There is a neat article by Robert Merton (from July last year) in the Harvard Business Review on the shift to defined contribution plans when saving for retirement.

There are two major types of retirement savings arrangements. The first is defined benefit pension plans. Under these plans, a set income is paid to retirees based on factors such as years of service and final salary, with the income paid until death. These were once common, but they are now rare.

Today most of us are in a second type of arrangement, defined contribution plans. Under these, we contribute a proportion of our income to a retirement fund. Our retirement income is dependent upon our contributions and the performance of that fund. In Australia, we are required to contribute 9.5 per cent of our income to a superannuation account.

When I get a statement from my defined contribution fund, it tells me about my contributions, the asset value and the fund returns. There is no mention of the retirement income I might be able to obtain. I also have a choice of asset allocations, which are defined in terms of risk to the asset value. But as Merton points out, this is where things start to go wrong.

The trouble is that investment value and asset volatility are simply the wrong measures if your goal is to obtain a particular future income. Communicating with savers in those terms, therefore, is unhelpful—even misleading. To see why, imagine that you are a 45-year-old individual looking to ensure a specific level of retirement income to kick in at age 65. Let’s assume for simplicity’s sake that we know for certain you will live to age 85. The safe, risk-free asset today that guarantees your objective is an inflation-protected annuity that makes no payouts for 20 years and then pays the same amount (adjusted for inflation) each year for 20 years. If you had enough money in your retirement account and wanted to lock in that income, the obvious decision is to buy the annuity.

But under conventional investment metrics, your annuity would almost certainly look too risky. As interest rates move up and down, the market value of annuities, and other long-maturity fixed-income securities such as U.S. Treasury bonds, fluctuates enormously. In 2012, for instance, there was a 30% range between the highest and lowest market value of the annuity for the 45-year-old over the 12 months. However, the income that the annuity will provide in retirement does not change at all. Clearly, there is a big disconnect about what is and is not risky when it comes to the way we express the value of pension savings.

So what does that mean for fund managers ?

The particulars are, of course, somewhat technical, but in general, they should continue to follow portfolio theory: The investment manager invests in a mixture of risky assets (mainly equity) and risk-free assets, with the balance of risky and risk-free shifting over time so as to optimize the likelihood of achieving the investment goal. The difference is that risk should be defined from an income perspective, and the risk-free assets should be deferred inflation-indexed annuities.

Then there is the consumer side of the equation. As a start, financial advisers should be asking what are the consumer’s retirement income goals and what action would need to be taken to meet them.

But rather than suggesting the adviser try to educate the consumer about the technicalities of this decision, Merton suggests more consumer engagement may not be a good thing.

Consumer education is often proposed as a remedy, but to my mind it’s a real stretch to ask people to acquire sufficient financial expertise to manage all the investment steps needed to get to their pension goals. That’s a challenge even for professionals. You’d no more require employees to make those kinds of decisions than an automaker would dump a pile of car parts and a technical manual in the buyer’s driveway with a note that says, “Here’s what you need to put the car together. If it doesn’t work, that’s your problem.”

It might even backfire.

Experience also suggests that customer engagement in investment management is not necessarily a good thing. People who are induced to open a brokerage account in their IRAs often become very active in investing for their pension, trading stocks around the world on their computers after work. This is far from a good idea; such short-term trading will not improve the savers’ chances of successfully achieving retirement goals—in fact, it will diminish them.

This is, after all, why we have financial professionals – there is a need for (and benefit to) specialisation and trade.

It is fair enough to expect people to provide for their retirement. But expecting them to acquire the expertise necessary to invest that provision wisely is not. We wouldn’t want them to. We don’t want a busy surgeon to spend time learning about dynamic immunization trading instead of figuring out how to save lives, any more than we would want skilled finance professionals to spend time learning how to do their own surgery.

It is interesting that Merton uses automotive and medical examples. People are often wary of trusting mechanics. In medicine, it is hard to asses surgeon quality before an operation, and we receive almost no reliable feedback on whether they did a good job (unless they accidentally leave an instrument in you). If anything, the trend in medicine is for people to become more educated (hello Google) about what services they are about to receive rather than completely letting go and trusting the medical professional.

