Sunday 25 September 2011

CPF system and its application of behavioural economics

Retirement planning, is it an art or a science?

Singapore is a successful nation which revolves on a national philosophy of self-reliance. Throughout our rapid development, we have refrained from becoming a welfare state. This was made possible through the introduction of the Central Provident Fund (CPF) in 1955. 

There are many external forces which can hinder the effectiveness of our CPF system. One of the most prominent are the behavioural bias among CPF members which may potentially hurt the CPF’s mission of ensuring that workers could support themselves with dignity in retirement.

We shall highlight some common behavioural bias among CPF members and the measures undertaken by the CPF board to minimise its impact.

  •     Bounded Rationality
    Bounded rationality is the idea that in decision making, rationality of individuals is limited by the information they have

    Most people have a strong tendency to underestimate their post-retirement needs. According to the Singapore department of statistics in 2010, the life expectancy of an average retiring Singaporean male is 83.  The figure is expected to rise further due to advances in medical technologies. For example, a young male graduate spending $1,200 monthly and wishing to retire at age 55, will need a lump sum in excess of $860,000 just to ensure self sufficiency for day to day expenses. This is without taking into account increased healthcare and hospitalisation costs in retirement years.

    Most Singaporeans generally cannot envision themselves living past age 80.  By making individual savings compulsory, CPF is able to kill two birds with one stone, namely addressing the problem of a lack of foresight, as well as a lack of discipline.

    •         Hyperbolic Discounting

    The idea of hyperbolic discounting states that given two similar rewards, humans show a preference for one that arrives sooner rather than later.

    The CPF Minimum Sum Scheme addresses people’s tendency to value short-term usage of CPF monies (E.g. investments, housing or education) significantly over their longer-term retirement needs. 

    Locking up part of the individual’s CPF savings until his retirement age and then disbursing the monies as lifelong annuity stream constrains the individual's ability to over-consume in his early years of retirement.

    •        Loss Aversion
    Loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains. Some studies suggest that losses are twice as powerful, psychologically, as gains.

    For employed CPF members, the employee contribution is deducted directly from their income before they are paid monthly; this reduces the feeling of loss among CPF members.

    The Medishield programme is also a good example of CPF’s application of loss aversion principles.  By making medishield an automatic enrolment and an opt-out scheme, an individual will tend to feel he is losing something if he were to opt out; this encourages CPF members to stick to the default option of staying with medishield.

    Can behaviourial economics save us from ourselves?
    •   Status Quo Bias
    Status Quo Bias suggests that people tend not to change an established behaviour unless the incentive to change is compelling.

    Many Singaporeans are unaware of the mechanics of medical insurance, term & mortgage insurance and whole life annuities. If these individual decisions are to be left to CPF members, the complexity of these financial products would probably result in CPF members postponing their decisions and being severely underinsured.

    As a result, the CPF board has designed these programs such that they are on an opt-out basis. Examples include medishield, dependent protection scheme, home protection scheme and CPF Life.
    Even for the all important decision of a lifelong annuity scheme, CPF life, the default option for retiring CPF members is also set as the “Balanced” plan, which is deemed to be the preferred option.

    •      Self Serving Bias
    Self Serving Bias is the tendency to claim more responsibility for successes than failures.  The CPF Investment scheme has allowed members to invest in stocks, unit trusts, property funds and even gold due to the varying investment appetites of CPF members. This has encouraged savvy members who want to take charge of their investment returns to actively manage their CPF monies so they can attribute investment returns to their individual skills rather than earning a stable fixed rate of interest in the CPF account.

    Statistics paint a different picture though. As of FY2010, 86% of CPF members who use their OA for investments are unable to make net realised profits in excess of the OA interest rate of 2.5%.  In addition, 49% of CPF members who invested lost monies in their investments,

    In order to curb the self serving bias which encourages CPF members to invest for the sake of investing, the CPF board have indicated that only amounts in excess of $20,000 in Ordinary Account and/or more than $40,000 in their Special Account can be used for investments (As of Sep 2011).  It is likely that this limit will be further increased in the future if the trend of investment losses suffered by CPF members continue.


    Does the ends justify the means?
    Most Singaporeans suffer from information overload as well as attention scarcity, leaving decision making to CPF members can result in choice paradox and can have unintended negative consequences. Substituting the invisible hand of the market with the hand of the government, may not be a bad idea after all, even for the most crucial life decisions such as retirement planning.

    Do feel free to share with me your comments...