Is the tail wagging the dog?*

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A return to first principles for the savings industry in South Africa

By Amy Underwood, Senior Behavioural Economist, Nedbank

amySavings are a flow from households to the capital stock. This capital stock is then allocated by the capital markets into the business sector. In doing so, savings perform a function for both households and businesses, and more importantly, they shape the economy of tomorrow.

Historically, the assumption has been that because markets are rational, the allocation of savings for the highest return reconciles the functions of savings so that all interests are aligned. But markets are not rational, and so this raises the question of who, if anyone, is being served by the allocation of capital. Critically, it raises the questions of whether or not savings are serving the investors who painstakingly sacrifice consumption today for the hope of better tomorrow.

The functions of savings

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One of the simplest representations taught to students of economics is the circular flow of income1. In this model, households make two decisions. They allocate their income into consumption which enters the goods market and saving which enters the factor markets, more precisely, the capital markets. This is essentially a decision between consumption today and consumption tomorrow.

By passing into the capital markets and being allocated into productive businesses, savings generate a return for investors. These returns and the original capital then return to the household to consume at a later point in time. For most households, most of these savings will enter the market in order to generate an income at a point where households can no longer sell their labour in another of the factor markets. This could be due to old age, disability or death of a bread-winner.

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Savings is simply consumption moving through time. But this links to another key insight of basic economics which is that production is equal to income in an economy. By generating income at a later point in time, savings is simply transferring a claim on current production into a claim on future production2. Crucially, this relies on there being production in the future economy to claim.

This brings us to the other side of savings. A critical function of savings is to fund investment. As with production equating to income, most basic models equate savings to investment. It is for this reason, far more so than the effects on individual households, that a poor savings culture is considered so dangerous for an economy.

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Another simple model taught to first-year economic students is the production possibilities curve (“PPC”), or frontier. In this model, the trade-offs between allocating production to consumption goods or capital goods is often shown. If we allocate predominantly to consumption in this period, the PPC does not shift out by much. However, if we allocate predominantly to capital in this period, the PPC shifts out substantially. This illustrates in a simple form how our decisions on capital today shift the potential of our economy tomorrow.

This brings us to the critical construction of the capital allocation structure in an economy. Political-economic choices have a significant influence on how capital allocation takes place. In a more socialist economy, income for the old, disabled and so on may fall predominantly on the state. In such a case, the state will often fund these obligations through the tax system and typically on a Pay-As-You-Go basis. As Barr (2002) has shown, this is sufficiently equivalent to what happens in individual savings structures, such as Defined Benefit or Defined Contribution, though differing substantially in the detail.

In South Africa, the constitution lays the burden of social security on the state. Social security essentially aggregates the functions of savings for most households. In the case of poor households, the provision of social security is administered by the government in the form of social grants. However, for working households, the responsibility for social security has largely passed into the hands of the private sector. The government has established legal frameworks for retirement, banking and various forms of insurance, but within these frameworks, capital allocation is determined by private parties.

These private parties fall broadly into two categories. The first is the banks. The second are the financial services companies which manage most compulsory savings, typically asset managers managing retirement savings, and insurance companies, managing long- and short-term insurance. In determining how to allocate this capital, these organisations play a critical role in shaping tomorrow’s economy.

The allocation of capital

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When capital markets are shown in under-graduate economic courses, they are typically pictured as a down-ward sloping investment curve and an upward-sloping savings curve. Savers are the suppliers into the capital markets and the higher the potential the returns, the more they invest3. Investors are those who will use the funds to invest in capital goods (loosely defined as a good which can be used to produce other goods in the future) in the firms of the economy. On their side, the lower the required return on investment, the more they will borrow.

This abstracts from many of the complex realities of how our modern markets operate. The first is that it flattens out much of the intermediation in the market. It doesn’t show the financial planners who advise individuals, the investment consultants that advise pension funds, the pension funds themselves, the insurers or the investment banks that often both structure securities for other entities as well as being direct investors themselves. It doesn’t reflect the fact that there is not simply a single market where households and firms lends and borrow. There are multiple markets ranging from short-term to long-term fixed income instruments, fixed income through preference shares and structured equity to conventional shares. So, when we speak of the capital market in this single market, the equilibrium shown should really be thought of as an n-dimensional problem where multiple markets find equilibria across a range of risk-return profiles4.

