Psychological Impediments to Retirement Planning

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Psychological Impediments to Retirement Planning

• Elke U. Weber
• Center for the Decision Sciences Columbia
  University
• Dartmouth College Financial Education Workshop
• October 2005

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Retirement Planning and Investing as Risk
Management

• Economic and social costs of insufficient savings
  or suboptimal investments are huge
• Personal as well as societal implications
• Yet, few of us lose sleep over it
• True for general public, politicians, and even
  experts/researchers/practitioners who know better

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Preview

• Why arent people motivated to engage in
  retirement planning?
• Motivational impediment insufficient fear
• Assuming we could motivate them to care,
  would/could they do a good job?
• Other (cognitive and affective) impediments
• Financial education and policy implications

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Two processing systemsEpstein, 1994 Kahneman,
2002 Sloman, 1996 and others

• Analytic, algorithmic, rational, rule-based
  system
• effortful, slow, requires conscious awareness,
  and knowledge of rules
• e.g., probability calculus, Bayesian updating,
  formal logic
• Association- and similarity-based system
• evolutionarily older, hard-wired, fast, automatic
• greater emphasis on outcomes than probabilities
• emotions as a powerful class of associations
• two systems operate (in parallel)
• joint operation rises to awareness only when
  system output is in conflict
• when output of systems in conflict, behavior
  typically determined by associative/affective
  processing system
• (Loewenstein, Weber, Hsee Welch, 2001)

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Motivational impediments to Retirement Planning

• Affect is the wellspring of action
• Emotions are evolutions way to get us to do
  things that are good for our survival and
  reproductive success
• Positive emotions want to be maintained
• Negative emotions (fear, anxiety) act as an early
  warning system that triggers protective action
• woe speaks cease, go, but all lust wants
  eternity, wants deep, deep, deep eternity
  Nietzsche
• Without feeling of being at risk, we fail to
  allocate attentional and material resources to
  risk management

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• Affective or visceral reactions to the risks of
  inadequate pension savings are low
• Psychological risk dimensions shape risk
  perception in health and safety situations
• Reducible to two dimensions predictability and
  dread (Fischhoff, Slovic, Lichtenstein, Read,
  Combs, 1978 Slovic, 1987)
• Dread/affective component predicts risk
  perceptions of financial investments by U Chicago
  MBA students above and beyond probability
  distribution of possible outcomes
• Holtgrave Weber, 1993
• Risk of inadequate pension-saving scores low on
  both psychological risk dimensions
• thus fail to elicit subjective feeling of being
  at risk

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Should we scare people into worrying (more) about
their old-age financial security?

• Two downsides to affect-based decisions
• Finite pool of worry effect
• As concern about one type of risk increases,
  worry about other risks decreases
• Capacity to worry seems to be relatively fixed
  and takes time to regenerate (Linville Fischer,
  1991 Hansen, Marx, Weber, 2004)
• Raising worry/concern in one area by making it
  vivid or concrete may decrease or displace valid
  concerns in other domains
• Terrorism vs. civil liberties and environment
• Single action bias
• decision makers will take one action to reduce a
  risk that they fear, but are less likely to take
  additional steps that would provide incremental
  protection or risk reduction
• presumably first action suffices in reducing the
  feeling of fear or threat
• observed in medical diagnosis, farmers reactions
  to climate change (Weber, 1997)

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Other psychological impediments

• (Hyperbolic) discounting of delayed costs and
  benefits
• Finite cognitive capacity
• Inability to deal with too much choice
• Difficulty understanding probabilistic
  information
• Insufficient diversification/Home bias

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(Hyperbolic) discounting of delayed costs and
benefits

• Immediate consumption (small benefit now, large
  cost later) preferred over later consumption
  (large benefit later, small cost now)
• Lack of self-control
• Initially observed in children (Mischel et al.,
  1969), also in adults (Kirby Herrnstein, 1995)
  and other animals (Ainslie Herrnstein, 1981)
• Modeled by hyperbolic discounting (Loewenstein
  Prelec, 1992 Rachlin et al., 1991)
• Discounting strongest for immediate consumption
  deferral from now to now k
• Explained by
• preference construction processes (Weber
  Johnson, 2005 Weber et al. 2005)
• Immediate consumption considered first, with
  richer representation
• mental representation of present vs. future
  events (Trope Liberman, 2003)
• Future abstract Present concrete, affect-laden

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Finite cognitive capacity

• Cognitive constraints recognized as source of
  many human heuristics and biases
• Limited working memory and attention give rise to
  bounded rationality (Simon, 1990)
• Economic assumption that more choice is always
  better not true
• Quality of choices and satisfaction with choices
  often reduced when number of choice options
  increase over the magical number 7 (2) (Iyengar
  Lepper, 2000)
• Shown to apply to selection of contributions to
  401(k) retirement plans (Iyengar, Huberman,
  Jiang, 2004)

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Difficulty understanding probabilistic information

