Wednesday, April 4, 2012

The Plight of the Rational (Investor)

For those of you who may not know what rational choice theory is, the behavior of picking what is right for you when it comes to your retirement plan creates what many are seeing as the greatest hurdle. The leap between what is right and what is most cost-effective, is the result of how we compare one move to another. This thinking which gave rise to behavioral studies that made Daniel Kahneman famous has proven to be less reliable than economists previously thought.

Consider the annuity. There is no doubt in anyone's mind that the concept of a steady stream of reliable income in retirement is what we all want and stive for. Knowing what we can expect gives us the much needed push to place a single monthly amount as the focal point in our plans for a post-work life. From a rational point of view, knowing what we can live on should drive us to pick this sort of product over any other method. But this is where rational choice theory fails.

If you knew you could determine the amount of income a certain investment could provide the logical (rational) choice would be to gravitate towards that choice. But those that do buy annuities are not governed by that thinking. And those who don't choose annuities for even a portion of their retirement investments seem to be ignoring what would be considered the most rational choice.

Perhaps we should first look back on the way we used to think. There was a time when pensions dominated the landscape. This sort of plan, referred to as the defined benefit plan had its drawbacks: it wasn't portable (you couldn't take it with you if you decided to change jobs) and it was at its most beneficial in the last years of employment (essentially a trade-off for years of sweat equity which became capital equity at retirement). The introduction of plans such as the 401(k) or defined contribution plan changed that thinking giving workers greater mobility (you could take your contributions and any matching employer contributions with you when left provided you worked for a certain amount of time called the vesting period) and of course the much advertised ability to self-direct your investments according to who you are.

These pre-401(k) days also saw a focus amongst workers of paying down mortgage debt in order to gain home equity. While this is still a good idea, it has fallen out of favor over the last three-to-four years for what could be called obvious reasons. Economic troubles aside, we view the pension as prohibitive and full ownership of our homes as all but unattainable.

Three decades later, after numerous bull markets and more bear markets than we feel should have occurred, we are back to thinking that this pre-retirement knowledge of how much we will actually have at when we stop working is not such a bad idea. And while paying down your mortgage hasn't gained the same attention, our thinking about retirement income is gradually shifting.

This shift is based on knowing how much you will actually receive rather than continually trying to calculate how much you can withdraw. But does the annuity provide the best offset between worrying about drawing down your retirement savings too fast and potentially outliving your "nest egg" or learning to live within the confines of a set amount paid to you year-over-year. Some of the decision is based on the ability to adjust spending while you are working, usually with the adoption of a "spend what you make" thinking which upon retirement become a "spend what you can [afford]". Neither work well.

While we are working, our spending increases to meet our income. That option disappears once you are retired replaced by spending that adjusts to you ability to optimize your portfolio to meet the needs you might have. You have no way of knowing what those needs are when you are working and only a slightly better idea what they are once you retire.

According to a recent paper titled "Annuitization Puzzles" Schlomo Bernartzi, Alessandro Previtero and Richard H. Thaler, the the conceptually difficult question of how much is available to spend is answered with the annuitization of retirement savings. In other words, annuities take the calculations out of the mix. Studies have revealed a certain type of withdraw (or drawdown mentality) that many attribute to two basic ideas: fear of health costs and the wish to bequest. These 401(k) retirees focus not so much on how much they will need to spend but how much they will have left to spend should something happen medically and if that doesn't occur, how much they will leave to their estate once they are gone.

The paper makes it clear that conservative withdrawal rates at retirement are usually attributed to wealthier retirees and quicker drawdown rates that are mostly done by poorer retirees are not the problem: it is the calculation of how much is enough. The bequest motive, the authors point out is confusing considering most of those who focus on leaving money behind live on less to leave more for children who quite possibly don't need it and in more instances than not, are more affluent than their parents. Poorer retirees entertain the bequest motive as well but usually find that they need the money in greater quantities sooner than they anticipated.

Can annuities fix this "hard" calculation? Possibly but there are some psychological hurdles. One is the focus on retirement at 65. The less educated you are, the more you focus on this age even if you know that by waiting you will gain even more spendable income in retirement. But also ironically, the better educated retiree is more focused on leaving something to their heirs and in doing so, underspend.

While the choice of annuitizing is difficult, in part because our biases are so strong, the benefits of knowing should come to the forefront. Researchers suggest that if annuities were part of your retirement options in a 401(k), we would use them. Research has also pointed to the pivot point, when we retire and how the markets are doing at that point, as playing a role in the decision. If markets are robust, we don't buy annuities. When we feel less confident in the markets, we tend to purchase annuities.

Annuities do have cost hurdles with a great many people suggesting the fees and expenses as a reason to look the other way. Perhaps the best way to beat these biases is to plan with an annuity long before you make the decision to retire and having the choice inside your retirement plan at an early age could make your future plan more clear. It is no easy choice and it certainly shouldn't be your only choice, but for a portion of your retirement savings it could be the single easiest idea to take the worry out of retirement. Knowing also by default, focuses your savings as well.

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1 comment:

Finlandia Group said...

Retirement plan is a very important thing for some business man.Honestly i seen your blog very awesome thanks.