When one considers the sheer complexity of this in conjunction with what we know about human biases, it seems amazing to affirm that somehow this will all equate to the best possible outcome for the economy. Especially given that in so many cases, the mandate to professional investors is to seek to maximise returns for a given level of risk. In a theoretical world, maximising returns should be equivalent to allocating to the best investment prospects for the future. In reality, this assertion appears far murkier.

Individual investors and their decisions

Since work began on understanding financial literacy levels globally by Lusardi and Mitchell in the 1980s, the results have been consistently dismal. Even the most basic of concepts such as compound interest, inflation and diversification are poorly understood even in well-educated populations. In such a context, the idea that savings is a transfer of consumption through time and that returns and compound interest are the mechanic that keep everything lined up is likely lost on most investors.

The basic idea that saving today is for some point when they won’t have income in the future is likely more accessible. But the behaviour of individual investors do raise many concerns. Around the world, individuals tend to save too little, allocate too little to riskier asset classes, make poor timing decisions, under-diversify and favour assets with which they feel more familiar5. The financial advisors on which they rely often show the same pre-dispositions for systematic biases6.

In response to this, there have been many arguing for greater levels of financial education. There are two broad problems with this approach. The first regards its efficacy and the believed transmission from knowledge to decision-making and behaviour. The second regards its benefits and whether such a heavy investment in the financial domain makes sense within the context of investor’s broader lives.

Financial education

Simultaneous to their work on assessing financial literacy across the globe, Lusardi & Mitchell have also produced many studies which show that individuals with higher levels of financial literacy make better financial decisions7. They save more, diversify more appropriately and stay invested for appropriate periods of time. This seems to lead us to the neat conclusion that raising financial literacy will improve decision-making.

Unfortunately, as Mullainathan and Shafir (2013) caution us in their work on cognitive overload, the attraction to educate to fix every development problem can be a false siren. This becomes particularly true in a context like South Africa and savings decisions. On the South African side, higher levels of inequality can be expected to exacerbate levels of stress at every level of income8. As regards savings, the challenge is that savings decisions have frequently been shown to be particularly prey to problems of cognitive and choice overload9.

Even in situations where individuals have been able to spend less than they earn and put money aside for saving, inertia and procrastination often delay decisions as to what to do with that money. Crises of trust in the financial services sector only increase the perceived danger of committing to a specific savings strategy.

Moreover, and more significantly, as more has been invested in financial education, very little has been shown to result. Over the past few years, extensive meta-studies10 have been produced collating the last few decades of attempts to improve financial literacy. Though with varying levels of confidence in whether financial education has a future, they all agree that thus far the results have been poor. Billions have been wasted. The transmission from knowledge to decision-making and behaviour is not as simple as it may first appear.

There are some rays of hope in all this. Approaches like heuristic-based or rules of thumb do seem to show more effectiveness in improving long-term behaviour11. Educational interventions relying on edutainment such as soap operas, comics and so on have some promise12. But in many cases, the promising areas largely short-cut the improvement of knowledge and focus squarely on what influences behaviour. Behavioural interventions like defaults which are growing increasingly popular both globally and locally entirely short-cut individual decision-making.

The importance of rules of thumb is worth dwelling on for the moment as historically, many savings decisions have relied on them. This includes rules of thumb based on replicating parents’ behaviour to relying on the trust-worthiness of brands. More significantly, though, the rule of thumb used most often is to expect high performance to come from the same places it has come from in the past13.

While this could be seen as a vague approximation of maximising returns, it also can be quite different. It often ignores risk levels, the variability of investment strategies and the time periods or reference groups used can be fairly arbitrary. Performance chasing and the often turbulent trading and investment strategies that exemplify it have been held responsible in many studies for the large discrepancies that lie between how markets perform and the returns enjoyed by individual investors14.

Rules of thumb are very powerful and they can work for and against investors. In studies done on the financial education of entrepreneurs, researchers found that using a heuristic-based structure for separating individual and business expenses resulted in better financial decision-making than more formal accounting education15. What this relies on is that rules of thumb need to be ones which work well for most people most of the time. Performance chasing arguably does not meet this criteria.

