Hyperbolic Discounting
05 Aug

Will Hyperbolic Discounting Bankrupt British Pensioners?

Hyperbolic Discounting

As the likely outcomes of the new pension freedoms are vehemently debated in the press and in the industry, a very special psychological phenomenon could help predict the consequences of these new pension freedoms on the British pensioners. Enters hyperbolic discounting.

Behind this very fancy aphorism lies a very simple concept: humans tend to prioritise the present (or the short term) over the long-term. Because humans have a strong tendency to seek immediate gratification, they may very well spend large sums on experiences or goods today rather than tomorrow, even if it is at the expense of their future financial security. In short, we humans would discount our tomorrows when making financial decisions and pounce on opportunities in the present. The fear, therefore, is that the hundred of thousands of British depositors that now have access to their pension pots will engage in reckless spending precisely to obtain the instant satisfaction effect inducing by hyperbolic discounting.

So far, the theory seems to hold as close to £2 billion have been cashed out since the reforms have been introduced. It is furthermore noteworthy than thousands have been denied access to their pension pots by their provider, suggesting that had the freedoms been unchecked, the above-mentioned amount could have been much higher. Another aspect giving credit to this phenomenon is that much of this staggering sum has been spent on holidays and new cars. These are hardly income-generating assets that would bolster household finances. Yet, there is an upside to this spending frenzy, in the short-term at least, as it buoys consumption, which has a positive windfall on the overall economy. On the longer term, however, there is potentially a risk that pensioners end up with too little to get by if they are not careful. This great raid on pension pots could therefore have very serious ramifications on the financial stability for thousands of households across the UK. The risk is compounded by the fact that life expectancy has significantly increased since the Baby Boomers generation, thereby adding to the need to ensure that pension pots will last long enough to provide sufficient income to pensioners.

If we are to take the view that hyperbolic discounting will affect a majority of pensioners-to-be in the UK, there is indeed reason to be anxious. Indeed if too many of them ‘fall off the wagon’, the state pension will be there to provide a safety net for those in need. At £15,000/year, it is designed to supply a decent income for a couple. The worry is that if the number of state pension beneficiaries were to soar, so too would the strain on public finances: something the government has vowed to curb. More importantly, it could generate fiscal imbalances that the government would struggle to handle. This being said, it remains to be seen whether depositors will spend frivolously or whether they will show self-restraint. Experiments of a similar nature having been undertaken in Australia and Canada show that it could go either way. In Australia indeed, the government had to introduce a tax on pension lump sum withdrawals to counteract the free pension cash out policy they had enacted in the first place. Thanks to this measure, Australians now have come around to favour systematic periodical withdrawals. Effectively, the policy has been reversed. In Canada, on the other hand, the opposite is true: Canadian pensioners do not spend enough of their pensions and continue (astonishingly) to save in retirement.

The debate on the new pension freedoms will undoubtedly continue as the pros and cons will be weighed against each other. The point of this article is that hyperbolic discounting is a factor that should be taken into consideration and one which could tip the balance one way or the other.

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