Life After Full-time Work Blog

A brilliant new paper should be expanded into a book

You may remember that recently I wrote very positively about a series that explains the financial side of retirement income. The authors, David Bell and Geoff Warren of the Conexus Institute, have now teamed up with Hazel Bateman (a professor at the School of Risk and Actuarial Studies at UNSW Sydney, Australia, and an expert in consumer choice within pension systems). Together they have added to the series, with a paper  entitled “Behavioral influences on retirement decisions” – and it’s a gem.

I think they ought to expand it into a book, it’s that good, and covers so much ground. The paper itself is only 12 pages of large-print text, so you can imagine that it gets right to the point with every aspect that it covers.

It identifies a number of things that influence our behavior as we make financial decisions about retirement. In other words, things we should be aware of as we make our decisions. (I’ll identify them for you in a moment.) The authors tell us how each of these things can lead us to make sub-par (but very human) decisions. They then make very helpful suggestions about how we can do better, including how awareness of some tendencies might be used to help make better decisions.

So, what are these negative influences? They divide them into three categories: bounded rationality (a technical way of saying that we don’t have enough knowledge about these things to make good decisions); poor self-control (a perfectionist’s way of saying that we make very human mistakes in our decisions); and decision biases (lots of natural, human ways in which we tend to act that may result in sub-optimal decisions).

The authors sum up the problem as follows: “Retirement decisions are so complex and understanding often so low that it is unsurprising that [people] may procrastinate or make impulsive decisions, resort to simple rules of thumb, respond to what is most visible (salient), or take what is offered on trust. The consequence is that they become vulnerable to making poor choices.”

You’ll gather, then, that these are very knowledgeable and expert authors who are setting things out so that average people can make better personal decisions in this very complex field that all of us will encounter. In fact, they quote Nobel Prize Winner Bill Sharpe as saying that retirement is “the nastiest, hardest problem in finance.” And if that’s what he thinks, what hope is there for the average person? My answer: a lot, after you’ve read and absorbed this paper. (And by the way, on a technical rating scale for readability, from Novice at one end through Industry Professional in the middle, to Boffin at the far end, this paper rates close to Novice, you’ll be glad to know.)

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Let me expand a little bit on the first category of negative influences: bounded rationality. This means that we don’t have enough knowledge to make well-informed or well-considered choices. And the authors mention five factors under this heading:

• Low financial literacy and numeracy. That’s right: most of us don’t have adequate financial expertise or an instinctive grasp of numbers. So we don’t really understand our choices well enough. And so there’s a greater chance we’ll adopt a rule of thumb or accept an outsider’s advice. An action step is to find a way to educate ourselves. Or our pension plan provider could help with education and communication.
• Poor longevity awareness. As I’ve mentioned before, most of us underestimate how long a group of people of our age will survive, on average. This may result in drawing down our assets too fast, or, at the other extreme, a reluctance to touch capital because we’re afraid of running out of it. Again, self-education or communication from our pension plan provider could help.
• Lack of knowledge. We may not even know how the system works, or what our options are. You guessed it: help from our pension plan provider.
• Decision states. We need to make decisions in steps: first, some knowledge about our options, then learn about them to understand how they apply to our circumstances, before we are finally in the position to make a choice. In other words, think of this as a journey rather than a one-shot decision. And start preparing some time before retirement.
• Cognitive decline. We may be over-confident, not realizing that our ability to make good decisions declines as we age, as well as increased likelihood of the onset of dementia.

As you’ll see from this very brief summary, there’s a lot to consider. I think the part about our decisions constituting a journey, and thus starting before retirement, is particularly important.

I won’t go into detail on the rest of the paper’s contents: I’ll let you look at the paper yourself. I think you’ll find it intriguing when I just list the other topics considered.

Here’s the second category, which they call poor self-control. Why might we take inappropriate actions?

• Procrastination: we delay taking difficult decisions
• Status quo bias (we leave things the way they are) or short-termism, where we just look at the short term rather than the whole potential future, or we give more weight to the near future.

The third of the three categories – decision biases – contains a range of reasons why we make bad choices.:

• Acquiescing to defaults and recommendations: we can accept what is offered without really understanding it.
• Anchors and reference points: for example, we use past experience or the first thing we’re told in a new context as the point of comparison in making decisions. This can lead to loss aversion or a tendency to hate ‘losses’ relative to the reference point so much that we’ll give up the chance of making a gain.
• Framing: if we change the context in which we consider the choice, we might reach a different decision. For example, it’s helpful to think of the assets we’ve accumulated not in terms of a lump sum (which simply makes the total look big), but in terms of the income it could provide, which gives us a clearer perspective on whether it’ll be adequate.
• Mental accounting: meaning a tendency to look at things in isolation. For example, we may focus only on what we have accumulated in the company’s plan while working, when we should be considering all our assets and sources of income.
• Wealth or money illusion: this means thinking in terms of today’s dollars rather than the lower purchasing power they’ll bring in the future; or, to put it another way, we intuitively ignore future inflation.
• Rules of thumb: shortcut ways of making decisions that may be used out of context.
• Implied endorsement by some “authority”: we treat this as a recommendation, and it saves us from thinking about the matter ourselves.
• Trust: very similar to implied endorsement, but differently motivated, by trusting the person or organization rather than the expertise we hope they have.

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I think you’ll probably recognize that you may have exhibited many of these tendencies yourself before. And they become all the more important when applied to such a big financial issue: what to do with all the money you’ve accumulated, to create an income stream that will allow you to live the future life you desire, no matter how long, in the face of uncertain investment returns and future rising prices.

Yes, books have been written about all of this. And if the authors don’t expand this into a book, you’ll benefit hugely by reading their brief paper. Try to understand which of the tendencies apply to you, what are the potential implications, and what’s within your power (or the power of someone who advises you) to make good decisions.

I’ll end with a personal observation. Note that I simply say “make good decisions.” I don’t say “optimal decisions” or “the best possible decisions” because there’s far too much uncertainty about the future and the role you’ll play in it. It’s not until your time is over that anyone (else) will be able to look back and identify what would have been the optimal set of financial decisions. That’s a dream none of us will ever achieve. So just try to do something sensible, and be prepared to adjust modestly as life evolves. Not only should that be good enough, but it’s also as good as any of us will ever achieve.

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Takeaway

Retirement finance is very complex. It almost invites mistakes as we consider it, for many reasons. One is that we don’t know very much about it. A second is that we’re prone to put big decisions off and leave things as they are. A third is that our minds are human, and prone to biases. This paper explains all those reasons, and how we can counteract their negative influences on our retirement financial outcome.

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