Optimal Financial Advice for Pension Products

Table of Contents

Catalog of Figures

Catalog of Abbreviations

1. Introduction

2. Innovation in Private Financial Consulting
2.1 The threat of insufficient pensions & the overregulation of the industry.
2.2 Behavioral Finance & Influence on the problem
2.2.1 Kahneman & Tversky - Prospect Theory / Heuristics
2.2.2 Gerd Gigerenzer - Distinction of Risk and Uncertainty
2.2.3 Richard Thaler - Nudge Economics
2.3 The detailed role of regulations
2.3.1 Financial regulation in Germany - MiFID II - WpHG - FinVermV
2.3.2 Potential alternative - Fiduciary principle
2.4 Status quo in the market - Test Consultancies
2.4.1 Methodology
2.4.2 Assessment of examples
2.5 Reflection on the research and improvement proposals

3. Conclusion

4. Appendix
4.1 ERGO - Insurance company
4.2 Sparkasse Bielefeld - Bank
4.3 Questionnaire for the Test Consultancies

5. Bibliography

Catalog of Figures

Figure 1: 3-layer pyramid - German pension system

Figure 2: From Nudging to RECAP

Figure 3: Illustration of optimal decision environment

Catalog of Abbreviations

Abbildung in dieser leseprobe nicht enthalten

1. Introduction

The central problem which led to the idea of this thesis is the problematic situation in pension saving, private pension consulting and the involved regulations which deal with it. In this sense it was investigated how one could design the optimal regulative decision environment for the consumer. Poverty among the elderly de- velops further and further, becoming a serious threat in the current German sys- tem. The amount of people which depend on state aid either due to low pension savings or early retirement because of inabilities to work more than doubled in the past couple of years (Die Zeit Online, Bastian Brauns, 2016). The demographic change affecting Germany as one factor and the poor management of the state trying to solve the problem did not slow down the process.

The only solution, rather than accepting to live in poverty, is to deal with the issue privately to at least lower the impact on the individual. That is the critical discussion of this thesis, as the average German citizen is not sufficiently educated to deal with the problem completely alone, nor does he or she have the time or will to do it (Stocker, 2017). That is where the financial service industry steps in, seeing enormous potential and a large regulative task.

The industry walks on a thin line between trust and actual monetary value they create for their customers. Their role in solving the pension issue is crucial, as they are supposed to solve the issue for the customers that are unaware or im- prudent in their savings. Many fraud cases within the industry led to massive reg- ulations also on the European level. MiFID 2 is one of them, aiming for increased consumer protection (European Securities and Markets Authorities, 2018).

This paper questions the role of these regulations and their impact on the industry. What was the purpose of them and how does it really improve the situation for the consumers? On top that it critically assesses alternative approaches taken out of the field of behavioral finance, being a mixture of psychological, cognitive, social and emotional elements and their effects on economic decisions of individuals.

The science of behavioral finance already delivered promising results, which might have positive influence on regulations and future design of the consultancy processes, to optimize consumer experience and outcomes. These results are set into context to the problem, connected to the role of the regulations and then deducted into an optimized framework for private consultancy.

A combination of secondary research and primary research is provided to validate the scientific outcomes of the Thesis and underline the findings. However, the sample size is limited to the scope and size of the thesis itself. Three different consultancy processes were to be assessed and outlined in primary research of which only two made it into the final version of the paper. They however, provide an overview on what is currently going on in practice.

“The overall goal I want to achieve is driving possible innovation into the financial industry, inspiring decision makers, consumers and advisors for an improved pro- cess. ”

As a small teaser of what kind of content is dealt with one example is presented. The so called “financial cognitive dissonance” describes an internal tension or anxiety of individuals when subjected to conflicting beliefs. Often this leads to bad decisions and harsh overreactions. There are two major ways to deal with such situations. Firstly, changing past values, feelings or opinions according to the new knowledge or secondly, attempting to justify old beliefs and opinions staying in old paradigms.

