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The Pitfall of Mental Accounting in Retirement

Christine Benz

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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Benz: Have you looked at structures that involve buckets, and do you find them to be helpful for people who are in retirement? So maybe they have that near-term liquidity bucket as well as the longer-term total-return portfolio?

Statman: Precisely. This is a different kind of bucket from creating portfolios, but it is a useful set of buckets. And so, when a financial advisor moves money from stocks and bonds into a money market fund and then designates it as income, then I can write checks on it if I'm retired and leave that, and it feels fine. It feels like I'm not violating any rule, and that can be extremely useful for people in helping them consume enough, but not too much.

Benz: Let's talk about another area that is often identified as kind of a behavioral pitfall for people in retirement, and that is a resistance to annuitize part of their portfolios. So there's obviously a lot of academic data that point to annuities being helpful to retirement portfolios and yet we see that retirees feel resistant about it. They don't want to part with that capital and send it to the insurance company. Why is that, and how should retirees think about that particular situation?

Statman: Well, I'm not in the camp that advocates annuities, not that they are bad for everybody, but they are not a panacea as they are presented. First of all, there are many people who have way more wealth than they need. It makes no sense for them to buy an annuity because they have enough contingent income. The equivalent of that is really, for me, to say insure my dishwasher. If it breaks down I'll replace it without any major trouble. And so for the rich, annuities make no sense. For the very poor they just don’t have the money to buy annuities. Moreover annuities kind of provide you particular income for life, perhaps even indexed to inflation. But what about health-care costs. What about nursing homes. What if you have those kinds of expenses?

Moreover people use houses, equity in houses, as being kind of a safety net, an extra safety net that they don’t really touch, they don’t really consider part of consumption. But they have it; if need be I'll use it. And if not then I'll leave it for the kids. So I'm not really thinking that there is much of a puzzle in not using annuities. Annuities are not nearly as good as they are presented, and they are not much of a solution for the real complicated issues of life.

Benz: That’s arguably especially true right now, given how low annuity payouts are due to the low-yield environment that we are in.

Statman: Annuities are priced fairly today. Interest rates are low, and so annuity payouts are going to be low relative to what you put in. There is nothing in it. Annuities are in fact a way to dip into capital because you take $1 million, say, and you convert it into income and now you can consume it. That’s one reason people don’t like it. And so you know there is really no big deal. I don’t really see this great push for annuities.

Remember, there are families. Parents still have responsibilities as they see it to grown-up kids. Grown-up kids have responsibilities to parents. They might resent it, but they’re not going to abandon their parents. In other words, what we’re talking about kind of a very abstract idea of two people saving during work life and then consuming it and dying with the last dollar and so on. That’s absurd.

Benz: Now I'd like to talk about market-induced behavioral pitfalls. A couple of years ago I think I might have said that excessive loss aversion was very much in play. We saw investors sending money to bonds and bond funds even though the stock market was doing very well. Now, I wonder if overconfidence is maybe the bigger behavioral pitfall because equities have been so good for so long.

Statman: I think that overconfidence does change over time, but more important, confidence varies by age and stage of life. To say, that we thought people are overconfident is really overreaching. Retired people are no longer in 2008. They might be in 2009. They’re still feeling pretty precarious, and whenever they feel just a bit overconfident comes another whammy, like the increase in interest rates that is now decimating bonds.

And so, I don’t really see overconfidence. I don’t really see exuberance. That I don’t think is the issue. There are real issues of helping people create portfolios that are going to sustain them in retirement. But I see the need to temper people’s emotions when they’re overconfident and to chill them up a bit and give them some more confidence when they think that the world is coming to an end.

Benz: I’d like to talk a little bit about the fact that we’re talking about an older population, people who are retired or getting ready to retire, and as people advance in years that's sometimes accompanied by diminished mental capacity. What’s the interplay, and obviously this is a big question, but what’s the interplay with behavioral pitfalls and diminishing mental capacity?

Statman: Well, diminishing mental capacity means that our judgments are not as good. One extreme case, unfortunately all too common is falling prey to con games. It is very easy when people are close to [their final years] or even a distance away from them for somebody to offer them something too good to be true and for older people to think that is indeed something good and true. And so, here is one element.

Another element is that all the people are more likely to be withered, are more likely to be alone, are more likely to have kids who live and away and cannot keep an eye on them. And that loneliness creates another temptation. And so when somebody comes with a friendly voice and suggests some ideas that seem to kind of make sense, that is way too tempting. And again this really is where family comes in. Older kids, grown-up kids, still have responsibilities to parents in, for one thing, helping them to resist those poor decisions that they are likely to make as they age and lose mental abilities.

Benz: Meir, thank you so much. It’s obviously a big and important topic. We really appreciate you being here to share your insights.

Statman: Thanks, Christine.

Benz: Thanks for watching. I’m Christine Benz for