Traps in Building Wealth for Retirement

Christine Benz: Hi, I am Christine Benz for Morningstar.com. Behavioral pitfalls can affect investors at all life stages, including when they are accumulating assets for retirement. Joining me to discuss some of the key ones is David Blanchett. He is head of retirement research for Morningstar.

David, thank you so much for being here.

David Blanchett: Thanks for having me.

Benz: David, you've provided a list of some of the key aspects of retirement planning that can be problematic from a behavioral perspective. Let's start with a couple of them. One is called hyperbolic discounting. Let's talk about what that means and how that affects retirement planning.

Blanchett: Well, hyperbolic discounting is this notion that people value kind of consuming today much more than tomorrow. They kind of think of the future is some far-off place, and so it doesn't work for them to kind to save for retirement. They have this kind of incredibly high discount rate. So, someone who is thinking about saving for retirement, well, that's 30 years from now, and that just seems a lot less real than going out and buying that new iPad today. And so the kind of the discount rates required to actually make people save sometimes can be relatively extreme.

Benz: Do you find that this is a bigger problem for people who are earlier in the accumulation phase and people maybe who are getting closer to retirement, or is it across the board a problem?

Blanchett: I think this focus on the cost of saving and kind of the rate of return you are required to earn kind of decreases over time. I mean, think of it as trying to talk a 10-year-old out of buying a truck with some new money that just came in to you. Now, kind of the older you are, I think the better people become at realizing, "Hey, I need to kind of save for retirement." And so, I think things like time preference just kind of do become less of an issue over time.

Benz: You've provided a couple of other terms that fall under this heading of problematic areas for accumulators. One is, something you call bounded self-control; the other is called inertia. Let's talk about how those two issues affect people when they are in the accumulation mode?

Blanchett: Sure. I'm a great example of bounded self-control. If someone were to buy me a piece of chocolate cake and put it in front of me, I'd probably eat it for dessert. And so I know that I kind of lack self-control, and so I don't order a chocolate cake for desert. And that same kind of concept applies to people saving for retirement. People want to save for retirement, but they just don't. I mean they know that it's the right thing to do, but they just can't bring themselves to do.

And that kind of ties into inertia. Inertia is the concept you know an object in motion can stay in motion. And so once you've kind of started not saving for retirement, so once you kind of entered the 401(k) plan or you chose not to and you are getting this paycheck, it's kind of easier to stay on that course than make a change. And this is why I think it's so important to make smart decisions early, so you get used to doing the right thing that comes to saving for retirement.

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Benz: In terms of the complexion of the portfolio, there are obviously a lot of behavioral wrinkles, as well. One thing that you wanted to talk about, and academic researchers have certainly observed, is excessive loss aversion, and this certainly applies to people who are in retirement accumulation mode. Let's talk about that problem, why people do tend to want to be quite loss-averse and position their portfolios more conservatively than they probably ought to be given their life stage?

Blanchett: I think loss aversion ties into risk aversion. People kind of perceive and feel what just happened in the marketplace and they kind of respond to that in their portfolio. So, we saw back in the late 1990s for example, that the average equity allocation of individuals increased because the markets were doing well. They went back down when the technology bubble crashed in early 2000s. They went back up when the markets recovered. They went back down again after 2008. People kind of respond to investing based upon the current market. But the problem with that even though you have maybe 20 or 30 or 40 years to invest for retirement, having kind of a good long-term plan is better than reacting to the market as it changes over time.

Benz: Right. How do you think past performance factors into all of this, and how can that be a behavioral trap? I know I see it in my work that people tend to want to look at a fund or stock that has performed really well and sort of extrapolate that into the future and believe that will keep going on. Why is that problematic for people who are trying to accumulate assets for retirement?

Blanchett: Well, I think it's very problematic because people like to chase performance. If they are looking at a menu of investment options perhaps in their 401(k) plans, they may pick the one with the highest performance. And the problem with that is the things that have done well don't always keep doing well. And so the best portfolio for most people is going to be a balanced portfolio. Well, balanced portfolio by definition never has the highest return. Many of the investment options are part of a lineup. And so I think that people need to just kind of take a step back and recognize that it's great to kind of think about, "Hey, if I bought this fund a year ago or five years ago, it would have gotten this performance." It's a lot easier to identify funds that have done well in the past than pick those that may do well in the future.