In investment or saving matters this can be quite a big problem, as they usually tend to aim for the long term success, creating a huge time span for making mis- takes in this matter. That does not exclude a learning process in generally but awareness of this issue can help all partners in decision making for investments to think critically before acting and prevent them from irrational moves.

2. Innovation in Private Financial Consulting

2.1 The threat of insufficient pensions & the overregulation of the industry

Poverty among the elderly in Germany is the central problem to be discussed. According to the newspaper Die Zeit, the trend of people over 65, which depend on the basic state aid called “Grundsicherung” is steadily rising to a current state of 14.4%. Citizens which earn less than 780€ are supposed to consider to apply for it to potentially get the missing amount or receive support up to the minimum standard of living (Die Zeit Online, Bastian Brauns, 2016). Many people end up in that state aid mechanism, which is supposed to be a temporary support, due to low pensions and low savings.

The development of the pension level, published by the official German social pension program, is steadily decreasing from 52.9% in 2000 to 48.1% in 2016 and the government already predicts it to further decrease to lower than 43% till 2030 (Deutsche Rentenversicherung, 2018). The pension level in Germany is based on the apportionment procedure, where current contributors are financing the pen- sioners. The demographic change however, leads to a shift in the relation of con- tributors versus receivers, which was favorable in the past, but, reflected by the pension level, will threaten the functioning of this part of the social system.

Politicians in Germany are discussing various approaches to prevent this from happening. Raising the retirement age, lowering current pensions to build reserves, raising the contributions to the pension system, directly or indirectly via taxes, are the three major variables in this context. Economic and social system specialists already forecast that the contribution will rise to over 22% till 2030 (currently at 18.6%) to finance the pension promised already made (Rasch, 2008)! The government is not unaware of the issue, as there was already a major reform in 2002, which tried to lower the problems impact. However, the major part of the problem remains, making it undeniably important for the citizens to privately deal with their financial future to avoid future poverty.

Most German savers are very aware of this issue, saving in one, two or even three layers of the pension system (as seen below). Up to this date there exist over 42 million different pension insurance contracts (Gesamtverband der Deutschen Versicherungswirtschaft (GDV), 2017).

Figure 1: 3-layer pyramid - German pension system

Abbildung in dieser leseprobe nicht enthalten

The current saving trend goes towards saving on bank accounts, building loan agreements, cash-value life insurance or real estate. Only about 20% of the Germans also save within Investment funds or stocks. Both of these represent the conservative strategies of the citizens (Verband der Privaten Bausparkassen e.V., 2017). However, these options are likely to perform poor in solving the actual problem of saving for retirement to keep their living standard.

Based on the individuals living circumstances there exist very different saving gaps and financial needs for the future. Some might inherit significant amounts of capital or real estate while others have to stem the capital need on their own. Those who benefit from previous financial intelligence are on a rather safe side, if this intelligence is taught to them. The others have to be enlightened to their prob- lem and have to solve it. Despite the mode of solution one can break down the problem to an individual capital need till the desired time of retirement. If those variables are decided by the individual decision maker, in theory there are three

factors influencing the realization of this goal. One is the yield per annum, sec- ondly the time horizon, thirdly the amount which has to be saved to fill the gap.

The financial industry as indicated earlier in theory understands this issue and therefore is serving an undeniably important need. According to the German consumer advice center a good consultancy in this sense should clarify this issue to the consumer, respect the individual wishes and circumstances and create a tailor-made individualized solution, which solves the problem of the consumer (Verbraucherzentrale, 2018).

However, current image surveys indicate that there is a lack of trust in banks and financial services. The financial crisis in 2008 and fraud cases in private consult- ing such as the AWD who created millions of financial losses for their customers by systematically exploiting their consultancy proficiency are comprehensible rea- sons (Bernhard Odehnal, 2011). Only 53% of the respondents (35% in Germany) believe in the economic stability of the financial institutes and, according to them, the regulations did not improve the situation (Frank Stocker, 2017).

