CPD: Human behaviour in retirement

Investor behaviour can influence investment decision making in retirement.

To best understand how and why clients make decisions about their finances, particularly in retirement, advisers must consider ‘investor behaviour’ and the factors that underpin those decisions. This should be done before starting to address the more technical and product-specific dimensions of retirement planning.

As humans, it’s accepted that we have inherent behavioural biases that can influence our thought processes and choices. For an adviser, the ability to pre-empt these factors and recognise how they influence financial decision making can help build client confidence and increase financial certainty.

Behavioural finance examines how people make financial decisions and the psychological factors that can influence their choices. As well as studying the influence of psychology on the behaviour of investors, it focuses on the fact that investors are not always rational, have limits to their self-control, and are influenced by their own biases.^[1]

As individuals increasingly take more responsibility for their retirement savings, the human (and emotional) element becomes more important. Emotion can become a critical determinative factor as to whether or not an individual makes good or bad choices with their money and ultimately, whether they’ll be able to enjoy financial security in retirement or outlive their savings.

Left unchecked, behavioural ‘blinkers’ can significantly impinge on a retiree’s capacity to feel a sense of control over their retirement income. Longer-term, it can impact their ability to achieve their financial or lifestyle goals.

A detailed study conducted and compiled by Professor Shlomo Benartzi of UCLA and sponsored by Allianz of America^[2] noted a number of behavioural insights you can draw on to overcome common biases and cognitive behaviours to deliver positive client outcomes.

Behavioural insight one: Framing

Framing describes the way humans interpret information based on how it is presented, instead of relying on the individual facts. As clients move away from wealth accumulation, there’s a need to help them focus on income generation over seeking investment returns.

If you consider framing in an advice scenario, asking a retiree to decipher what percentage return they require from their investments to cover their annual expenses isn’t as relatable as asking them how much income they need to manage their bills.

In framing, context is king. How you frame the client conversation can help deliver the desired mindset and outcome.

Behavioural insight two: Vividness

If you ask yourself what life will be like in 20 years, it can be hard to envisage. However, that’s the mindset a client needs to adopt when making financial choices about retirement.

A research study^[3] undertaken by Professor Daniel G. Goldstein and London Business School, asked individuals to immerse themselves in virtual reality to look into an age-morphed mirror. Individuals were then asked to allocate money towards today’s living expenses and their hypothetical retirement account. Those that saw their ‘future selves’ were more than twice as likely to add money to the retirement pot when compared to those that saw their own, current reflection.

While advisers don’t need to invest in virtual reality, you can use tools, scenario-based case studies, or real-life comparisons to support your client conversations. This can help you clients to better see how their present financial assumptions may affect their future wealth and lifestyle satisfaction.

Behavioural insight three: Hyper loss aversion

Hyper loss aversion refers to the propensity for people to become more sensitive to financial losses as they age. Retirees fear a loss ten times as much as they value a gain. The average person in accumulation phase fears a loss only twice as much as they value a gain.

Our decision-making faculties can be vastly skewed when we consider the risk of losing money to, for example, a sudden market downturn or negative returns. Loss aversion has implications for how retirees make decisions, and fear can manifest in suboptimal investment choices.

Allowing a sense of control and flexibility shouldn’t be underestimated when dealing with loss aversion in retirement portfolio construction. Incorporating products that provide income with a greater degree of certainty in outcome is important to provide your clients with a sense of control over their destiny. It is also crucial that retirement solutions specifically address loss aversion, particularly for those who are hyper-sensitive, while addressing retirement specific risks such as longevity or sequencing risk.

Behavioural insight four: Cognitive impairment

While ageing may deliver the benefits of experience and wisdom, it can also impact the quality of cognitive function and decision making.  A study^[4] of older adults saw a decline in ‘analytical cognitive functioning’ – the ability to learn, think, reason, remember and problem solve. In addition, the study showed a marked decline in financial literacy, including mathematical skills and the ability to understand charts, graphs and tables.

