By Michael Wilson, CFP®, CRC®, RICP®, Integrity Financial Planning
We all know there are certain things we should do, like eat right, exercise, get plenty of sleep, etc. The same is true for retirement saving: we all know we should be saving now for an unknown period of time in retirement.
Multiple studies and surveys have indicated how woefully inadequate average retirement savings are. But head knowledge doesn’t always translate into action, into current behavior. What’s the disconnect? Why aren’t knowledge and education enough to move us to do the “right thing” now?
This article will examine several behavioral mental traps, or biases, that can help (or hinder) our ability to save for retirement, as well as suggest ideas for putting these biases to work in a positive way.
Behavioral finance is a relatively new field that has become more popular in the five years or so that combines behavioral cognitive psychological theory with conventional economics and finance, to explain why we do irrational things with money.
Examples of mental biases include:
Some of these you may have heard or been familiar with already. Unfortunately, merely being aware of them doesn’t mean we don’t still get tricked by them occasionally or don’t fall into some of these mental traps. We’ll review key biases.
How Does Designing in Friction Affect Behavior Change?
Imagine watching a favorite Redbox movie at home. Of which snack will you eat more?
Twenty-nine percent of webinar attendees went for the big 12oz bag of chips, 36 percent said “No difference. No one can eat just one chip,” and 21 percent wanted to know why veggies weren’t an option.
What’s going on with this? Friction. In this particular experiment, you have the option to open a bag one time, where it’s pretty easy to blaze through that bag of chips. Or, you have three small bags with the overall equivalent amount of chips, where the act of say opening that second bag might cause you to stop and think, “Am I going to open the second bag? Do I need another bag of chips?” By the time you hit that third bag, again there’s that pause where you have to say, “Am I going to open the third bag of chips? I’ve already had two bags of chips. Do I really want a third bag or not?” Just those pauses, that friction, and that extra effort can cause you to pause and possibly change your behavior.
It’s the same idea when it comes to retailers saving your credit card data. Think about Amazon, for instance. They have that one-click purchase option. Are they doing that because it’s great customer service? You could probably spin it that way, but Amazon also knows if they can make it as easy as possible for you to buy, especially if it’s kind of an impulse purchase, you’re more likely to go through and make a purchase. If they can make the friction as little as possible or as small as possible, you’re more likely to engage in a particular behavior.
If you want to encourage behavior, you want low friction. That’s why things like auto-enrollment, auto-escalation, and auto re-enrollment, or maybe just one-click deferral changes if you’re in your retirement savings plan, can help people to save more. The easier you can make these changes and the lower the friction, the more likely people are to engage in a particular behavior. On the flip side, if you don’t want them doing a specific behavior, then you want to put in lots of friction. Maybe you have distribution forms that have a lot of information on them, or if you’re tracking moving money from your firm to another firm, you say, “You know what? You also have to give us the other company’s rollover form.” Put in things like signature guarantees. If you work for a retirement provider that offers loans from their 401(k)s or 457s, maybe you do things to make the loans harder to obtain – more fees or more paperwork – instead of allowing those things to be completed online.
What is the Endowed Progress Effect?
Which of the following cards is more likely to be used? A blank card requiring eight punches or a ten-punch card with two free punches? Or is there no difference; it’s eight punches either way?
It’s better to have two free punches on the 10-punch card. This is an example of the “endowed progress effect.” It’s this idea that because a task has kind of already been started for us, it’s easier to follow through than one where we have to start from scratch. Endowed progress is if you provide folks with a sense of artificial advancement towards a particular goal, they’re going to exhibit greater persistence toward actually reaching the goal. In this specific example, if I have to start from scratch and I’m looking at the eight-punch card, the task hasn’t started. If I get that first punch done, I’m one-eighth of the way there. That doesn’t sound so great to me mentally, but if I have the 10-punch card and two of the punches are already done, I’m already 20 percent of the way there. When I get punch number three, I’m 30 percent of the way there, etc. I’m more likely to then actually follow through or to continue to use the 10-punch card.