The central question in this respect should be, how the industry can improve its image. Monetary discussions are one of the most sensible topics in society and quality and transparency are key values for a good development, as to be derived from the secondary research. Quality in this sense is an optimal decision environ- ment for the consumers paired with transparent and digitized information. Moreo- ver, it can be measured by the fulfillment rate of the desired outcome of the prod- ucts recommended.

According to the consumer advice center and the market research agency con- sulimus, consultancy in financial topics is helpful and demanded. A research in 2016 showed that almost every participant classified the consultancy as helpful and around 75% of the consumers chose to follow the recommendations or started further investigation (Verbraucherzentrale & consulimus, 2016). This rep- resents the relevance of the chosen topic and the importance of ensuring quality for the future of the industry and hence optimizing the consumers’ decision envi- ronment in terms of regulations.

2.2 Behavioral Finance & Influence on the problem

The first focus in creating an optimal decision environment are the theories of behavioral finance. The consumer decision environment can be seen as a sand- box of psychological patterns. In order to understand the relevance of behavioral economics on financial decisions the roots of the scientific fields are interesting to investigate. The scientific field of behavioral economics and the sub-field of be- havioral finance deal with studying the effects of cognitive, psychological, social and emotional elements on economic decisions. It draws attention to the conse- quences of different behavioral patterns for resource allocation, market prices and returns (Simon, 2000). It is an interesting field, as knowledge about certain deci- sion patterns of humans can guide towards influencing behavior, which can be quite controversial when values like freedom are held high.

Before the actual development of a „science“, predicting individual’s behavior started in the 17th century. Simple gambling games where the definite probabilities are known marked the beginning, based on the assumption that every participant knows all probabilities and acts accordingly rational. The simplicity of basing prediction on money rewards was advanced by substituting it with „utility“ in the expected utility theorem (EUT) by Bernoulli. This firstly implied implicit psychological factors because of subjective perception of utility (Heukelom, Kahneman and Tversky and the origin of behaviroal economics, 2006).

Then the game theory by von Neumann and Morgenstern introduced the variable of a decision influencing external agent. A few axioms were derived from their work: (i) the preference in ordering assumption, explaining the influence of the order of the presented options; (ii) the choice according to preference assumption; (iii) the transitivity assumption, stating a consistency of preferences; (iv) independ- ence of irrelevant alternatives assumption, excluding external options not men- tioned and (v) the invariance assumption, assuming it does not matter how op- tions are presented, as long as they are logically equivalent (Heukelom, Kahneman and Tversky and the origin of behaviroal economics, 2006). This can directly be applied to the consultancy proficiency. The natural information asym- metry in consulting presumes that the advisor is trustworthy and has professional

expertise, which might lead to profiling customers and consultancy processes beforehand. Whether this takes place in practice is investigated in practical research and then assessed in terms of effectivity.

Friedman and Savage continued by marking the transition to Kahneman & Tver- skies work. They broadened the „utility“ phrase and introduced „uncertainty“ to the discussion. Distinctions of risk-adversity and risk seeking behavior in this re- spect described the reasoning behind „insurance“ thinking and pure gambling. However, stating that individuals would correct their decision when knowing about their mistake was proven wrong by further research (Simon, 2000). This finding indicates one major psychological flaw of potential customers in consulting. It is highly complex to assess the different outcomes of consultancies, whether advi- sors always communicate the potential mistakes and the ones which might skip some of the information. Within the scope of this thesis it has to be left out but should be considered in future research.

Heuristics were then the actual start of the „science“ and tried to find rulesets behind the judgement and decision making of people in situations of uncertainty. They represent mental shortcuts to break down a thought process and excluding possibly too complex variables. Based on the assumption that human decisions are made rational this theory puts every irrational factor aside and characterizes it as „cognitive bias“ (Lewis, 2008). In the financial world it represents the „rational“ process of assessing the level of risk. Scientists wanted to advance knowledge about these uncertainties and Amos Tversky and Daniel Kahneman were devel- oping respective theory and defined boundaries of rationality (Klein, 2009). Alt- hough the theory of heuristics-and-biases defined the basis of behavioral eco- nomics Gerd Gigerenzer criticized it as being too focused on heuristics explaining the uncertainties (Gigerenzer G. , 1996). In the consultancy process an optimal customer decision would be to collect as much information as preferred by the individual and rationally assess the potential yield to risk relation. In this sense the advisor however has an advantage of knowledge and expertise which can be used to influence directly or indirectly the customer’s decision. Apart from that, the results of their research shows that every decision made to a certain degree

includes uncertainty and potential irrationality. The boundaries of rationality, described by the effects Kahneman and Tversky, are to a certain degree assessed in the practical research as well.

