Overcoming human nature for retirement success
A well-designed retirement savings plan is one that helps participants start saving and investing early, stay invested, have enough retirement income based on their retirement goals, and make smart decisions along the way. Behavioural finance, which is the study of psychology that explores how people make financial decisions, has become a driving force in retirement plan design.
It can be challenging to stay committed to a savings plan because human tendency is not always rational. That’s why my65+ has incorporated some of the best behavioural finance thinking to work with, and not against, how human beings are wired. Here are three lessons that help my65+ deliver retirement income success for members.
Insight #1: Make it automatic
In the past, retirement savings plans were designed on the premise that financially rational savers would figure out on their own how much to save for retirement, and then carefully implement their plan, month by month, until retirement. But from a behavioural finance perspective, it is difficult to pay close attention to financial matters that seem far off, such as retirement. So “nudges” may be necessary to help you save appropriately for retirement.
The idea of “nudges” is central to the work of Richard H. Thaler, an American economist who was awarded the 2017 Nobel Prize for Economics for his contributions to behavioural economics. Thanks to insights from Thaler and his colleagues about human financial behaviour, some retirement savings plans have begun to prompt — or “nudge” — participants to create retirement savings goals, and then ensure that their contributions are set at a level to fulfill these long-term goals. For example, a nudge can take the form of offering a default option for you to automatically increase your savings contributions over time.
How my65+ incorporates this insight: it incorporates a feature called “automatic escalation” or “auto-escalation,” which will automatically increase contributions each year to help you achieve your retirement income goals. This feature is especially useful if you want to reach a certain savings target but aren’t able to save that much today and would like to ramp up your savings over time as your earnings increase. This feature is entirely voluntary, and you can opt out of it at any time.
Learn more: Save More Tomorrow: Practical Behavioral Finance Solutions to Improve 401(k) Plans – Shlomo Benartzi (2012)
Insight #2: Focus on retirement income
When you’re saving for retirement, the value of your investments will fluctuate over time. As part of setting retirement goals, you will need to figure out how much fluctuation you can tolerate. Many investors, however, tend not to treat gains and losses in the same way. That’s the finding of Daniel Kahneman, an Israeli-American psychologist and economist who is known for his work on how people make decisions, and was awarded the 2002 Nobel Prize for Economics.
Kahneman’s research demonstrates that investors “overweight” losses relative to gains, making many overly risk averse and fearful. This can lead to savers being overly conservative with their retirement investment strategies, instead of taking a balanced approach to investment risk and return. Retirement plans that incorporate Kahneman’s research on loss aversion will help participants choose an investment allocation that strikes an appropriate balance between investment risk and return likely needed to achieve long-term retirement goals.
Just as retirement savers need to balance the trade-offs between investment risk and investment return, they need to balance the needs and priorities of the present and the future. But similar to how many struggle to find the appropriate balance between risk and reward, there can be a tendency to choose smaller, immediate rewards rather than larger, later rewards.
This phenomenon is driven by something called “temporal myopia,” which causes settling for smaller payoffs now, rather than larger payoffs later. When an event is far away in time, it seems less clear and pressing, and so there can be a tendency to “underweight” the importance of the future in decision-making. This can pose a problem in saving up enough for retirement, which can seem so distant.
How my65+ incorporates this insight: The plan helps members focus on their target retirement income versus what you can expect in retirement income if you continue to save as you have to date, rather than on how markets and investments are performing day to day. Whenever you visit your my65+ dashboard, you will see your long-term goal – generating enough income later in life so that you can enjoy your retirement – and if you’re on track to meet it.
Learn more: Thinking, Fast and Slow – Daniel Kahneman (2013)
Insight #3: Less is more
When you’re saving for retirement, you might think that having many options is better than having only a few options. But what you may not realize is that having too many choices often leaves to worse outcomes.
Decision-making takes up your psychological resources. Just as you get tired at a certain point when you’re engaged in activity that requires effort, when you need to make many different decisions at once, it’s easy to hit “decision fatigue.” Behavioural scientists call this “choice overload.” Research shows that the saver who is faced with selecting from too many different investment options may struggle to select an option they’re satisfied with or may not make a choice at all until later.i
Choosing from a few good, thoughtful options within a retirement savings plan — including a good “default” option — is usually much more effective for retirement savers than having to choose from many different options.ii Of course, it’s important that these few good options available are meaningfully different in order to meet the needs of investors with different preferences and circumstances.
How my65+ incorporates this insight: it provides target date funds and suggested options for many of the key choices you will need to make in participating in the plan, including your investment path, your savings rate, and the contribution split between TFSAs and RRSPs.
Learn more: Choosing Not to Choose: Understanding the Value of Choice – Cass R. Sunstein (2015)
i Donald B. Keim and Olivia S. Mitchell, “Simplifying Choices in Defined Contribution Retirement Plan Design”. Pension Research Council, Wharton School, University of Pennsylvania (2015).
ii Choi, Laibson & Madrian, “The Importance of Default Options for Retirement Saving Outcomes: Evidence from the United States” (2009).