The Biggest Mistake Most People Make in Choosing a Pension and The Best Opportunity to Save Hundreds of Thousands of Shekels
A long time ago, when Daniel Kahneman, future nobel laureate in economics, was teaching a group of Israeli Air Force officers about effective training and positive reinforcement, he was challenged by one officer. “On many occasions, I have praised flight cadets for their clean execution of some aerobatic maneuver. The next time they try the same maneuver, they usually do worse. On the other hand, I have often screamed into a cadet’s earphone for bad execution, and in general he does better on the next try. So please don’t tell me that reward works and punishment does not, because the opposite is the case.”
A powerful challenge, no doubt, and one I think we can all sympathize with in some of our personal and business relationships.
But the truth behind this challenge is explained by Kahneman using statistical principle called regression toward the mean. In various situations where luck is present, you are always more likely to go toward your average. If a variable is extreme on its first measurement, it will tend to be closer to the average on its second measurement—and, paradoxically, if it is extreme on its second measurement, it will tend to have been closer to the average on its first.
Take these pilots for example. Let’s say that one a scale of 1 to 5, a pilot named Yosef flies a 3 on average. Yosef flew a 2, for which his commander screamed at him. Since Yosef on average flies a 3, the next time he is more likely to do better, irrespective of the yelling. Similarly, if Yosef flew a 4 and was given a hearty shkeyach from his commander, the odds are still that he will do worse next time, since he flies a 3 on average and 3 is worse than 4. Positive reinforcement is proven to work in the long run, but in the short run, specifically in a situation where luck is a major factor, regression toward the mean is king.
I bring up this to demonstrate what is in my opinion is the biggest mistake people make when choosing a pension, or making any investment for that matter. People I have met tend to focus on the past performance of a fund or company to choose the right investment. But if there is one thing that past performance has shown, it is that it is a never good indicator of future returns. Also, due to regression toward the mean, people who choose the better performing funds are almost always disappointed within a year or so since, as regression analysis proves, the next year is more likely to be more toward the average return, which for anyone starting from a point above average, is worse.
Now that the year has ended, you will likely be bombarded by company after company showing off their past performance, as if it means anything. Their salesmen and agents will admit that past performance doesn’t guarantee future returns, but they’ll end the sentence while pulling out a nice graph showing how well they did over the past five years. They’ll jokingly admit that theirstock pickers are no better than chimps with darts, but still find a way to make them look prophetic. You need to ignore these people and follow the science.
What does matter in choosing a pension is (1) getting a significant discount for the rest of your life and (2) that the company has the proper range of options available for investments for the rest of your life. When you are young, or at least in good health, pension funds are more likely to offer discounts and if you succeed in getting a discount for life. But when you get older, and especially if your health deteriorates, most pension companies won’t want you since your being in the fund will cause damage to the actuarial balance all pension funds must maintain. And even if they do accept you, the chance of you getting a huge discount on fees is very slim since, as far as they’re concerned, you’re no longer a long term investment for them. Remember, in your 50s and 60s you have the most money in your pension you’re ever going to have and having a significant discount on fees during this time will likely save you hundreds of thousands of shekels, on accumulation fees. It’s up to you to take advantage of your youth, health, and work connections to make sure you save this money before it’s too late.
Focusing on options is also important since you will need to solidify your investments as you reach retirement and unless the company that has given you a discount has the proper investment options, you could be left with the terrible choice of either settling on having too much risk or else moving your money to a new fund, potentially forgoing any discount and losing tens of thousands of shekels in fees.
Concentrating on investment options and fees doesn’t mean you should ignore פנסיה נט completely; you should have an idea how your fund is doing compared to the market and how it is performing and invested. It means that you should take such information with a grain of salt and be less concerned with statistically insignificant issues such as how well the fund performed over a single year and more concerned with issues that will save you hundreds of thousands of shekels such as the investment options available by the company and the fees you’re paying.
Jonathan Degani is a licensed pension consultant by the Ministry of Finance. If you’re looking for help choosing or reviewing a pension, please feel free to call 052-790-6824.
The anecdote at the beginning of the article above is taken from Daniel Kahneman’s book, Thinking, Fast and Slow. The definition for regression toward the mean is taken from wikipedia.