Planning for retirement is a tricky business, with people all too commonly tripping themselves up due to a host of behavioural foibles. Some are more guilty than others in this respect; answering two simple questions will provide a clue as to whether you're at risk of making imprudent decisions with costly long-term consequences.
Question 1: You’re told you are due a tax refund and you must make a choice as to how you would like to receive it – €1,000 now or €1,100 in 18 months’ time. Choose.
Question 2: Again, you’re told you’re due a tax refund, but the choice is slightly different. Do you choose to receive a €1,000 refund in 18 months or a €1,100 refund in 28 months?
Patient types, no doubt, will opt to wait for the bigger payments – earning an extra 10 per cent over an 18-month period represents a nice return – while less patient souls might prefer to get their hands on the money straight away in both instan ces.
Others, however, take a more inconsistent approach. If both choices involve a delayed payment (as in the second question), they are happy to wait the extra 10 months in order to collect the extra €100. However, when offered the prospect of an immediate payment (as in the first question), they opt to choose the smaller sum of money.
This tendency can be problematic. Inconsistent people may evaluate and choose a sound financial plan only to not stick to the plan following a subsequent re-evaluation. In a recent German study, The Influence of Time Preferences on Retirement Timing, these and similar questions were put to more than 3,000 people who took part in an online survey.
The German pension system allows people to retire earlier than their full retirement age, but doing so can be costly, as it results in constantly smaller monthly benefits.
Those who chose the “time inconsistent” approach were, the researchers found, much more likely to lower their planned retirement age as they got older. The closer they got to retirement, the more tempted they were by the prospect of early retirement. This group were twice as likely as their consistent counterparts to retire early.
The most inconsistent participants retired about 2.2 years earlier than those who answered consistently. This had “severe consequences”, resulting in a reduction of some 13 per cent in their monthly benefits. Almost one-third of these early retirees regretted their decision, saying that they would retire later if they could decide again.
Readers who answered the above questions in a consistent manner may feel like giving themselves a pat on the back, but they shouldn’t feel too smug. A recent Aviva report estimated the average worker in Ireland needed to increase their monthly pension contributions by more than €1,000 to fund their retirement needs. Although financial pressures no doubt contribute to the pension gap – the gap between pension savings and what people are likely to need in retirement – there’s little doubt that a variety of behavioural sins such as inertia, loss aversion and myopia are also at play.
Delaying pleasure in favour of future benefits is not easy, notes behavioural finance expert Shlomo Benartzi in his book Save More Tomorrow. "Seduced by temporal myopia in their younger years, many people get around to saving seriously for their retirement far too late in their career, in their 40s and 50s in many cases, which greatly reduces the amount of money they will have available for their retirement," he writes.
Auto-enrolment
One of the most frequently-suggested remedies is the policy of auto-enrolment, whereby employees are automatically enrolled by their employer into pension schemes while retaining the right to opt out.
Auto-enrolment has become widespread in the US, UK and other countries. Ireland has yet to follow suit, despite much chatter about the idea in recent years, although Benartzi cautions that it is not a panacea in any event.
The main limitation of auto-enrolment schemes is that employees may choose to stick with a relatively low default savings rate that is not sufficient to meet future retirement needs.
Together with fellow behavioural finance guru Richard Thaler, Benartzi developed the Save More Tomorrow (SMarT) programme, which combines auto-enrolment with auto-escalation, whereby employees' pension contributions are automatically increased over time.
There is also potential for personalisation of pensions, argued Benartzi in a recent Wall Street Journal article discussing the aforementioned German research. For example, the simple two-question quiz would reveal which employees are most at risk of present bias – that is, the tendency to place too much value on immediate rewards at the expense of long-term goals. Such people are more likely to be tempted by an early retirement; accordingly, they may be better off being defaulted to a higher savings rate during their working years, suggested Benartzi, so that they do have sufficient savings should they end up retiring early.
Another novel approach is to provide pension fund investors with age-enhanced images of themselves so that they can see what they are likely to look like as they age. The idea sounds quirky, but is underpinned by a strong rationale.
Brain scan research shows that when people think about their future self, it results in neural activation patterns that are similar to the activation patterns associated with thinking about a different person. In other words, we think of our future self as a different person; lacking that emotional connection, it’s hardly surprising that many people don’t bother saving money for their later years.
The findings inspired Stanford researchers to investigate whether connecting people to their future selves could inspire them to save for their future. In an experiment involving virtual reality software, one group of participants were provided with digitally altered images to show what they would look like at 65, while a second group saw images of their present self.
As part of the experiment, each participant was given money to spend as they saw fit. Those who were exposed to their future self allocated more than twice as much money to retirement funds as the control group.
Now, a sceptic might suggest people were primed with the concept of ageing, thereby prompting them to save more for retirement. To investigate this possibility, the researchers carried out a second experiment where participants were shown aged images of other test participants rather than themselves. This time, however, spending choices were unaffected; only people who saw themselves aged 65 were motivated to increase their retirement investments.
The findings have been noted by the finance industry; Bank of America Merrill Lynch has developed a “Face Retirement” app that gives customers a preview of their future self. With age-progression software freely available online, it’s likely that this potential remedy will become a more frequently-used option in coming years.
Similarly novel cures for short-termism and inertia are likely to be developed in coming years as researchers become more aware of what motivates people’s actions and inactions.
However, there is also the risk that progress will be unintentionally undone by policy reforms. Last year, for example, the UK embraced the concept of pensions freedom, allowing 55-year-olds to withdraw their entire pension pot and spend it as they see fit.
Fears that people would undermine their retirement plans by giving into temptation did not move former pensions minister Steven Webb; if people want to splash their cash on a Lamborghini, said Webb, "that becomes their choice".
Thus far, data indicates people are not buying Lamborghinis, with recent figures showing only a very small minority are withdrawing imprudently large sums. Nevertheless, some experts see the move as questionable, given the research indicates people all too often choose immediate gratification above their long-term interests.
Impatience
One final word of advice regarding this impulse towards instant gratification: don’t engage in financial planning when you’re down in the dumps. Sadness can bring on impatience that in turn leads to poor financial decision-making, according to a 2012 Harvard experiment that asked participants to answer questions about various investment options. Some options involved the prospect of real money upfront, whereas others offered bigger rewards to people prepared to wait three months. Before they answered the questions, however, one group of participants were asked to watch a sad video.
Stark differences emerged in the investment choices. “Sad” participants were much more likely to opt for instant gratification, valuing superior long-term rewards by up to 34 per cent less than the control group. When it comes to financial choices, the researchers cautioned, “the sadder person is not necessarily the wiser person”.