It is also worth considering whether financial education is worth all that effort. The levels of financial literacy required in a population are often determined by structural issues. Because in South Africa, most social security for employed people fits into the employee benefits systems and most employers offer defined contribution structures, the requirement for individuals to make investment decisions is higher than it would be under other structures. The move by the government to promote more and better defaults is meant to help counter-balance this.

Arguably, South Africans have areas of financial literacy that are more important than understanding the minutiae of investment decisions. Being able to making sound borrowing decisions in our over-indebted population is probably a more important topic. However, the industry does not have a squeaky-clean history and lack of trust in an industry often fuels the focus on up-skilling individuals.

There is also an argument that focusing on finances in great detail is not good for their overall lives. The most common term used in economic literature to summarise this concept is subjective well-being, but the concept is the same as that historically reflected in the concept of utility or to go back to Aristotle, happiness. In this framework, all aspects of a person’s life trade off against one another. Time spent on managing money is time not spent on family, health, or social connection.

So, as all questions in economics come down to – is the trade-off worth it? Studies have shown that thinking about money reduces our enjoyment of many other things in life, including browsing on the Internet and listening to music16. They have also shown that when people are told to spend time thinking about their savings, this often reduces the quality of their day and these thoughts can be even more negative amongst the wealthy17. Priming people with concepts like money consistently tend to reduce pro-social behaviour and result in individuals spending less time with friends and family18.

Money can and does contribute to aspects of subjective well-being such as providing options or a sense of freedom as well as a sense of security19. They are valuable, but they are not the only things which are valuable. Even within the context of money, investments tend to be amongst the trickiest and most technical of topics, and probably have less impact on financial stress than poor decisions about debt.

This can raise quite the conundrum. People’s long-term savings are important both at a household and economy level. Yet they tend to make poor decisions about it, investment decisions are quite challenging to make and can trigger inertia, and financial education seems to have limited impact. The idea then of having an informed and engaged investment public is likely then to be something of a mirage, and the question then is how the industry needs to think about best serving its investors’ interests.

The industry and the individual

The challenge in any industry with asymmetric information is that it becomes very tempting for one side to exploit the other. To tell whether such exploitation is happening comes down to what the industry is meant to be doing for the individual.

As we have seen, investing is supposed to perform specific functions. The first is to smooth the household’s consumption through time, and allow the household to have an income at some point in the future when they won’t be earning one. The second is to allocate capital in the economy to fund the investment which will shape the economy of the future. In a way, the old economic identity that production equals income mean these boil down to the same thing. That future income only means something if there is future production to purchase.

If one considers the compulsory savings industry as an example, the poor state of replacement ratios20 reveals that in terms of providing an income for the future, the industry is failing to perform this function. This could be predominantly attributed to low savings rates and preservation rates, and put back at feet of the investor and their lack of education, but it doesn’t change the fact that all the money swapping hands in the industry is not accomplishing much. Legislation is looking to tidy this up by defaulting as much as possible and closing loop-holes. But it remains the case that the amount of wealth being accumulated is not yet even covering people’s needs for their retirement years – despite the fact that South Africa has one of the highest ratios of pension fund assets to GDP globally.

If we switch focus to the other side of the equation, the production side, things are also tricky. If we again use the compulsory savings industry as an example, about 25% of all funds are invested off-shore. In conventional investment theory, this is seen as a diversifier that helps to bolster returns at lower risk.

Beyond this, many retirement funds would normally have about 55-60% of their fund invested in local equity. But this is where the conundrum lies for South African investors. Local equity and the local economy are quite disconnected. Beyond the sheer concentration of the index, many of the major shares in the South African economy have limited activity in South Africa. Even where they may have reasonably high levels of activity at this stage, many are investing predominantly elsewhere.

So, investing money into these companies which then reduces their cost of capital offers little for the South African economy. In traditional investment, it would be argued that if these companies present the best opportunities, they will provide the greatest growth for the investors. This is fine as far as it goes, but it does obscure the fact that the economy in which the investor will be spending their income is the local one. Even when imports are taken into account, imports rely on decent terms of trade, which an economy with failing production is unlikely to provide.

