Psychological Impediments to Retirement Planning

Elke U. Weber

Center for the Decision Sciences Columbia University

Dartmouth College Financial Education WorkshopOctober 2005

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

Preview

• Why aren’t 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

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)

Motivational impediments to Retirement Planning

• Affect is the wellspring of action– Emotions are evolution’s 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

• 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

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)

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

(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

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)

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 people’s use of probabilities falls short

• Decisions from statistical description often deviate from decisions from personal experience (Hertwig, Barron, Weber, & Erev, 2004, 2005)

• 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)

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 one’s 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

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)

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

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)

Stocks

Bonds

%

%

%

Probability Distribution Of Wealth

Covariances

Interest Rates

Inflation Rates

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The $1,776,000,000,000 question

Cash

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Uncertainty

Minimum level

Typical level of retirement income(Perceived loss point)

Income levels (% of pre-retirement income)

100 moveable people, one of which represents the user(experienced frequency representation of probability)

Cost

Framework for experiencing risk-return tradeoffs

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

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

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 people’s heuristics and biases work for them, rather than against them

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Review of Financial Studies, VII, 45-60.• Epstein, S. (1994). Integration of the cognitive and the psychodynamic unconscious. American Psychologist, 49, 709-724.• Fischhoff, B., Slovic, P., Lichtenstein, S., Read, S., & Combs, B. (1978). How safe is safe enough? A psychometric study of

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