The ability for your clients to understand and assess the potential impact of factors such as sequencing risk on their retirement savings is challenging enough; add some cognitive impairment and it can be extremely difficult for them to understand the issues that pertain to retirement finances.

To help clients make good decisions about drawing and protecting their income in retirement, you can consider encouraging older clients to do several things:

1. Lock in their retirement strategy as early as possible
2. Consider forms of capital protection to preserve their retirement savings
3. Secure the provision of a regular income stream, ideally a guaranteed lifetime income
4. Ensure access to capital.

Behavioural insight five: Tangible mental accounts

The fear of outliving retirement savings and making investment losses are genuine concerns for retirees dependant on existing assets for a regular income stream. At the same time, they may need access to capital, whether for ‘lumpy’ medical expenses or something lifestyle oriented such as a holiday.

One way you can help clients is to identify specific needs or goals each has and separating them into ‘buckets’ for easy reference. This can help your clients to mentally account for and control their spending, and investment strategies can be developed accordingly.

For example a bucket that pays for essentials such as utilities, council rates, medicines and groceries could be invested conservatively. Conversely, a bucket that pays for discretionary expenditure such as holidays or luxury items could be invested more aggressively to provide growth.

Going one step further and labelling these ‘buckets’ can also make them much more tangible and provide relevance and emotional engagement. They can also provide a basis for ongoing conversations around spending, meeting needs and realising financial and lifestyle goals.

Behavioural insight six: Inertia

In behavioural finance, inertia can be described as a form of resistance, with people likely to stay with the status quo. This resistance may be driven by fear of making a wrong decision, so no decision gets made, or a sense of being overwhelmed. Inertia can manifest as resistance to making a change, complete inaction or the tendency to stay with a previous choice to seek comfort in the familiar or to avoid regret.

Inertia bias can easily equate to suboptimal investment choices and, in many cases, inhibit an investor from making necessary changes to their portfolio. About 800,000 Australians have their superannuation in default funds that have significantly underperformed over the long term^[5], a fact that exemplifies inertia. On the other hand, it can sometimes be positive – for example, inertia may stop a client unravelling a long term strategy in response to short term market conditions.

Regardless of whether the inertia is rooted in fear, or a retiree is purely seeking comfort in the familiar, dislodging these behaviours requires significant personal motivation.

How can advisers help clients minimise inertia when it’s holding them back, or use inertia to help them achieve their goals?

One strategy is to establish regular savings goals, ones they can opt out of. This is a good way to get a client to increase their retirement savings. A series of smaller changes is less likely to meet resistance than a single large change. The ability to opt out creates a sense of safety for the client, even though inertia might work in their favour so they don’t actually use the opt out feature!

Behavioural insight seven: Evaluability

Evaluability looks at our tendency to want to assess and make decisions based on like for like comparisons. If presented with two options, one easier to comprehend than the other, it is common to base the selection on the relative ease, regardless of whether it is the optimal choice for our circumstances.

Professor John Payne of Duke University^[6] suggests that to overcome evaluability in presenting retirement income solutions, advisers need to approach conversations with new language that positions potential implications in quantifiable or measurable terms.

This would encompass viewing product features in ‘apples-to-apples’ comparisons, in addition to placing them within a client’s own circumstances. He also suggests avoiding the use of complexities or industry jargon, instead presenting relevant points with transparency and simplicity wherever possible.

An evaluability bias in investment terms can be the source of a missed opportunity and at worst, ignoring the best solution because of its relative complexity. In the quest to keep things relatively simple, there is a very real risk of overlooking a superior investment outcome. The power of keeping and promoting an open mind, for you and your client, cannot be underestimated when considering that client’s best interests.

Many retirement income products have inherent complexity. As super funds and investment managers race to innovate in the wake of the Retirement Income Covenant, drawing upon an evaluability framework that weighs the likely benefits, consequences and cost will be paramount.