If an employer offers a five percent contribution or a five percent match, one way to frame this or one way to present this to folks who are saving for retirement is to say, “Hey, good news. You’re a third of the way there already. Let’s get you the rest of the way,” and again they’re more likely to say, “I’ll kick in one percent” or “five percent” or whatever the case may be.
How Can We Use Anchoring?
When is it better to start Social Security? Later, because you get larger monthly checks? Or it depends? Part of this decision can be related to anchoring, which is this idea of the first number I see is going to influence any other amounts that are going to be displayed to me.
Earlier in my career when I would explain to folks the pros and cons of starting Social Security early versus late, I used to mention the age 62 number first just thinking, that 62 is the earliest you can begin. Maybe their full retirement age was 67, and then 70 would be the latest they can claim. Age 62 then becomes the anchor, and any other numbers that I would throw at them they would relate to 62. Depending on how I framed it, if I said, for instance, “At age 62, you’re going to get $700 a month; at 67, you’re getting $1,000 a month, and at age 70, you’re getting $1,300 a month.” If age 62 was the first number that mentioned, that’s the one to which everybody related.
In the retirement savings world for instance, if you influence your enrollment forms whether they’re on paper online, do you want to start with a high or a low suggested savings percentage?
Anchoring suggests you probably ought to start with something high. If your suggested percentages are eight, six, four, or two, then list them in that order. Don’t display them in order of lowest to highest – because if you start with two, if that’s the first number they see at the top, that’s the one folks most likely are going to click on just simply because it’s first.
On Social Security statements, age 67 is the first number you now see, not age 62. Why is Social Security doing that? They understand the concept of anchoring and other behavioral finance concepts. Age 67 is now the anchor. That’s the one they are subtly trying to convince or to encourage taxpayers to shoot for when it comes to taking their Social Security benefit. Next, they show the age of 70. Well, then you could frame that as saying, “Hey, at 67, you get this amount. At age 70, look, your benefit goes up. You have a gain at that point if you are willing to wait an additional three years to take your money,” but now look at age 62. In this example, if I start at age 62 – again depending on how I frame it – I’m losing about $500 a month compared to age 67.
How I explain it can certainly influence their behavior. I could pitch age 70 as, “Look, you’re getting an extra $500 a month,” and age 62 as, “Oh, you’re losing $500 a month, and this is what the current statement looks like.” How it’s framed and how it’s presented can certainly have an impact on the decision people make about whether to start Social Security early versus late. I’m not trying to say one is better than the other; that’s something for you to think through with the clients you work with and the members of your retirement systems as to how you present this information. The idea is that we have to be aware that the way we present things certainly can have an impact on how it’s going to influence someone’s decision to do things like start Social Security.
The bottom line in all of this is the order in which we present things really does matter.
What is Framing?
Another example of framing is Dr. Shlomo Benartzi. He wrote a book called Start Saving More Tomorrow. It was this idea of making pre-commitments, and why pre-commitments work.
He did a study where he asked half of the users if they could start saving $150 a month towards a particular goal. About seven percent of those surveyed enrolled via an app to save $150 a month. For another group, he suggested that they save five bucks a day. Five bucks a day for 30 days a month is essentially the equivalent to the first savings option, but because of the difference in how the dollar amounts were presented, four times as many people signed up for the five-dollar-a-day option. Because five bucks a day was presented as “hey, that’s a latte,” more people chose that rather than thinking, “Oh, $150. Well, that’s more like a car payment.”
Framing makes a big, big difference. When you’re talking to clients or members who are saving for retirement, think through when you give folks target amounts, are you expressing them maybe as annual amounts, as monthly amounts, or maybe even per-paycheck amounts? Probably the smaller you can make those target amounts, the more likely people are to buy into going with your particular recommendation. Framing again through all of this can certainly have a significant impact in terms of how we behave.