The second major field „framing“ introduced another factor to the debate. It takes social constructions, such as cultural, religious and political influence or media effects into account and aims to assess the grade of influence all these factors can have on decision making. It distinguishes processes of thought and actual communication and how people interpret information, building up individual deci- sion filters (Druckman, 2001). Framing is a complex field of science in behavioral finance, which is not dealt with in this thesis, but should also be considered in a broader scope of research.

Becoming more complex and diving deeper into determining the unknown part of the science, the studies of market inefficiencies are the third major field. Also known as market anomalies they are represented in market price inefficiencies (stock market), behavioral biases of either heuristics or framing and any other observed effect, which led to questioning a „rational“ behavioral theory (Shefrin, 2002).

2.2.1 Kahneman & Tversky - Prospect Theory / Heuristics

The theory these two scientists became famous for was the prospect theory. They brought together two strings of research into one approach, namely the psycho- logical elements by Kahneman’s perceptual error theory and mathematics by Tversky, who focused more on the economic factors (Heukelom, Kahneman and Tversky and the origin of behaviroal economics, 2006). Prospect theory in this sense assumes that people logically do not always act rational when doing deci- sions. Objectively correct decisions, even rated as that by their makers, are made differently based on subjective experience and decision patterns. Especially in uncertain situations these patterns were investigated and observed (Simon, 2000).

Their greatest advancement is to step out of the experimental scenery and as- sessing past theory in „real-world“ situations. This did not only lead to the prospect theory, but increased future consciousness about psychological effects, com- pared to the inherent believe of rationalization in the decision making process (Heukelom, Kahneman and Tversky and the origin of behaviroal economics, 2006). They found out that in positive circumstances people tend to act risk- averse, while in negative circumstances they become risk seeking. That is an in- teresting finding, when applied to financial decision making and consultancy. A good advisor knows about this irrationality of the customer, which might be de- structive for long term plans. Either a certain level of trust exists and the consumer discusses any action before acting or the consumer on his own is capable of eval- uating the situation with the required degree of rationality. That is a point of risk to be discussed and assessed within the consultancy process.

Moreover, they state that the mixture of individual experience, experienced utility, and probability expectations, called decision utility, leads to subjective „decision weighting“. Most of the time these two differ and create the so-called „reference dependence“. One is looking at past decisions and the other „tries“ to assess con- sequences of new choices. The realization of this phenomena led to further ef- fects. The „mistake“ of subjectively overvaluing high probabilities while underval- uing low probabilities is an observed psychological error. This is underlined in the example of finance, when an investor weights losses much worse than the same gains, also called „loss aversion“ (Simon, 2000). Objectively these people would realize their error, but their psychological experience patterns might still lead to the same result. Mathematically one could call that effect the semantic differential

(SD). Additionally, the more complex the decision becomes or the more different elements come together in a small time span, the more errors naturally occur. People „believe“ in their capability of doing many and complex things right and might not realize their flaws, increasing the errors further (Heukelom, Kahneman and Tversky and the origin of behaviroal economics, 2006).

Hyperbolic discounting is another effect derived of their work. It displays the rela- tion of time, in terms of consequences, and perceived optimism. The closer the consequence, the higher the impact of the subjectivity and decision weight (Heukelom, Kahneman and Tversky and the origin of behaviroal economics, 2006). This effect is also called „diminishing sensitivity“. For retirement saving this is especially important, as people have to save now for their „far away“ benefit. In investment situations this can often be observed, as the „buy and hold“ or other long term orientations suggested by the theory, are often interrupted by irrational moves and influences, making people forget the long-term goal.

