“There’s a boy I know, he’s the one I dream of” are the first lines of Whitney Houston’s hit single “How will I know” from her debut album launched in 1985. The song became Houston’s second number-one single on the US Billboard chart and together with the accompanying music video you can still watch on the link launched Whitney into super stardom. The song is today considered one of the classic hits of the 90s and listening to it just the other day I noticed a very subtle line in the pre-chorus uncovering some great behavioral lessons that can be applied not only to romantic relationships, but also to – you guessed it – retirement planning. Let’s look at the song’s lyrics.
The song starts with …
There’s a boy I know, he’s the one I dream of
Looks into my eyes, takes me to the clouds above
Ooh, I lose control, can’t seem to get enough
When I wake from dreaming, tell me, is it really love?
… and now pay attention to the pre-chorus
Ooh, how will I know? (Don’t trust your feelings)
How will I know?
How will I know? (Love can be deceiving)
How will I know?
And right there and then you have it – Don’t trust your feelings. We are not getting into the romance department in this blog, but if there is one area where you definitely don’t want to trust your feelings is retirement planning and investing your money. Here what may feel right in most cases turns out to be wrong, very wrong. Let’s look at some classic examples related to retirement planning.
Saving for retirement in company stocks and home bias – What can be safer to invest in than the company I work for? For sure I would know if something is not OK, are just some classic lines many tell themselves when thinking about where to invest their 401(k), but they couldn’t be more wrong. Nobel laureate Robert Shiller was one of the first to study investor behavior called “anchoring” and one of the things he found out was that besides the so-called quantitative anchoring, which is related to numerical values (f.e. anchoring on purchase prices of stocks), we are also influenced by moral anchors which is the influence of intuition and emotions [1]. A nice example of moral anchoring is investing your retirement savings in shares of the company where you work and used to be very common in the US.
This occurs because we feel a false sense of security, as we feel we know the company where we work more than others and because of this, we perceive it as a safer investment. A plant worker at Ford will perceive Ford shares to be much safer than for example BMW shares, or even a diversified equity portfolio. This way employees take on too much risk, as if something goes wrong with the company where they work, they will not only lose their job, but also their savings. And we all know the old saying “don’t keep all your eggs in one basket”. Luckily after the Enron fiasco in 2001 where both the company and it’s retirement plan tanked (in 2000 62% of the assets held in Enron’s 401(k) retirement plan consisted of Enron shares, yes, you read it correctly) less and less retirement plans offered company stocks and most plan sponsors started to discourage concentrated stock positions. If you are interested in this topic there is some nice research from Vanguard written by John Lamancusa and Jean Young [2]. Similar is home bias that means we perceive investments in for example our home country to be more familiar and also safer than investments in other countries. To most investing in 5 local companies feels much safer than investing in a diversified global equity portfolio. The reality is just the other way around.
Another example, where you don’t want to trust your feelings, is about when you are planning to retire and how much costs you will be facing. Many plan to work beyond the standard retirement age when they can first claim social security and by doing this, they plan to increase both their public pension (most countries offer incentives for working longer) and also their private pension. The gap between the age when workers plan to retire and the age when they actually do is revealed in Prudential’s study where 51% of retirees in reality retired earlier than planned. Only 23% retired earlier than planned voluntarily, meaning they had enough money saved to retire, or were just tired of working. The majority of those who retired earlier than expected did so involuntarily – 46% because of health problems, 30% were laid off or offered an early retirement package, and 11% left work to take care of a loved one [3].
Retiring early has a considerable negative impact on retirement income – lower social security and lower private savings and retiring just 5 years early can reduce income in retirement by an estimated 36%. The last few years are especially important as they are on average also our top-earning years and losing just one will reduce our retirement income substantially. Similar over-optimistic outlook is revealed regarding expected costs we will face in retirement. 37% of retirees say their overall cost estimates turned out to be low. Healthcare costs seem to be the most underestimated, as 44% said they faced higher-than-expected costs.