As a broad indication of the effects of measurement error in 23andme, ancestry analysis for two identical twins is below. It suggests the decimal point isn’t yet justified. (Their Neanderthal ancestry estimates are also off by 0.1% from each other.)

I am rereading Nassim Taleb’s Antifragile: Things That Gain from Disorder. The first time I read it was during a series of long-haul flights, so some parts of the book are almost unfamiliar.

The below passage is among my favourites. I try to avoid getting sucked into the news cycle and am constantly looking for useful ways to control the flow of information I consume.

[T]hose in corporations or in policy making (like Fragilista Greenspan) who are endowed with a sophisticated data-gathering department and are therefore getting a lot of “timely” statistics are capable of overreacting and mistaking noise for information—Greenspan kept an eye on such fluctuations as the sales of vacuum cleaners in Cleveland to, as they say, “get a precise idea about where the economy is going,” and of course he micromanaged us into chaos.

In business and economic decision making, reliance on data causes severe side effects—data is now plentiful thanks to connectivity, and the proportion of spuriousness in the data increases as one gets more immersed in it. A very rarely discussed property of data: it is toxic in large quantities—even in moderate quantities. …

The more frequently you look at data, the more noise you are disproportionally likely to get (rather than the valuable part, called the signal); hence the higher the noise-to-signal ratio. And there is a confusion which is not psychological at all, but inherent in the data itself. Say you look at information on a yearly basis, for stock prices, or the fertilizer sales of your father-in-law’s factory, or inflation numbers in Vladivostok. Assume further that for what you are observing, at a yearly frequency, the ratio of signal to noise is about one to one (half noise, half signal)—this means that about half the changes are real improvements or degradations, the other half come from randomness. This ratio is what you get from yearly observations. But if you look at the very same data on a daily basis, the composition would change to 95 percent noise, 5 percent signal. And if you observe data on an hourly basis, as people immersed in the news and market price variations do, the split becomes 99.5 percent noise to 0.5 percent signal. That is two hundred times more noise than signal—which is why anyone who listens to news (except when very, very significant events take place) is one step below sucker. …

There is a biological dimension to this story. I have been repeating that in a natural environment, a stressor is information. Too much information would thus be too much stress, exceeding the threshold of antifragility. In medicine, we are discovering the healing powers of fasting, as the avoidance of the hormonal rushes that come with the ingestion of food. Hormones convey information to the different parts of our system, and too much of them confuses our biology. Here again, as with news received at too high a frequency, too much information becomes harmful—daily news and sugar confuse our system in the same manner. …

To conclude, the best way to mitigate interventionism is to ration the supply of information, as naturalistically as possible. This is hard to accept in the age of the Internet. It has been very hard for me to explain that the more data you get, the less you know what’s going on, and the more iatrogenics you will cause. People are still under the illusion that “science” means more data.

As a random personal story, in 2010 when mineral and energy prices were having a slight post-GFC decline (before climbing up to new highs over the following couple of years), a lot of Perth-based mining firms were shutting down projects, cutting costs and generally panicking.

I asked a friend who was working for a major oil and gas producer whether the shifts in prices were affecting his world. He replied that as they were building an asset with a 40-year life, with another five years before it would start production, why would they even look at the day-to-day fluctuations in energy prices? A lot of the firms caught in the panic of the time had projects of a similar lifespan, but they were drowning in noise.

Links this week:

1. Eugenics, ready or not. A good long read.
2. Tort reform preventing people from suing for “weight related harms” may increase attempts to lose weight. HT: Ryan Murphy
3. What does behavioural economics mean for income distribution? The argument ignores most the interesting subtleties, as there are questions around what the reference point is, how you could redistribute while avoiding loss frames etc., but the idea is still worth considering.
4. Cholesterol is OK.
5. The number of childless women in their 40s is falling, particularly among the most educated.
6. If you’re in Sydney on June 17, Rob Brooks is presenting on the price of sex.
7. Some coverage of my new paper in the Daily Mail and (for those who can get through the paywall) The Times.

