Practice Management
Editor’s Note: This is the first in a two-part series concerning behavioral finance.
Retirement readiness is more than dollars and cents. It’s also timing. And it’s also… the mind.
A variety of factors are at play in preparing for retirement, and there is growing recognition that employee and participant behavior also are key to being ready. Since employees and their behavior are at the root of most decisions about retirement plan participation and how individual accounts are managed, insight into behavior that affects those decisions can be a useful tool in understanding how those choices are made.
Mentality can have powerful effects, and employers and plan sponsors must contend with that from a variety of perspectives—including mindsets that expect little. The AP-NORC Center for Public Affairs reported in 2019 that 45% of the adult Americans they polled said that they are not very prepared for retirement or not ready at all, and more than half of those age 18-49—56%—held that view. Further, approximately one-quarter expect to continue working after they turn 65, and almost another one-quarter do not plan to retire at all.
They are not alone in that finding. Ann Marsh in Financial Planning’s “Why Retire? 10 Reasons Clients Should Keep Working” writes that according to many planners, some clients—including baby boomers—don’t plan to stop working.
The reasons for that are practical, such as the need to save more and the need for health insurance. But they also include intangible reasons that involve emotion and mindset, such as fear of the loss of a spouse’s income, lack of confidence in an employer’s long-term viability and the need to contribute and be productive.
But while many do not expect to retire, even more do expect to, according to the AP-NORC study, which also says that almost three-quarters of those they polled expect to do so. In addition, more than half already considered themselves ready to retire.
Still, there can be “shocks” that cause even those who may not be planning to retire to do so. Alicia H. Munnell, Geoffrey T. Sanzenbacher and Matthew S. Rutledge in “What Causes Workers to Retire Before they Plan?” write for the Center for Retirement Research at Boston College that there are four shocks that can result in altering retirement plans. These involve changes to:
- an individual’s health;
- employment;
- family circumstances; and
- wealth.
All of which suggests that employers and plan sponsors have an opportunity to assist employees in a variety of ways that can boost retirement saving—by assuaging fears and concerns, as well as by supporting behaviors that will bring expectations of retirement readiness to fruition.
Behavioral Finance
Enter behavioral finance—a way of examining what’s behind investment decisions that goes beyond conventional ways of understanding decisions and what fuels them.
Amanda Manthey, an internal advisor consultant at PIMCO, in a webcast argued that conventional finance ignores how real people make decisions. She argued that the right and left sides of the brain are in a “constant struggle” and that intuition “has a very significant influence on how investors make decisions.” And that influence may not always lead to good decisions, she says, so intuition should be balanced by deeper thought and analysis.
Investor behavior, said Manthey, has a significant influence on investment results. The Corporate Finance Institute (CFI) agrees, and says that behavioral finance suggests that investors:
- are “normal,” not “rational”;
- have limited self-control;
- are influenced by their biases; and
- make cognitive errors that can result in bad decisions.
Among the mistakes and biases that the CFI says behavioral finance entails are:
- Self-Deception—mistakenly thinking that one knows more than one does, which can lead on to miss information necessary for making informed choices.
- Heuristic Simplification—making errors in processing information.
- Emotion—moods affecting decisionmaking and making it less rational.
- Social Influence—others’ influence in one’s decisionmaking.
Manthey also identified behavioral factors that can affect how people manage their retirement funds and the way they are invested:
- The illusion of control. “We can control taxes and expenses,” said Manthey, but not future outcomes. “Trading-oriented investors believe they possess more control over outcomes because they are ‘pulling the trigger’ on decisions,” she said.
- Hindsight bias. This tendency to lend importance to what has happened makes investors perceive investment outcomes as predictable even if they are not, Manthey said. The CFI says that it can lead one to conclude that one always knew that they were right, and Matheny expressed a similar view, warning that hindsight bias can result in ‘a false sense of security” and lead one to “excessive risk-taking.”
- Confirmation bias. This tendency leads investors to observe, overvalue or actively seek information that confirms their claims and to ignore or devalue that which discounts them, Manthey said. For instance, she observed, it can lead investors to seek positive information concerning their portfolio holdings, but to ignore negative opinions. Biases can limit one’s ability to make investment decisions that are purely rational, the CFI warns.
- Mental accounting. How investors look at different sums varies based on where they mentally categorize them, Manthey said. For instance, she said, risk-averse investors prefer to put assets in “safe” buckets. However, she warned, viewing all money as ‘safe’ risks suboptimal returns. It is better to look at a portfolio as a whole unit, she suggested.
- Anchoring. Manthey said this occurs when investors are influenced by purchase prices or arbitrary price levels and prevents investors from viewing investments holistically. Similarly, the CFI says that anchoring bias results from an individual relying too heavily on pre-existing information or the first information they find.
- Framing. Investors sometimes respond to situations differently based on the context in which a choice is presented, Manthey said. Likewise, the CFI says that such bias takes place when people base a decision on how information is presented.
- Recency bias. This tendency leads investors to look at recent returns when making important financial decisions, Manthey said.
- Loss aversion. This occurs, the CFI says, when an investor is so afraid of loss that he or she is more intent on avoiding it than making gains. It further cites research that found that investors feel the pain of loss more than twice as strongly as they enjoy making financial gains. For her part, Metheny said that the pain of loss can prevent investors from unloading unprofitable investments and cause them to take risks to avoid it.
- Status quo. Investors can be predisposed to choose options that keep conditions the same, Manthey said.
- Overconfidence. The CFI says that such a mindset, which it calls “dangerous” and “very prolific,” leads one to a false and misleading view of one’s abilities and skills. And Matheny warned that overestimating or exaggerating one’s ability to successfully perform a given task can influence investments.
Next Week: What to Do?
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