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By Christine Benz | 07-17-2013 11:00 AM

The Pitfall of Mental Accounting in Retirement

Professor Meir Statman advocates a structured, total-return approach to income so retirees can tap their portfolios responsibly, but he also says annuities aren't the panacea they seem to be.

Christine Benz: Hi, I'm Christine Benz for Morningstar. Retirement planning is ripe for behavioral pitfalls. Joining me to discuss that topic is Meir Statman. He's a professor of finance at Santa Clara University.

Meir, thank you so much for being here.

Meir Statman: Good to be with you.

Benz: Meir, I'd like to start by doing some stage-setting. Why is it that financial planning in the years leading up to retirement and during retirement is a time that's really ripe for these behavioral pitfalls?

Statman: Well, let me talk about people who are already in retirement or coming close to retirement. The emotion that is predominant in many of them is contentment. Lots of people have actually saved more than enough for retirement. They play with their grandkids. They pay into the college-savings plans of their grandkids. They feel good about it. They are still in good health. So a lot of people are doing really well.

The problem with it is that some people are doing very poorly. For some people this really is a time for fear. That is the predominant emotion, a feeling of pessimism, a feeling they will not have enough. And indeed, half the people have no sufficient wealth to buy an annuity that would pay you $5,000 a year for life. So people worry about health-care costs, about nursing homes, about inflation ruining their savings and so on. So what we have are kind of two populations with contentment on one side and great fear on the other. And we need to take care of the ones who really are afraid.

Benz: I want to follow-up with you on that in a second. But first I'd like to talk about one behavioral trap that I see a lot, which is where people do sort of this mental accounting. They've got their principal and then they want to try to live off the income that that principal kicks off. And they never want to invade the principal. And that especially as yields have gone down in recent years has led them into some very risky securities just because they happen to kick off the income that they need.

Statman: This is right. It is really ironic that self-control that helped them gain the kind of savings they have today is really hampering them now when they need to consume from their savings. So thinking in mental accounts is natural to us. Money that we get from the lottery is different from money that we earn at work. We distinguish capital from income. We have the rule that says, spend income, but don't dip into capital. And that is a wonderful rule for savings.

But when retirement comes, and you have to live on your portfolio, that's the time to dip into capital rather than try to generate income by getting into high-risk securities. So what is necessary is to create some alternatives to that. For example, a managed payout plan of the kind that several mutual fund companies have is a good idea because that pays you say 7%, some from interest and some from dividends and some from dipping into capital.

Financial advisors can be very helpful in creating a similar structure where they take so much, say 7%, from your portfolio and put it in a money market account that you can consume from. And 7% of course is one number, it can be 3% or 4%, or whatever is right. In other words, what is necessary is to create a structure, such that you can focus on the total return and then consume from it responsibly.

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