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What Behavioral Finance Teaches About Retirement Planning

Status quo bias suggest that once investors get set in their tolerance for risk and desire for control, they’re not likely to change.

New Year’s is a traditional time to make resolutions and set goals. As behavioral economists know, it is also prime time for hyperbolic discounting.

What is hyperbolic discounting? In daily life, it can be as simple as eating the ice cream that’s in front of you and promising to start that diet tomorrow — in other words, instant, rather than deferred, gratification. This type of behavior has implications for retirement investors. You’ll be hearing a lot more about hyperbolic discounting and other behavioral finance terms as the institutional investing world continues its massive transition to the defined contribution model.

Whereas investment strategy is built on the rational agent of classical economic theory, the success of DC plans relies to a great extent on the behavior of individual participants. The rational economic agent is a sophisticated decision maker, maximizing utility by mobilizing every penny and possessing the willpower to carry out precise long-range planning. By contrast, the financial literacy of the general population is fairly low. Many DC participants forgo the essentially free employer match and are perplexed by the permutations on the investment menu.

Behavioral finance integrates psychology with economic thinking. The savings and investing challenges of DC plans make an excellent laboratory for the practical application of behavioral finance concepts. For example, hyperbolic discounting can induce overconsumption today and undersaving for retirement. One solution is to establish a precommitment mechanism such as automatic enrollment of workers in a retirement plan and auto-escalation of their contributions each year until they are saving at an adequate level. Some workers may change their minds and abandon the precommitment. That’s time inconsistency in decision making. But the likelihood of a massive reversal is substantially reduced by other behavioral biases:

• People tend to sign up, forget about it, and let the program carry on. It’s the classic force of inertia — but in a positive way.

• Escalated contributions can coincide with pay raises, leaving take-home pay largely intact, and the savings increase may then have the illusion of appearing low-cost.

• As time elapses, investors will notice a growing pie of wealth, attributable to their own savings, the employer match and capital gains, giving them a sense of accomplishment.

When it comes to investment, the rational economic agent prefers more options to fully optimize and diversify. For the average investor, however, too many choices can produce information overload, taxing their cognitive resources and leading to indecision. Another reaction to complex investment menus is naive diversification — investing evenly in all available options.

Behavioral finance can help identify the most efficient combination of options and tier them according to participants’ financial sophistication and desire for involvement. Here’s a rundown:

Tier 1: Do it for me.All-in-one target-date funds, professionally constructed and managed, can be the default offering for these participants.

Tier 2: Help me do it. A handful of core funds, clearly categorized by their objectives, is an option for investors who prefer to be more involved in asset allocation decisions.

Tier 3: Do it myself. For those craving a greater degree of control, there is an array of specialist funds available. Another step further toward autonomy would be a self-directed brokerage plan.

Why is the menu so important? A phenomenon called status quo bias means that plan participants rarely change asset allocations once they are set. Over a 20- to 40-year investment horizon, the presentation of an investment menu can lead to diverging wealth levels, with lasting effect.

Behavioral finance emerged as a serious body of knowledge in the late 1970s and 1980s, at the same time that 401(k)s were created through changes to the U.S. tax code and Internal Revenue Service regulations. Although the two events were coincidental, it is no exaggeration to say that the increasing prevalence of DC plans helped vitalize the research in behavioral finance and served as a great outlet for its influence. Prior research was mainly through hypothetical questions, and the results could be easily discredited. What people say is often vastly different from what they do. The choices available in defined contribution plans and heterogeneous individual selections provided real-life observations and drove an explosion in behavioral finance. As DC plans continue to grow as the primary vehicles for retirement savings and investment, it could pay to learn more about hyperbolic discounting, naive diversification and their multisyllabic cousins.

Gaobo Pang is senior vice president and head of investor analytics, defined contribution solutions, at Northern Trust Asset Management in Chicago.

See Northern Trust Asset Management’s disclaimer.

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