Kahneman and Tversky created a proposal of „prescriptive“ policies, which are supposed to bring the normative, objectively correct, and the descriptive, real observations, together. It is assumed that these policies had further impact, also on Richard Thaler‘s work, as these scientists held a roundtable of behavioral economics in the 1980‘s (Heukelom, Kahneman and Tversky and the origin of behaviroal economics, 2006). This might be proven by the endowment effect, Thaler advanced in his theories. It represents the effect of individuals valuing things they already „own“ higher than things they do not own, although they objectively might have the same value (Kroebler-Riel, 2013).

In the end they connect psychology and economically attractive heuristics and equally accept both of them. They are correlating and only together they could lead to valuable and good predictions in the business world. Critics state that the psychological elements of their theory leave out the important factor of emotions in decisions completely (Newell, 2007).

2.2.2 Gerd Gigerenzer - Distinction of Risk and Uncertainty

As a critic of the work of Daniel Kahneman and Amos Tversky, Gigerenzer argues that heuristics should not lead us to perceive human thinking as riddled with irra- tional cognitive biases, but rather to understand rationality as an adaptive tool that is not identical to the rules of formal logic or the probability theorem. He and his collaborators have theoretically and experimentally shown that many so-called cognitive fallacies are better understood as adaptive responses to a world of un- certainty—such as the conjunction fallacy misjudging probabilities under conclusive conditions compared to a single general one, the base rate fallacy neglecting previous information for the sake of more recent arguments, and overconfidence, in which overestimation of predictions take place.

Gigerenzer distinguishes risk in decision situations as knowing all alternatives, consequences and their probabilities certainly, which is the case in e.g. simple gambling games. For this part of a decision, investments into algorithm investiga- tion can pay off very good, as it can be displayed completely by numbers. On the other hand, there is uncertainty situations in which some part of information is unknown. The previous assumption was to gather as much data and complexity as possible to predict the uncertain parts of a decision by complex heuristics (Gigerenzer A. S., 2016). The information asymmetry between consumer and ad- visor in financial consulting naturally is an uncertain situation. According to the German consumer advice center a good service would be to recommend a sec- ond opinion before forcing a deal with the customer (Verbraucherzentrale, 2018).

Recognizing heuristics is elementary for Gigerenzer, but he strives for using it in a simpler way. His research has shown that in a lot of complex problems a simple heuristics solution can lead to much better results in terms of cost or effort against the return. This outcome is also known as the „accuracy-effort trade off“, which is advisable in situations of risk, and the „less is more“ effect that potentially applies in situations of uncertainty. He does not argue that simplicity in heuristics is always the better solution or should be done excessively, but he wants to invite behavioral science to question their assumptions from time to time (Gigerenzer A. S., 2016). Questioning old believes and examining the „less is more“ effect was revolution- ary and contradicts every previous view.

The first key advise Gigerenzer is therefore to take heuristics seriously. Fine-tun- ing and complex algorithms are potentially creating the illusion of certainty in ac- tual situations of uncertainty. He suggests to firstly investigate the cognitive tools on a descriptive level and secondly analyzing the environment under which they succeed and fail and deriving prescriptive recommendations. This will lead to more reliable predictions, that will not only try to validate past data and theory.

Additionally, testing of theories should be done with competing models and not compared to „chance“ and probabilities (Gigerenzer A. S., 2016).

The second advise is to take uncertainty serious as well. Gigerenzer identifies two flaws in that respect, being (i) complex problems require complex solutions and

(ii) that solutions are searched for situations of risk, rather than for uncertainty. The first argument is underlined above, while the second one should become clear when thinking about previous definitions (Gigerenzer A. S., 2016). Consum- ers potentially cannot differentiate between risk and uncertainty in that respect. A clear definition of what the actual risk in the recommended products is should be provided. The risk, as Gigerenzer says, in numbers and the uncertainty, which are non-numerical factors both have to be included. Financial advisors in theory are already obliged to clarify the potential risks and costs which the consumer is faced with, but too often it is disguised or only indirectly communicated to lure consumer into a deal (Süddeutsche Zeitung, 2016).

