Mind over matter: The psychology of retirement planning

Most people understand the importance of planning ahead to achieve a financially secure retirement, beginning with your choice of super fund and investment options.

As retirement approaches, more big decisions need to be made. How should we invest our nest egg? Pension or lump sum? Will we outlive our savings?

Thanks to the complexity of super and our retirement system, not to mention the uncertainty around investment markets and our own mortality, these are not easy decisions and mistakes can be costly.

Dr Andrew Grant, senior lecturer at the University of Sydney Business School, says that unlike buying a car or choosing a mobile plan, retiring is something we generally only do once. We don’t get to learn from our mistakes and do better next time.

Cognitive overload

Unfortunately, government and the superannuation industry often point the finger at consumers and assume that more information will solve the problem.

“Information alone is not enough to get people to act,” says Dr Di Johnson from the Griffith Business School.

This was highlighted recently by the small number of people who switched funds after the Australian Prudential Regulation Authority (APRA) named 13 MySuper products that had failed its first annual performance test. Two months down the track and only 7% of the 1million accounts affected were closed.

Johnson suspects cognitive overload may partly to blame. “People tend to become overwhelmed by large amounts of information, leading to delay or not taking action. Inertia kicks in hard, particularly with complex, high-stakes choices,” she says.

Then there’s “attribution bias” where people attribute an outcome to an erroneous cause such as “I’m bad with money”. “If we feel the poor outcome or choice was our fault, there is an extra emotional component to work through to pick our selves up and seek help so that we can trust in the next choice,” she says.

5 common cognitive biases

The following are some of the most common cognitive biases.

Anchoring

This refers to our tendency to rely too heavily on one piece of information and then anchor our behaviour to it.

Where super is concerned, one particularly weighty anchor is the minimum drawdown rate in retirement phase. Under the super rules, retirees must withdraw a minimum amount from their super pension each year, depending on their age.

The Retirement Income Review noted that many retirees wrongly assume that the minimum drawdown is the maximum amount recommended. As a result, it found retirees were often living more frugally than necessary and dying with a small fortune left in their super.

“People get anchored to (the minimum drawdown rate) because this is the amount that’s written down, but you could spend more if you wanted to,” says Grant.

Loss aversion

Countless psychological studies have shown that we tend to feel the pain of a financial loss more intensely than the joy of a similar sized gain. So the pain of watching your super balance fall by $1,000 is felt more acutely than the pleasure of seeing it go up by $1,000.

This helps explain the tendency to hold onto poorly performing investments or super funds for too long.

Grant says there’s often a conscious choice to hold off and see what happens. “They think if I switch funds and the fund I switch into does badly, that’s going to make me feel worse than if I stay where I am.”

So rather than suffer a potential loss, they sit tight in the hope that their existing fund might come good. Or they wait for a particular investment to return to what they paid for it, or to reach a previous high, before selling.

Framing

Another mental hurdle faced by retirees is the way super is explained, or ‘framed’. While you are still working, your super is typically referred to as savings or a ‘nest egg’. So it’s hardly surprising people are reluctant to crack open their nest egg and gobble it up when they retire.

This leads to a common misconception by retirees, also picked up by the Retirement Income Review, that they should live solely on the income from their investments and preserve their capital.

Yet our super system is designed with the expectation that you should gradually draw down capital as well as income to fund your retirement.

Grant says there is also some loss aversion at play when people focus on their retirement balance and consider any drop in that balance once they retire as a loss, even if the money was spent on living expenses.

“A sensible approach to retirement is that your ultimate goal is to spend what you’ve got,” he says.

Present bias

This refers to our tendency to overvalue the present and undervalue the future. “People place excessive weight on current consumption relative to future consumption,” says Grant.

This was likely a factor in the large numbers of people who took advantage of the government’s early access scheme. Under the scheme, individuals suffering financial hardship due to COVID could withdraw up to $20,000 of their super.

For younger members, Grant says it can be difficult to envision what life will look like in 20–30 years when they can access their retirement savings. Instead, they reason it makes more sense to use that money today to pay off credit card debt or build a home deposit.

While taking advantage of early access may have been a sensible decision for some people, for others who didn’t need the cash it ignored the value of compounding interest and growth over time. “If your super fund makes a return of 8% a year, that dollar not spent today will double in nine years and quadruple in 18 years,” says Grant.

Overconfidence

Overconfidence is something we can all recognise in others, less so in ourselves. For example, 73% of Americans think they are above average drivers, and 84% of Frenchmen think they are above average lovers. You do the maths.

In investing, overconfidence can lead to people overestimating their ability to beat the market and an unwillingness to heed advice.

This is worth keeping in mind if you believe you can do a better job than the professionals at managing your super.

Control is regularly cited in surveys as the main reason people start their own self-managed super fund. While there are excellent reasons for having an SMSF, it’s possible not all the 1.1 million Australians flying solo will do better than they would by handing over the controls to a professional.

A recent study by Monash University Business School found most SMSFs with a share portfolio underperformed the market and would have been better off investing in an index fund. The study analysed more than 47,000 SMSFs over various timeframes in the eight years to April 2020.

Overconfidence can also lead people to think their risk tolerance is higher than it actually is, especially after a period of high market returns.

Another recent survey found 77% of Australians aged 18–40, buoyed by recent investment success, would consider a ‘non-traditional’ super fund such as an industry fund with DIY options, a super wrap or an SMSF. It remains to be seen how many would feel the same after a market crash.

How to improve your decision-making

While it’s important to acknowledge you’re fallible, don’t beat yourself up about it.

Johnson says the super industry could do more to help us make complex decisions, with more personalised tools, wizards with targeted, personalised questions and even the option of a final check by a trusted adviser before hitting the “switch” button. Advice is particularly important where there are extra layers of choice such as life insurance.

Even so, there are ways you can reduce the risk of making poor decisions involving your super and retirement planning.

• Give super the attention it deserves. Many of us spend more time planning our next holiday than we do on our super, yet super is likely to be our biggest asset outside the family home. Make sure you get the simple things right, such as comparing and selecting the right fund, investments and insurance for your circumstances. Then review on a regular basis, paying attention to long-term performance after fees and tax.
• Seek financial advice from an independent financial planner. It may seem expensive at first glance, but it may well be worth it in the end. Your super fund may also offer free or low-cost advice. An adviser can help you clarify and set goals, devise a strategy to help you achieve them and act as a sounding board and money coach to keep you on track.
• Explore free online resources. If you’re not planning to seek advice, or even if you are, Grant suggests taking advantage of the many self-advice tools available. There are a variety of online retirement calculators that can help with questions like: Am I going to have enough to live the retirement lifestyle I want? If not, how can I get there? Your super fund’s website may be a good place to start.
• Make use of retirement planning rules of thumb. While nothing beats developing a personal financial plan, sometimes it helps to kick off the process with simple estimates that have stood the test of time. For example, the 70% target replacement rate for retirement income, ASFA’s Retirement Standard and the 10/30/60 Rule.

The bottom line

Learning more about super is a good way to inform your decision-making but learning to recognise your mental mistakes can be just as helpful as you navigate the complexities and uncertainties of retirement planning.