Furthermore, for many investors, there remains a significant time-lag between now and when they would receive their income from their retirement investments. If under-investment results in South Africa’s economy struggling in the interim, this likely threatens many investors’ jobs and these jobs, which represent their human capital, are likely far more important than their investments, which represent their financial capital. Even with astronomical returns, investments would not grow sufficiently to compensate for shortened working lives in a down-ward spiralling economy.

The argument that South Africa’s investment problem lies in the lack of savings does not hold water. Savings is a flow to the capital stock. The allocation of the full capital stock is what matters. Even if we simply consider the pension fund industry alone, South Africa has one of the highest ratios of pension fund assets to GDP globally. In addition, South Africa’s insurance industries are large given its level of development. It is also worth remembering that diminishing marginal returns means we expect flows to taper off in the presence of high levels of stock. In addition, even were South African households to triple their savings over-night, how much of that money would be invested in South Africa once it had passed into the hands of the investment industry? As we have seen, most of that money would be invested off-shore, regardless of where the investment is listed.

The reality is that there is a very serious question to be asked about what versions of South Africa the portfolios of South African asset managers are likely to produce. Every investment portfolio represents a picture of a future South Africa. The likelihood is that the aggregation of these portfolios is the face of the future. Which raises the question – are asset manager’s portfolios creating a future that their investors want to live in?

Concluding Thoughts

The investment industry exists to solve two challenges for the economy:

  • The need for the household to smooth consumption through time;
  • The need for capital to be allocated to the most efficient firms.

Much of investment theory is built on the assumption is that so long as investment returns for a given level of risk are maximised, these two challenges can be solved simultaneously. Unfortunately, this relies on a slew of assumptions around the decision-making of individual investors, their intermediaries and capital allocators. Particularly in the South African context, it seems naïve to believe that these assumptions, or anything resembling them, is being met. We cannot rely on the assumption that correct risk-return trade-offs will result in the industry serving investors.

For this reason, it behoves the industry to return to first principles. Their responsibility is to produce an income for their investors to spend in a future which will be largely shaped by their current investment decisions. The question then is: are they fulfilling on this responsibility?

*This is a working paper based on the ongoing research of Amy Underwood that also formed the basis of a paper delivered at SAIFM Investment Summit in May 2016.

Footnotes

[1] The physiocrats used the early forms of this concept, while the modern form originates in Knight(1933).

[2] As Barr(2002) argues specifically in relation to retirement savings to highlight the fact that the difference between PAYG and funded systems is over-stated.

[3] Though there is significant behavioural evidence against the traditional determinants of savings. See, for instance, Engen, Gale & Scholtz (1996), Chetty et al (2014), Shefrin & Thaler (1988), and Thaler (1994).

[4] A problem which is typically assumed to be solved using a Markowitz model.

[5] See, for instance, Benartzi & Thaler (2001) on naïve diversification, Benartzi(2001) on bias towards employer stock, Barber & Odean (1999) on the disposition effect, French & Poterba (1991) on home country bias.

[6] See, for instance, Russo & Schoemaker (1992) on excessive confidence in analyst forecasts, Thaler & Johnson (1990) on the house money effect amongst professional investors.

[7] See, for instance, Lusardi & Mitchell (2014).

[8] See, for instance, Wilkinson & Pickett (2010) which collates research on the effects on inequality.

[9] See, for instance, Trope & Liberman (2003), Trope, Liberman & Wakslak (2007), Fiedler (2007), Liberman & Trope (2008) on how detail can overload financial decision-making.

[10] See, for instance, Fernandes, Lynch & Netemeyer (2014) and Miller et al (2014).

[11] See for instance, Drexler et al (2014).

[12] See for instance, Berg & Zia (2013).

[13] Despite all the warnings issued to the contrary.

[14] A phenomenon first identified by Bogle.

[15] Drexler et al (2014).

[16] DeVoe & House (2011)

[17] Dolan & Metcalfe (unpublished, 2011)

[18] See, for instance, Mogilner(2010) as well as this meta-study, Vohs(2015)

[19] See, for instance, Benjamin et al (2014)

[20] See industry studies such as Alexander Forbes’ annual Benefits Barometer or Old Mutual’s annual Savings & Investment Monitor.

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