How Can We Help Prevent Fear of Regret?
Who’s going to feel worse after running an Olympic marathon? The Gold, Silver, or Bronze runner? Some of you are crazy enough probably to have run marathons. When asked, half of the respondents said the silver medalist probably feels worse, and roughly a third said the bronze medalist. The silver medalist is thinking, “Man, if I’d only been a tenth of a second faster, I could’ve had the gold medal.” The bronze medalist is looking down at the fourth-place person saying, “Man, good thing I was just a few tenths faster; otherwise, I wouldn’t be up here on the podium at all.” It’s relation-perspective. In some cases, this is classified as this fear of regret.
In the financial world, we hear, “Hey, the market is too high. I’m afraid if I get in, it’s going to go down,” or “The market’s too low. It’s too scary right now because if I do get in, it’s going to go down even further. I’m going to regret deciding to invest and get into the markets.” So, what’s the solution? Just maybe a nudge or a toe in the water instead of all at once. Maybe make one smaller decision: “Let’s start doing dollar cost averaging;” rather than one big decision: “Let’s throw all of the money into my Roth IRA all at once.” Maybe it makes more sense to say, “You know what? I’m just going to put $100 a month into the Roth throughout the year” rather than say “Throw in all $1,200 at once.” The idea is that doing the nudge and that one small decision, I’m less likely to have that sense of regret if the market misbehaves and does something different than what I expected.
Which Country Do You Suppose Has the Highest Organ Donation Rate?
Ninety-nine percent of Austrians are organ donors, and 12 percent of Germans are organ donors. Austria has this incredibly high rate. Well, why is that? In the Austrian system, you have to opt-out if you don’t want to be an organ donor. On their driver’s license form, in essence, the box that says, “Would you like to be an organ donor?” is pre-checked. Now, you can get out of it; you just have to take some action. You have to check the box. Germany, on the other hand, is very similar to the U.S. There, you have to opt-in. Again, you have to make some effort and say, “Yes, I would like to be an organ donor.” Germany and Austria are two countries right next to each other with some cultural differences certainly, but again why the big difference? It’s the choice architecture. The Austrian Motor Vehicle System has essentially said, “We’re going to assume people want to be organ donors,” and that’s their default assumption. People can opt-out, but they’re going to have to take some action if they want to do so.
This is an example of status quo bias or inertia. You want to think through the defaults that you want your participants, your customers, and your clients to take. Think about the default settings on your computer, your browser, or your phone. Those things aren’t just there haphazardly. The companies who put those products together have a lot of intentional choice architecture put in place with a lot of thought behind the defaults that are listed there for you. They have particular reasons why they want you to use those things. In your retirement system or employer plans then, think about auto-enrollment. Auto-enrollment is an opt-in default. You can use inertia, this idea that people most likely aren’t going to change; they’re just going to go with whatever the default option is. If you are do something like auto-enrollment, do you want to set it at say three percent or six percent? There’s research out there that folks are perfectly comfortable with six to seven percent their pay. You go above seven percent, and then you start seeing people opting out, but you can go anywhere between three and six percent and most folks will just kind of accept that as “That’s just normal. That’s just kind of what I expect.”
What is Hyperbolic Discounting in Behavioral Finance?
When folks were presented just with the choice of “Do I want a chocolate bar or a piece of fruit today?” the majority went for the chocolate bar. When they were presented with a choice of receiving a chocolate bar or a piece of fruit in a week, more people chose the piece of fruit. The difference is an example of hyperbolic discounting, which means when we’re receiving something far off into the future in sometimes as short as a week, we’re more likely to be kind of more rational and make better choices if it’s further down the road. If it’s the chocolate bar or piece of fruit today, it’s just too tempting and because this hyperbolic discounting says, “Well, I don’t even know what’s going to happen down the road. I want to maximize my pleasure today.”
