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Does Your Mindset Affect How You Make Retirement Income Decisions?

Why do we as humans need to be coached in our behavior? Evolution has not designed us to be effective long-term investors, but rather to seek to avoid short-term dangers. The fields of behavioral finance and behavioral economics have uncovered various biases humans have which are great for day-to-day survival, but somewhat maladaptive for long-term investing.

A significant body of research is dedicated to detailing these investor behaviors. Some of the most common behaviors an advisor helps individual investors with are:

  • Availability Bias/Recency Effect: Using recent or current market behavior to predict future market behavior.The most recent events are always freshest in our minds, and we tend to extrapolate recent events into the future, expecting more of the same. Large recent market gains lead us to be optimistic about our chances, and vice versa. It takes discipline to overcome these natural tendencies.
  • Overconfidence: Believing you know more than other investors.While investment research increasingly points to the difficulty of beating the market—especially after fees, trading costs, and taxes are taken into account—it is natural to believe we know more than everyone else. This is the “Lake Wobegon effect” in practice. As Garrison Keillor relates in A Prairie Home Companion, Lake Wobegon is a place “where all the children are above average.” It is all too easy for investors, and even many advisors, to fall into this kind of thinking.
  • Loss Aversion: Fearing a loss more than you want to make gains.As human beings, we tend to feel the pain of experiencing a loss is greater than the joy felt by an equivalent gain. Not recognizing this predisposition can cause people to misjudge their tolerance for risk, making them more likely to bail on their financial plan. Research by Eric Johnson at Columbia University shows loss aversion is greater among retirees. Johnson found that retirees feel roughly ten times worse about losing $100 than they do about gaining $100. Or, more specifically, the retirees in their research said they would not accept a gamble with a 50% chance of winning $100 and a 50% chancing of losing $10. The general population is loss averse, but generally not to this extent.
  • Hindsight Bias: Thinking you can predict market behavior because you believe you know why past market behavior occurred.In hindsight, market losses may seem to have an obvious or intuitive explanation. This bias can feed into our overconfidence and cause us to believe we will be able to anticipate such market changes the next time around.
  • Survivorship Bias: Underestimating the risk by ignoring the failed companies.We may underestimate the degree of market risk if we look only at companies still operating today. This misses out on the lessons of many failed companies no longer on the investment radar. It’s like thinking a marathon would be easy to run because you watched a bunch of people cross the finish line. You’re ignoring all the people who gave up before reaching the end. This can also feed overconfidence.
  • Herd Mentality: Judging your own success or failure based on that of others.Sometimes the herd mentality can be rationalized. You don’t want to miss out on being rich when everyone else is rich. And perhaps being poor is not so bad when everyone else is also poor. But for a long-term investor, continually following the herd rarely makes sense.
  • Affinity Traps: Taking advice from someone just because you know them.We often take the advice of someone simply based on the fact that we like them or share a social circle, regardless of whether that person’s qualification to speak on investment and personal finance topics.

Further behavioral issues must be considered when it comes to retirement income. Research by Alessandro Previtero at UCLA shows that recent stock market performance has a big impact on the decision between lump-sum or lifetime income options from pensions.

Those making the pension decision after stock market increases over the past six to twelve months are much more likely to select a lump sum instead of guaranteed income, allowing recent market performance to influence this important and irreversible decision. That is recency bias in action.

Research from Jeffrey Brown at the University of Illinois illustrates how the framing of lifetime income can lead to different answers. His research team surveyed more than 1,300 people aged fifty and older and asked them to choose between, (1) a life annuity paying $650 each month until death, or (2) a traditional savings account of $100,000 bearing 4% interest.

These choices are designed to support the same lifetime income after incorporating life expectancies, but the annuity choice in option (1) was expressed in two different ways. With a “consumption frame,” option (1) was described as a monthly income of $650 for life. With an “investment frame,” option (1) was described as an investment with a $650 return for life.

When expressed in terms of consumption, 70% of respondents preferred the annuity. But when expressed as an investment, only 21% of respondents choose the annuity. Both versions of the question offer the same returns, but the answers elicited differ greatly. Framing an annuity as an investment makes people worry they will die early and “lose” on their investment. When expressed as lifetime consumption, the annuity option sounds less risky and more attractive.

Further research from Suzanne Shu, Robert Zeithammer, and John Payne demonstrates how retirees gravitate toward options that are easier to understand. He cites how retirees may choose single-life annuities because they offer higher monthly income than joint-life annuities without fully reflecting on the potential impact for spouses.

I have also observed this problem with complex annuities like variable annuities with guarantee riders. Retirees frequently misinterpret the roll-up rates offered for the benefit base as a guaranteed return for their money. They may not realize that when this higher hypothetical return number is combined with a lower payout rate later on, the combined outcome may actually leave them worse off.

It’s important to dig beyond the marquee numbers jumping out of the marketing literature and reflect on what is truly happening when all variables and levers are combined into a cohesive whole.

A final issue is money illusion: the difficulty people have distinguishing between observable dollar amounts over time and the underlying change in purchasing power of wealth. This can complicate retirement planning, since it is important to plan over long time horizons. Even a low inflation rate adds up when compounded over a long time period.

To find out more about the most important risks to your retirement, read our ebook the 7 Risks of Retirement Planning.

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