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Most people understand the need to plan ahead to achieve financial security in retirement, but what many people don’t realise is the significant role psychology has to play.
That’s where the field of behavioural economics – and the cognitive biases it highlights – is proving a potential game-changer for retirement planning.
Retirement savings through a behavioural lens
Unlike traditional economics, which assumes that people are rational and will always choose to do things that are in their best interests, behavioural economics believes that people aren’t always rational and that there are hard-wired biases that influence our decisions.
When it comes to retirement, insights from behavioural economics are revealing that money-smarts are only one piece of the puzzle in achieving a secure retirement.
What’s just as critical, proponents of this economic approach suggest, is overcoming a range of in-built cognitive biases that can hinder people reaching their financial goals.
Anchoring or status quo bias
One of the biggest cognitive hurdles when it comes to retirement planning, according to The University of Melbourne’s Reuben Finnigan, is what’s known as the anchoring effect.
This is a cognitive bias referring to the tendency of people to rely too heavily on the one trait or piece of information when making decisions, once the anchor is set. In a retirement planning context, Finnigan says anchoring impacts millions of Australians.
“When we talk about anchoring it related to a tendency to stick with the default position, for example, in superannuation, a savings rate of 9 per cent whether it’s appropriate or not for your needs,” he tells SuperGuide.
Present bias
While anchoring refers to the tendency to fixate on one piece of information, so-called present bias refers to overvaluing the present and undervaluing the future.
While this is understandable to a certain extent, Finnigan says it’s proven that you can achieve greater benefits if you delay gratification especially when it comes to money. He points to this bias as having a potentially damaging impact on retirement planning.
“Present bias makes our preferences inconsistent over time and leads people to save less than they would like to, and leads people to invest very little time in understanding their retirement,” he says.
“For instance, it’s typical for people to spend less than an hour choosing funds and savings rates when this decision will profoundly shape decades of their life.
“There’s also framing bias here which is the tendency to make decisions based on how the information is presented like choosing a fund because its advertisement is attractive.”
Limits to rational calculation
Another bias that behavioural economists emphasise isn’t so much a cognitive default as a failure to appreciate the concept of compound interest – one of the most important ideas to understand if you want to manage your finances in retirement.
As Finnigan puts it: “It’s our difficulty with understanding the importance of compounding in that we tend to miss that interest rate and savings rate differences that look small today can add up to enormous sums in the future.
“For this reason, it’s very important that we invest more in financial literacy and provide tools to help people understand the consequences of these decisions.”
Overconfidence
Ted Richards, of robo investment adviser Six Park, nominates the Dunning Kruger effect as another cognitive bias those headed towards, or already in, retirement need to conquer.
Identified in 1999 by then-Cornell psychologists David Dunning and Justin Kruger, it posits that people who are incompetent at something can’t recognise their incompetence and in fact are likely to feel they’re actually competent at it.
In relation to retirement planning, Richards says this plays out in many people lacking expertise on financial matters, but remain supremely confident about decisions they make.
“They mistakenly hold high levels of confidence in their own ability in relation to retirement, they make poor investment decisions that unknowingly sets our retirement savings back,” Richards tells SuperGuide.
Endowment effect
Richards also highlights how investors, including retirees, tend to think what they own is worth more than it actually is. He say contrary to popular opinion this is not a case of poor research or a knowledge deficit, but actually the brain playing a trick on you.
Known as the endowment effect, this bias results in investors having the tendency to overvalue the investments that they already own, regardless of what the real value is.
“The endowment effect is very relevant to people’s retirement, especially if at some stage you’ll be selling investments like stocks or a property,” he says.
Confirmation bias
Richards says we’re all also guilty of confirmation bias. This bias comes from our biological hardwiring that makes it is easier to understand confirming data. As a result, people tend to spend most of their energy looking for retirement investment strategies that supports their existing investment approach.
“We’re all guilty of this and it’s very hard to side step. We don’t put evidence first, we often put conclusions first and search for evidence to support the conclusion,” he says.
Recency bias
Decision making that is highly influenced by what’s going on in the market can also be the product of recency bias, the investment specialist says.
He says people more easily remember recent events compared to events that happened in the past. Due to this, investors are often influenced by the short term ‘noise’ of the market and may make emotional investment decisions at the worst possible time.
He urges the use of evidence-based algorithms to help overcome this phenomenon.
“By making important decisions with the help of algorithms is growing in popularity as an algorithm isn’t influenced by ‘noise’.
“It provides a rules-based approach to making investment decisions. A simple checklist may not be as advanced, but it can help in a similar way.”
Longevity bias
Griffith University’s Rob Bianchi says people living longer lives also factors in the complex biases picture. According to the associate professor, most people over the age of 50 significantly underestimate how long they are likely to live, substantially increasing the risk of a financial shortfall later in retirement.
The financial fallout of this misjudgement is often exaggerated, Bianchi says, by the tendency to become more financially conservative in old age.
“When you hit retirement age, you’ve got an average lifespan of 20 years so when you go from growth assets like stocks to defensive assets like cash and bonds, you’ve got a 20-year time horizon. We’re seeing people switching into conservative assets too early in the process,” he tells SuperGuide.
Overcoming cognitive biases
According to Six Park’s Richards, the first step in beating these and other biases is being aware that they are hidden drivers of behaviour. However, he cautions that “awareness alone is not enough as they’re not easy to overcome”.
“There is no golden rule, but there are different ways to try and mitigate their influence,” he says, pointing to high-quality financial planning advice as a way to deal with some of them.
For Melbourne University’s Finnegan, the priority should be investing enough time to consider in depth the big financial decisions set to impact life in retirement.
“The first thing people themselves should do is invest the time needed to think through their long-term financial plan, keeping in mind that these decisions may be worth hundreds of thousands of dollars over a lifetime of earning.”
After that, he says it’s important to focus on superannuation, with a few basic “boxes to tick off”. These include getting all your money in one fund, making sure your fund is among the lowest in fees, picking a fund with good performance over many years and being careful to assess whether extras are worth the cost.
“Be especially careful of retail funds, which have tended to be outperformed by industry funds,” he says