And if you missed them, my posts this week:

1. The thinking behind my newly published paper.
2. Fifty years of twin studies.

If you’re familiar with the literature, this is unsurprising. A meta-analysis in Nature Genetics of 2,748 twin study publications points to the strong role of genetics and the weak role of family influence (a major component of “shared environment”) in shaping human traits. The abstract:

Despite a century of research on complex traits in humans, the relative importance and specific nature of the influences of genes and environment on human traits remain controversial. We report a meta-analysis of twin correlations and reported variance components for 17,804 traits from 2,748 publications including 14,558,903 partly dependent twin pairs, virtually all published twin studies of complex traits. Estimates of heritability cluster strongly within functional domains, and across all traits the reported heritability is 49%. For a majority (69%) of traits, the observed twin correlations are consistent with a simple and parsimonious model where twin resemblance is solely due to additive genetic variation. The data are inconsistent with substantial influences from shared environment or non-additive genetic variation. This study provides the most comprehensive analysis of the causes of individual differences in human traits thus far and will guide future gene-mapping efforts. All the results can be visualized using the MaTCH webtool.

Also of interest, most of the resemblance between twins is due to additive genetic variation. This is a positive sign for plans to identify the causal variants behind complex traits. It’s just a matter of getting those sample sizes up in genome-wide association studies.

Amusingly, in one case this study has been flagged as a tie between nature and nurture. But the “nurture” we are talking about here isn’t reading to your kids.

A paper of mine has just been published in the Journal of Bioeconomics – Sexual selection, conspicuous consumption and economic growth.

I posted about this article when the working paper was first released, and that post still does a good job of explaining the motivation behind the paper. In that post I wrote:

Around ten years ago, I was rummaging through books in a bargain bookshop under Sydney’s Central Station when I came across a $2 copy of Geoffrey Miller’s The Mating Mind. It turned out to be a good use of my $2, as The Mating Mind is one of the most important books in shaping my thinking, and it was one of the first books I put on my economics and evolutionary biology reading list.

Miller’s basic argument was that sexual selection shaped the human mind. Whether through runaway selection or the brain acting as a fitness indicator, female choice led to increasing mental capacity and shaped our propensity to be humorous, create art or engage in other displays of mental fitness.

As I read the Mating Mind, it occurred to me that the growing mental capability and tendency to display it would have direct economic effects. It would be possible to argue that sexual selection shapes economic growth. Ten years after that idea, my latest working paper (co-authored with my supervisors Boris Baer and Juerg Weber) seeks to flesh out one element of it. The working paper provides a theoretical model for the hypothesis that sexual selection and the resulting propensity to engage in conspicuous consumption has economic effects, and in particular, the desire to engage in conspicuous consumption is one of the pillars underlying the emergence of modern economic growth.

The concept behind the hypothesis is relatively simple. Men who signal their quality through conspicuous consumption have higher reproductive success, as the conspicuous consumption provides a reliable signal of their quality to potential mates. To engage in conspicuous consumption takes effort by the men – whether in the form of art, humour or entering the labour force to acquire resources to consume conspicuously. As the prevalence of males who conspicuously consume increases, the total level of these activities also increases. The increased participation in productive activities results in a scale effect, whereby the greater number of people involved in creative and productive activities results in increased technological progress, which underlies economic growth.

The evolutionary part of the model is more interesting than the economic as there is minimal feedback from the economy back into the evolutionary dynamics. The lack of feedback also means that it is not very representative of modern society, as conspicuous consumption in modern societies is of limited threat to survival. Still, the model provides a starting point and I have a few ideas to take it further.

I have been introducing my talks on the paper with an example from Robert Frank’s Luxury Fever, in which Frank held up Patek Philippe’s Calibre 89 watch as an example of conspicuous consumption. Only four were made, with the first selling for $2.5 million and the latest auction price being over $5 million. Frank mocks the watch for its need for a tourbillon, a mechanism to account for the earth’s rotation, when his cheap quartz watch does not require such a mechanism, as gravity does not affect the vibrations of the crystal.

Now consider the innovation and thought that went into the Patek Philippe watch, including that tourbillon. This watch has 1728 components, gives you the date of Easter each year, and unlike most mechanical watches, will not record the years 2100, 2200 and 2300 as leap years while still recording 2400 as one (as per the order of Pope Gregory XIII in 1582). If you look at Patek Philippe’s list of patents, you get a feel for the innovation involved in making watches for what is largely conspicuous consumption.