This is particularly important because not all products will be comparable in a like-for-like sense yet may be equally or more beneficial for your client and their retirement outcomes. Interactive tools or scenario simulators that bring to life practical examples or use case studies can be very useful.

Behavioural insight eight: Money illusion

Most people fail to gauge the impact of inflation on their nestegg. They are inclined to think in nominal dollars, in terms of day-to-day prices. Inflation’s corrosive effect has significant implications for a person’s standard of living, not to mention quality of life.

The purchasing power of a dollar can vary greatly over time. Consequently, when it comes to retirement or any long-term savings goal, the impact of inflation is a critical consideration.

Consider the cumulative effect of compounding. Even low rates of inflation can multiply exponentially. An inflation rate of three percent compounded over 10 years can erode purchasing power by 25 percent. Compounded over 20 years, a three percent inflation rate can reduce purchasing power by nearly 50 percent.

Retirees can fail to recognise the extent to which the purchasing power of future payouts designated in nominal dollars will be diminished, leaving them with insufficient funds to maintain their lifestyle or pay for essential medical services.

The money illusion refers to the outsized influence of nominal dollars on decision-making. A study into this phenomena found that an individual’s preference for an inflation-indexed or a non-indexed contract could be influenced by the way the risk was presented^[7]. The research findings suggest that people naturally think about risk in terms of nominal dollars, but also indicated that if the risk to real dollars is demonstrated to them, the money illusion can be minimised.

Behavioural finance checklist

Behavioural finance has the potential to reshape the financial lives of retirees and can help add a human dimension to the design of a client’s retirement income strategy. The following checklist^[8] has been designed to provide a practical framework of questions to explore with clients to help overcome these common bias and cognitive behaviours.

The checklist provides a question derived from each of the above insights.

1. Is the retirement income strategy framed in terms of the monthly income a retiree will receive?
2. Are the implications of today’s financial decisions vividly presented so clients see how their future life will be affected?
3. Is the strategy appropriate for retirees who are hyper-sensitive to losses?
4. Are the number and complexity of choices manageable for older individuals?
5. Can retirement income decisions be made before the onset of cognitive impairment?
6. Do your clients’ retirement income strategies offer flexibility for multiple accounts to facilitate different goals, such as paying the rent or spending money on holidays?
7. Are retiree investors, carried by inertia, assigning themselves to the most appropriate investment options?
8. Does the language and context used to describe the retirement income strategy make it easy to evaluate its features as they relate to the client?
9. Does the retirement income strategy provide some inflation protection?

The transformative power of behavioural finance extends beyond theoretical frameworks to tangible impacts on the financial lives of your clients. By incorporating insights from behavioural finance, you not only enhance the effectiveness of retirement income strategies, but also infuse a crucial human dimension into the design process. Recognising and understanding the behavioural biases that can influence financial decisions will empower your clients to make more informed choices and create a retirement journey that aligns with their unique financial and lifestyle goals.

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Notes:
[1] https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/behavioral-finance/
[2] Behavioural Finance and the Post-Retirement Crisis, Sholomo Benartzi, UCLA, 29 April 2010
[3] IBID
[4] The Age of Reason: Financial Decisions over the Lifecycle with Implications for Regulation, Prof. David Laibson, 2009
[5] https://www.morningstar.com.au/insights/retirement/230234/australias-best-and-worst-default-superannuation-funds-revealed
[6] The Age of Reason: Financial Decisions over the Lifecycle with Implications for Regulation, Prof. David Laibson, 2009
[7] Money illusion, Quarterly Journal of Economics, Shafir, E., Diamond, P., and Tversky, A, 1997, 112(2)
[8] Behavioural Finance and the Post-Retirement Crisis. Prepared by Sholomo Benartzi, UCLA. Sponsored and submitted by Allianz of America, 29 April 2010; A Behavioural Finance Checklist for Retirement Income Strategies

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