Benz: Right. One related topic is employer stock, and that I think when you look at the data, people tend to want to buy their employer stock after it's already gone up a whole bunch. First of all, let's talk about why people in general beyond performance tend to accumulate a lot more than they should in their employer's stock?

Blanchett: Well, I think with employer stock, the first piece is that there is good news out there. If you go back about 15 years about 5% of all 401(k) plans had more than a half of the 401(k) in employer stock. Today it's less than 1%. And we've seen a lot of 401(k) plan sponsors kind of actively push participants out of the company stock because in the past there were a lot of behavioral issues associated with why people purchase employer stock in the 401(k) plan. One of the biggest is what was called the endorsement effect. A lot of companies will have the employer match with the 401(k) plan in company stock. And so, if you're getting company stock as some match, [people might think], "Hey, it's my company giving me money via the match in employer stock; it must be a good investment."

There are also things like including a discount to employees; you can buy [the stock] at a cheaper-than-market price.

And you also see a lot of kind of groupthink and people think, "Well, if everyone else is buying employer stock, I should." And so the focus kind of becomes for employers today, it can be a good thing to have some buy-in from employees but having most of your 401(k) plan in employer stock is not a good investment for most people.

Benz: What do you typically say is the upper limit on what someone would want to hold in their employer stock?

Blanchett: I would say no more than 10% on average. There are lots of exceptions to the rule, though. I mean there is this thing called a net unrealized depreciation that makes it kind of advantageous from a tax perspective; you kind of roll out employer stock from 401(k) plan when you retire. But for most people it should not be a significant investment as part of kind of overall financial capital.

Benz: David, I want to talk to you about some of the steps forward that retirement plans have attempted to make to circumvent some of these behavioral missteps that investors often make. There has recently been a great uptick of auto enrollment, auto investing, people in the first place getting them into the plans and then stepping up their contributions as they get raises. What’s your take on that general movement toward auto everything in retirement planning? And also do you see any pitfalls to this trend toward auto investment?

Blanchett: I think that this notion of automatic enrollment and progressive savings has done a great amount of help for the average person because people like to go with the flow. And if you think back to how enrolled in 401(k) planed works before the pension protection after 2006, you had to actively choose to be in the 401(k) plan, while today if you decide to be in the 401(k) plan, a lot of 401(k) plans, maybe most 401(k) plans, have a thing called automatic enrollment. And the good thing with automatic enrollment is it kind of automatically assumes you are going to join the plan. I think the one kind of misstep a lot of employment-plan sponsors have made with respect to automatic enrollment is they took a number too small.

A lot of plans that first introduced automatic enrollment used 3% as the default. So, if you didn't elect an enrollment percentage, and they claim to be automatic enrolled at 3%, well 3% is way too low of a savings rate. So, I think we have seen employers kind of wake up to this and are now introducing defaults that are smarter based upon what’s best for employees. So, you've seen 6% as a very common kind of default in the 401(k) plan, and [the plans] progressed the savings where the actual default baseline deferral increases by 1% every year after the enrollment plan.

Benz: I suppose the risk is that as you nudge that number up from say 3%-6%, do you people start to take notice and say, "Hey, that’s taking a big bite out of my paycheck. I don't want that at all." And do you risk potentially having participants back out of the plan altogether?

Blanchett: I think that’s the exact problem that a lot of plan sponsors are wrestling with. So, there has actually been quite a bit of a research that shows there is very little drop off if you move from a 3% default to a 6% default. Now I mean obviously, if the default is 20%, a lot of people might say, "Wait a minute." And so I think that there is a sweet spot out there that will get enough folks to default in the plan at some amount. I don't know if that’s 6%, 8%, 10%, but it's definitely higher than 3%.

Benz: David, thank you so much for being here to share your insights. This is obviously a huge and important topic. It's of a lot of interest to many accumulators. Thank you so much for being here.

Blanchett: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.