When you also consider the innovation undertaken by the potential buyers as they seek to amass the wealth necessary to obtain such a watch, the positive angle to conspicuous consumption grows. As a result, curbing conspicuous consumption may have costs (although, I still prefer taxing consumption to income). If nothing else, we should appreciate the historical role of conspicuous consumption – competition for sexual partners is a driving force for many productive activities, and one generation’s conspicuous consumption is another generation’s day-to-day tool.

In its life as a working paper over the last few years the paper has received a variety of comments, including from Matt Ridley in The Wall Street Journal, Rob Brooks in The Huffington Post and Chris Dillow at Stumbling and Mumbling.

If you want a copy of the paper and can’t get through the Journal of Bioeconomics paywall, you can download the working paper version or drop me a line. The major difference between the two versions are that the simulations have been shunted into the electronic supplementary material for final publication.

Links this week (or more like two weeks):

1. Another favourite behavioural science story bites the dust.
2. Three schools of thought on decision making.
3. Better teachers receive worse evaluations.
4. An attempt to reduce bias backfires.
5. Biased scientists.
6. Hayek and business management.
7. More highly educated women are having children.

Life continues to be busy, so posting will continue to be sparse for at least another couple of weeks.

Links this week:

1. On the misplaced politics of behavioral policy interventions. And hawkish biases.
2. Noah Smith v Bryan Caplan on education signalling – 1, 2 and 3. I believe signalling is an important part of the education story, but Smith’s argument about costly signalling is on point.
3. Robert Trivers on his friends and enemies. HT: Razib

And if you missed it, my one post this last week:

1. Bad nudges toward organ donation.

Life continues to be busy, so posting will continue to be sparse.

It’s a favourite behavioural science story. Countries that have opt-in organ donation have lower rates of organ donation than countries where you have to opt out of being an organ donor. If we change the way the choice is framed from opt in to opt out, we can dramatically increase the rate of organ donation.

Except, it’s not that simple. For countries where there is an opt-out system, there is no simple point where the choice is presented to them as the default and they can easily tick the box to be removed from the organ donation register. Instead, they need to find and fill out forms or call various government agencies to overcome a presumed consent.

Further, although opt-out countries tend to have higher donation rates, some countries with opt-in systems have higher donation rates than those with opt-out. The high numbers that get reported – 99.98% of Austrians are organ donors – are the numbers who haven’t opted out, not the number who donate. When it comes to the point of donation, other issues become more relevant, including the wishes of the family. It’s no surprise that the family might wish to intervene, particularly given that in an opt-out system there is no moment where the donor is required to express their wish.

It seems to have been on the cards for a while now, but I’ve just realised Wales is shifting to being an opt-out country. The rolling out of this nudge is lazy.

Instead of trying to design a system where they actually determine the wishes of the person and their family, they rely on the inconvenience of having to opt out to boost registered numbers. At the time of death, the family will have no sense of what the deceased wished for- after all, the number of people who choose to opt out is far less than the number who than indicate in surveys that they do not wish to donate.

There is no shortage of alternative approaches that don’t rely on granting (or attempting to grant) the right to organs through omission. Active choice is one option – when people get a driver’s licence or tax file number, ask them to choose whether they wish to be an organ donor or not. It will likely increase the number of registered organ donors over an opt-in system, while proving some indication of people’s wishes. An active choice also indicates these wishes to the family, with those wishes one of the major factors in families agreeing to donation.

Then there are the more interesting options that could be tested – markets for organs, preferential treatment for those on registers (as occurs in Israel), or systems to match donors. These options are often prohibited.

Instead of increasing the freedom to develop new solutions, we have a misunderstood story about a nudge gaining momentum, inadvertently placing the burden on family members at the time of death.

As an aside, I’m still hunting for examples of nudges introduced explicitly to increase freedom by allowing a hard requirement to be relaxed. Current count remains at zero.

*Searching around for information on the changes in Wales, I came across another perspective from Eric Crampton.

Links this week (or more like two weeks):

1. The problem with satisfied patients.
2. Happiness inequality.
3. Explaining the growth mindset.
4. Gender-blind economists.
5. Logical versus ecological rationality.
6. Slaughter scientific peer review. HT: Christopher Snowdon.
7. Poor children have smaller brains.

And if you missed them, my posts from the last two weeks:

1. Unemployment and self control.
2. Uncertainty and understanding behaviour.

Life is busy at the moment, so posting will continue to be sparse over the next month.