The third and final insight Gigerenzer wants to share is being aware of the „Bias Bias“. Diagnosing biases in others rashly without investigating whether a problem in that respect actually exists. A bias in this sense is the deviation of what is be- lieved to be rationally true, adding and weighing information before a decision is made (Gigerenzer A. S., 2016). This is a special problem with regard to the image of the financial industry and as mentioned is likely to be reduced with an increased quality of the service. In further primary research conducted this bias is only par- tially analyzed and assessed.

2.2.3 Richard Thaler - Nudge Economics

„Choice architect“ is a term by Richard Thaler, that describes the influencer of a decision environment. There is a set of tools a choice architect can use to nudge people to make better decisions (as judged by themselves) without forcing them into any direction. The highlighted tools are defaults, expecting error, understand- ing mappings, giving feedback, structuring complex choices, and creating incen- tives. In this sense we are moving in the field of the prescriptive tools, leading

individuals to the objectively correct decision, which they „perceive as correct“ (Thaler, Choice Architecture, 2010). “Choice architect” is equivalent to the financial advisor in the context of consultancy.

There are many examples of human thinking in which specific processing of senses and certain strings of thought are having different speed and „collide“ in a logical error. In behavioral economics this way of thinking was unusual as it goes beyond accepting that humans make decisions completely by their reflective sys- tem. If the human factor in terms of human behavior is well understood, a choice architect can either influence the decision, morally questioning, to his own interest or provide a better and more fair environment for the choice (Thaler, Choice Architecture, 2010). A description of the major relevant effects Thaler observed looks as follows.

Defaults: Laziness, fear and distraction are reasons for humans taking a choice of least effort or least resistance. When a default option exists and is not compar- atively more harming, most humans will naturally go for it. However, it can also not be fully neglected even if respective counter actions are taken. Defaults can be specifically used to simplify a standardized decision process. In the end that does not always mean a decision is made easier, it always depends on the de- fined outcome of the default (Thaler, Choice Architecture, 2010). When deciding for a default in private financial consultancy would be the extreme case of poverty when retiring, which is to be avoided by making fairly and realistically transparent what the consequences would be. It can also mean to decide for an alternative product, neglecting the option discussed, which might be in conflict with the reach- ability of the desired goal.

Expect error: In decision situations there is almost always the possibility of an error and the chance of hitting such an error can be influenced to a minimum. Regardless of the low chance errors will still happen and should be defined and dealt with. Decisions that involve a line of actions tend to inherit errors when they build upon each other (EC-card to withdraw money, forgetting it in the ATM). There are several ways to change that situation. Errors can be handled by cleverly influencing the „automatic system“ of habits, which often lead to „unexpected“ ex- pected irritation when incorrectly dealt with. Thaler‘s theory of nudging is all about creating decision frameworks that minimize errors (Thaler, Choice Architecture, 2010). Expected errors in decisions regarding retirement could be the effect ob- served by Kahneman and Tverksy, that in positive circumstances people tend to act risk-averse, while in negative circumstances they become risk seeking. It can yet be decreased to a minimum when the circumstances are again realistically presented. However, some of these errors cannot be disregarded by simply know- ing about the error. An important effect to be mentioned here is the „diminishing sensitivity“, as it is especially important for this problem type. The advised long- term orientation of saving is often interrupted by people weighing timely closer events higher than their savings plan. The actual value of spending now is natu- rally higher than the value of a secured future pension. The poor self-reliance when saving is a key error to be expected here, which could be reduced by poli- cies as presented by the “save more tomorrow” scheme or as indicated by a good service level and trust in the advisors. The effect of overconfidence is contradict- ing in this sense, but could similarly be avoided. Many of the errors are intercon- nected to other effects and mentioned respectively.

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