices about their future, based on how they feel about the words used to label those choices. That is not a reliable way to make good decisions.

At Quietroom, we’re on a mission to help the pension industry – and anyone else who has tricky but important stuff to say – talk in a more meaningful way, so people make better choices. That’s why we’re bringing together a group of industry leaders in a new campaign – Better Words Better Numbers. We all know that we need to engage people in pensions – this campaign will find solutions that we can share.

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To kick off, we’ve made this three-minute animation that explains drawdown, cash and annuities in a way that’s clear, vivid and real. If the animation helps you in your own efforts to engage people in pensions, please use it and share it – it’s free. And if you’ve got any ideas you want to share, please let us know about them. Because this stuff is important.