Who is to blame for our overly optimistic outlooks? The answer is “optimism bias”, which is considered to be one of the most prevalent and robust cognitive biases in behavioral science. Tali Sharot, one of the leading neuroscientists in this field, describes it as a cognitive illusion which developed in humans during our evolution to help us deal with a unique ability that we have and that is conscious foresight. This simply means we can imagine things and events in the future (animals can’t do this) and among other things we are also aware that someday in the future death and other bad things await us. Without developing positive biases during our evolution and looking at the future with the “glass half full” mentality, we could not function normally every day knowing death is around the corner, it would be just too damn depressing [4].
Optimism bias is also very dangerous when it comes to investing our money as we mostly just feel things on the market will only get better, but those are just our feelings and nothing more. After every bull market there is a “correction” or a bear market and if every stock would just rise and rise, investing successfully in the long term would not be so hard, as it is in reality. If we are investing for our retirement for 40+ years, we need to expect both bull and bear markets in between and diversify our portfolio appropriately.
Because of similar reasons we also tend to take on too much debt when purchasing our ars and homes, as we overestimate our future income. Why worry about paying the mortgage, as surely in the future we will get that promotion at work and our salary will increase. But we know in reality some get that promotion, some get the boot. More details and cases of the negative effects optimism bias can have on retirement planning in my article for The Decision Lab [5].
Estimating how much money you will actually need to generate a sufficient lifetime income in retirement is also something we tend to be very bad at and our feelings can quickly deceive us. I see this first hand from talking to members of our pension fund and many believe €50.000 is quite enough to be able to buy a decent life annuity and are shocked when I tell them that this only gives them roughly 160 euros per month (assuming today’s annuity rates and that they retire at 65) and in reality, they should be aiming to have at least €500.000 saved up. Most retirement plans nowadays offer online calculators that can show members what kind of income they can expect based on their current saving rates and how they can improve this by increasing contributions. Financial advisers can also provide their clients with different ways one can convert their savings into an income stream, as at the end of the day that is the point of saving for retirement – to receive income.
Connected with this is also how much people contribute to their pension plans and many anchor themselves on contributions that are too low. If the employer match is 3% many anchor on this and falsely think this is “the right” amount, as surely the employer knows best. By doing this they can save for their entire working period with a total contribution rate of 6%, which is by most estimates far from enough, as they should be saving with at least 10% of their salary.
Similarly our feelings can trick us into saving too conservatively given the long time horizon of retirement saving and younger members of pension plans should invest in funds with more equity exposure and transition to bonds only in the years prior to retirement, instead especially in Europe many still save for their entire working periods in guaranteed funds with majority bond allocation. It just feels safer, but what they are forgetting is that the yields will also be lower resulting in suboptimal amounts of assets at retirement and as a consequence lower retirement income.
I could go on and on, as there are so many ways our feelings can trick us to make bad choices when it comes to retirement planning, so I would encourage all to listen to Whitney’s song once again and count on our feelings only when making decisions about relationships, not retirement planning.
References:
[1] Shiller, J. Robert. Irrational exuberance (2015). Princeton, NJ: Princeton University Press.
[2] Lamancusa, A. John & Young, A. Jean. Company stock in DC plans (2020). Vanguard Research. Retrieved from: Company Stock in DC Plans (vanguard.com)
[3] Planning Your Retirement? Expect the Unexpected (2018). Prudential. Retrieved from: https://www.napa-net.org/news-info/daily-news/half-retirees-retired-earlier-planned-not-necessarily-choice
[4] Sharot, Tali. The optimism Bias – A Tour of the Irrationally Positive Brain (2012). New York, NY, US: Pantheon/Random House.
[5] Vižitin, Žiga. Optimism Is Good For Many Things, But Not Pension Savings (2020). The Decision Lab. Retrieved from: Why Optimism is Good for Many Things, but not Pension Saving – The Decision Lab
Irrational Retirement 