Tuesday, 17 March 2009

The Goodwin discount

Is it true that people get more rational when they have more time to make decisions?

Intuitively this would make sense. And if so, it partly explains Fred Goodwin's willingness to pay back the £2.7 million lump sum he's received from his pension pot, in return for bumping his annual pension income back up from £555,000 to £703,000.

This is a rational decision on the face of it, because it equates to an annuity rate of about 5.5% - which, although it's a level which should be available in the marketplace, is better than the 4.4% he is getting on the whole pension.

In which case, why did he take the cash in the first place? This is the phenomenon of hyperbolic discounting - where people overweight the value of cash or other benefits now, compared with the future. Time discounts, of course, are perfectly rational in themselves - but people discount more sharply in the current year than if they are pre-committing themselves for future years.

Possible explanations for this phenomenon include:
  • Decision-making under time pressure - people don't have time to work out the consequences of their decisions and calculate which is the proper rational decision.
  • Additional counterparty discount - the fear that the party offering the money will not be around in the future - while you know they are here now.
  • Fear of confiscation - very applicable in Fred Goodwin's case!
Indeed, the last point must be the dominant one in this case. Taking the cash up front is probably the most rational thing he's done, and returning it seems - on the face of it - a bit crazy. What if Harriet Harman gets her way and his whole pension is taken away in a month? He'd be a lot better off with the extra cash in the bank.

Of course, he undoubtedly has plenty of other resources - as CEO of a bank you get plenty of compensation other than pension - so he may not care about this too much. But I have to wonder - is Fred Goodwin quite as sensitive to regulatory and political risk as Goldman Sachs apparently is?

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