• Quantification of uncertainty into probabilities
  allows for communication, i.e., for its
  transmission to others
• Allows for vicarious learning, an evolutionary
  advantage
• Yet, concept of probability and probability
  theory a recent human accomplishment (conducted
  by our analytic, rule-based processing system)
• Prospect theory (Kahneman Tversky, 1979) and
  support theory (Tversky Koehler, 1994 Tversky
  Fox, 1995) formalize how peoples use of
  probabilities falls short
• Decisions from statistical description often
  deviate from decisions from personal experience
  (Hertwig, Barron, Weber, Erev, 2004, 2005)

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• Decisions from Description
• Outcome distribution fully described
• possible outcomes and their probabilities
  provided numerically or graphically
• almost exclusively studied in human choice
• 226 of 226 data sets in meta-analysis of Weber,
  Shafir, Blais (2004)
• Extensive use of analytic, rule-based processing
  system
• People overweight small-probability events
  (Kahneman Tversky, 1979, Tversky Kahneman,
  1992)
• Decisions from Experience
• Outcome distribution initially unknown
• knowledge of possible outcomes and their
  likelihood acquired by personal exposure in
  repeated choices
• Extensive use of associative, affective
  processing system
• Recent events get disproportionate weight
• People underweight small probability events,
  unless they just occurred, in which case they
  overreact (Hertwig et al., 2004, 2005)

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Insufficient Diversification/Home Bias

• Two common investment mistakes that are based in
  affective reactions
• Insufficient Diversification
• People underinvest in options that have negative
  correlations in their expected returns with
  current holdings
• Aversive to discover losers in ones portfolio
  each period
• Diversified investment assets judged to be
  riskier than undiversified ones (Weber,
  Siebenmorgen, M. Weber, 2005)
• Home Bias
• Investors hold far too little of their financial
  portfolios in foreign investments, despite large
  potential gains from international
  diversification (Cooper Kaplanis, 1994)
• Behavioral explanations show that the greater
  familiarity of domestic investments breeds
  greater liking (Huberman, 2001) or greater
  perceived competence (Kilka M. Weber, 2000)
• These positive feelings translate into
  perceptions of smaller risk (Weber, Siebenmorgen,
  M. Weber, 2005) and therefore more likely
  investment selection

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So how to proceed?

• On multiple fronts
• Active decisions are problematic
• Psychological risk dimensions (e.g., voluntary
  risk) fail to elicit affective early warning
  signal that would trigger action
• Decisions from experience make risks seem small
• Important to design decision environment in
  helpful ways
• Liberal paternalism (Sunstein Thaler, 2003)
• Creative use of defaults (Benartzi Thaler,
  2004 Johnson Goldstein, 2003)

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Implications for Aiding Investment Decisions

• Three classes of decisions
• Class 1 Decision to save and how much
• Class 2 Choice between plan providers and
  investment vehicles
• Class 3 Decision to periodically examine and
  rebalance investment portfolio

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Class 1 Decision to save and how much

• Diagnosis 1
• Contemplating old-age and retirement and
  infirmity is aversive
• Aversiveness results in avoidance behavior
• Recommendation
• Use defaults that turn avoidance behavior
  (passivity) into a virtue (Benartzi Thaler,
  2004)
• Diagnosis 2
• Abstract representation of distant future
  consequences fails to arouse fear/concern/anxiety
• Recommendation
• Concretize consequences of possible decisions
• through simulation tools like the Distribution
  Builder (Goldstein, Johnson, Sharpe, 2005)

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The 1,776,000,000,000 question


?
Uncertainty
Covariances Interest Rates Inflation Rates
?
?

?
?
?
?
?
?

?

Cash
Probability Distribution Of Wealth
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Framework for experiencing risk-return tradeoffs
Income levels ( of pre-retirement income)
Cost
100 moveable people, one of which represents the
user (experienced frequency representation of
probability)
Typical level of retirement income (Perceived
loss point)
Minimum level
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Class 2 Choice between plan providers and/or
investment vehicles

• Diagnosis 1
• Naïve diversification can be problematic
• Recommendation
• Design categories such that 1/n heuristic will
  lead to desirable portfolio
• Diagnosis 2
• Too much choice can immobilize decision makers
• Recommendation
• Arrange information hierarchically

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Class 3 Decision to examine and rebalance
investment portfolio

• Diagnosis
• Such action will not be triggered by affective
  processing system
• Task is boring and inaction is not scary
• Recommendation
• Establish habit for periodic reevaluation
• Repetitive indoctrination of simple rule
• Like flossing and seat-belt usage
• Take away inaction as the status quo
• Legislation/fines or beneficial defaults

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So how to proceed?

• On multiple fronts
• education and experiential interactions that
  concretize and dramatize future consequences can
  help, but.
• Active decisions are problematic for multiple
  reasons
• Decision environment can be designed in helpful
  ways to make peoples heuristics and biases work
  for them, rather than against them

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