When we do make choices regarding the future, we tend to be a little bit more rational or a little bit wiser about it. That’s just part of the function of the way our brains work. When we have immediate choices, our “reptilian” or “animal” brain goes for anything that’s right in front of us at the time in the heat-of-the-moment. Studies show that when we make more of our decisions in the heat of the moment with this more instinctive or emotional reaction, we tend to generate higher credit card debt, higher default rates, and lower credit scores. Letting that reptilian brain rule isn’t always in our best interest; in fact, a lot of times it isn’t.
In Dr. Shlomo Benartzi’s Save More Tomorrow book, he developed a campaign to test a sense of pre-commitment that asked participants to choose to increase their retirement savings by one or two percent in six months to one year. He found that people would then follow through because it didn’t cost them anything today – there was no pain associated with today – so they were making more rational choices, thinking “I know in the long run I should be saving for retirement.”
If you have for instance an employer or maybe you’re the retirement system or the agency, or you have clients who have matching contributions offered by an employer, the big key is to emphasize what’s in it for me now. Don’t stress, “Man, down the road, your retirement account’s going to be worth hundreds of thousands of dollars.” Emphasize what it’s doing for them now. “It’s doubling your money now” or “It’s adding an extra 50 percent return to your money today.” That’s where you want to have the focus.
How Can We Apply Behavioral Finance Concepts in Retirement Plans?
Studies tell us that the old stand-and-deliver approach, “if I dump a lot of information on people, they’ll get it and they’ll change their behavior,” by itself is not working so well. We have particularly in our industry a sort of this curse of knowledge and jargon. We may say things like “asset allocation” and “Monte Carlo analysis” and all of these wonderful terms. This just flies over people’s heads. Many times, they don’t get it. Any jargon word can cause a 10 to 15-second delay as the listener processes that word. When you say, “asset allocation,” and you continue to speak for the next 10 seconds or whatever, they’re still stuck on, “Asset allocation? What the heck is that?” If we can avoid some of those words and use words instead that people can relate to, they’re more likely to continue to listen to us. As it turns out, language really matters.
Words to avoid include percentages, match, budget, and Monte Carlo. Don’t say, “Monte Carlo.” Why not? With Monte Carlo, most people think of gambling. What words could you use instead? Instead of aggressive, use volatility. You’ll still probably have to explain that one. Instead of showing people percentages, show them dollars. Don’t call it a match; call it free money. Don’t call it deferrals; call it contributions. Don’t call it a defined contribution plan, which is probably the worst name ever invented; instead, call it a retirement savings plan. It’s not a budget; it’s a spending plan. It’s not “we have low fees;” it’s “we’re cost-efficient.” I’m sure there are others you’ve heard of as well.
When you’re explaining things like compound interest – that’s a bit of a jargon word – it helps to express ideas graphically. Show them the difference. When most people think of compound interest, they’re thinking of things just incrementally increasing along, not the exponential curve that we see with compound interest. Show it to them pictorially. “Your money is doubling over time.”
In any particular interaction – presentations, sitting down, or one-on-one – 20 percent of the folks are already disposed to making changes. Things like auto-enrollment and auto-escalation are ways we can take advantage of status quo bias. We can use technology and things like apps and texts to remind us. You may have to decide, “If we go this behavioral finance route, are we manipulating things without our members or our customers realizing it?” That’s something for you to decide, but I think when you’re trying to do something good for them in the long run, folks will support that.
About Michael Wilson, CFP®, CRC®, RICP®, Integrity Financial Planning
Mike Wilson is the owner and founder of Integrity Financial Planning, which specializes in personal retirement planning. In one form or another, Mike has been in the training and financial services industry for 30 years. He earned his MBA in Finance from Baylor University and is a Certified Financial Planer®, Certified Retirement Counselor® and a Retirement Income Certified Professional®.
Mike and his wife Nancy reside in Salt Lake City, where he enjoys hiking and mountain biking whenever possible.
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©2019, Michael Wilson, CFP®, CRC®, RICP®. All rights reserved. Used with permission.