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Commentary

Navigating Blind Spots on the Road to Retirement

The investment industry needs to offer services that align with how people make decisions.

The path to retirement can be long and arduous, and despite the best of intentions, the investment industry itself often impedes individual investors' progress. Complex products that even experienced professionals struggle to understand, savings plans with unappealing names like "salary reduction plan," and options so numerous as to overwhelm even the most determined investor--these well-intentioned efforts on the part of financial professionals can often backfire in the hands of the consumer. Add to this the natural cognitive processes in the human mind that work against long-term planning, and we have a recipe for saving too little and misallocating funds.

Behavioral science and consumer psychology have revealed many areas where our financial products and services might be misaligned with our natural decision-making processes, but is there a bright side? How can insights from behavioral science help the industry to assist people in reaching their retirement goals? Here, we will look at three behavioral blind spots that threaten retirement goals and ways that investors and their advisors can work around them.

1. Shortcuts That Make the Journey Longer
On any long course or process, we can be tempted to take shortcuts. This is especially true when it comes to the mental process of decision-making. Our brains have evolved to find patterns and glean from them simple rules of thumb, making the act of choosing more efficient and less costly in terms of both time and mental energy. This cognitive function, while adaptive in situations where survival depends on quick thinking and accurate gut instincts, is maladaptive in situations where careful thought and planning are needed. A quick judgment about a stranger's trustworthiness may save your life. Investments based on gut instincts can lead to ruin.

When it comes to the decisions involved in retirement planning, mental shortcuts appear time and again in empirical studies. These shortcuts (called heuristics in the academic literature) make the decision-making process easier, but they often come at the cost of financial security.

Enrollment Shortcuts
The fastest way to end the decision-making process is to simply abandon it. The number-one factor that leads to decision avoidance is not a lack of information but too much (Anderson, 2003). In an age that affords us access to mountains of free data at any time, we are simultaneously more equipped to make better decisions and less likely to do so. The fact is that we are simply overwhelmed by the information available to us. We cannot digest it all, so we fear making the wrong decision out of ignorance. Fear of choosing wrong often leads to avoiding the choice altogether.

Decision avoidance (also known as choice paralysis) plays out in retirement planning in terms of enrollment rates and asset-allocation strategies. When too many funds are presented to choose from, enrollment levels drop (Iyengar et al., 2004). This means that the well-intentioned act of offering a large selection of funds works against people by overwhelming their decision-making ability, leading to undersaving.

What to Do About It: Auto-enrollment programs have been very successful at improving the number of people taking advantage of retirement savings plans, especially among the lower-income group. Still, many employers have not adopted these programs. Additionally, enrollment itself is not enough to ensure adequate savings, and some experts have raised concerns that auto-enrollment may lead to a false sense of retirement security among the financially illiterate.

Decision aids such as star ratings have been shown to improve not only enrollment rates, but also the overall satisfaction that people feel about the choices they make for their portfolio (Morrin, Broniarczyk, and Inman, 2012). Comparison charts that are based on key attributes of each fund can also help to make the decision-making process feel easier (Broniarczyk and Griffin, 2014), reducing the likelihood of decision avoidance.

Contribution Shortcuts
For those who do enroll in retirement plans, shortcuts are the rule when deciding how much to contribute. One way we see this is through the fact that people tend to contribute percentages that are multiples of five (5%, 10%, 15%, etc.). Another shortcut is to simply contribute the minimum required to receive one's full company match. These shortcuts are less damaging than avoiding enrollment altogether, but they can still have perilous effects on one's future financial health. For example, enrolling at 5% to ensure a company match is not likely to secure a comfortable retirement, but without putting in the effort to make a true calculation of need, people may feel a false sense of security and preparedness.

What to Do About It: Behavioral scientists have suggested that companies may be able to help their employees increase contribution rates by working with these shortcuts rather than against them. For example, if an employer offered up to 10% of total income at 50% rather than up to 5% of total income at 100%, they could potentially nudge greater savings rates without increasing their out-of-pocket costs (Bernartzi and Thaler, 2007).

Encouraging clients to enroll in auto-increase and save-more-later programs can also improve savings rates (Bernartzi and Thaler, 2007). Auto-increases allow clients to commit to future savings without feeling the pain today. Save-more-later programs take advantage of pay increases to eliminate the feelings of loss that can accompany saving. Because increases in savings coincide with increases in pay, the client never experiences a drop in cash flow, avoiding an emotional cost.

Allocation Shortcuts
Once investors have created a retirement-savings account and determined a contribution amount, they must decide how to allocate their money. When asked how he allocated his own retirement assets, Nobel laureate Harry Markowitz, one of the fathers of modern portfolio theory, famously said, "I should have...drawn an efficient frontier. Instead, ...I split my contributions 50/50 between bonds and equities." (Pompian, 2006)

In general, researchers have observed that when several funds are available, people will tend to allocate their assets equally across the options. This is known as the 1/n heuristic. However, when many funds are offered, the 1/n heuristic breaks down and people move toward investment in money market accounts and bonds. Again, the impact of having too many options to choose from leads to a failure of judgment and a misallocation of resources (Bernartzi and Thaler, 2007).

What to Do About It: Informed rules of thumb can be very useful in asset allocation decisions. The "100 minus your age = % to keep in equities" rule is an easy-to-understand heuristic that is handy. Target-date funds also offer a lot of hope in this area. In one study, the presence of a target-date fund reduced the amount of decision avoidance by making the choice feel easier (Broniarczyk and Griffin, 2014).

Again, advisors can offer clients help by reducing the amount of information that is presented. By digesting the data for them and offering simple, smart heuristics that are easy to understand but grounded in sound principles, advisors can present clients with just enough information to make an informed asset-allocation choice without overwhelming their decision-making capacity.

2. Discounting the Future
The longer we have to wait for something, the less value we tend to place on it, and this discounting has profoundly detrimental effects on retirement planning. At present, more than 20 equations are in circulation in various literatures to describe the exact shape of the discounting curve (Doyle, 2013). However, most empirical studies on time preference support the hypothesis that temporal discounting follows a hyperbolic (Mazur, 1987), or quasi-hyperbolic (Laibson, 1997) pattern.

Shortening Psychological Distance
Discounting the future happens because of what psychologists call psychological distance. Physical distance measures how far away something is in space. Psychological distance refers to how far away something seems in our minds, and this depends on our subjective mental picture of the situation (Trope, Liberman and Wakslak, 2007). Discounting interferes with retirement planning because the years in between today and retirement cause us to mentally discount the importance of our future needs. The steeper people's discount curves, the more dramatically they will discount their own future needs, and the less likely they are to adequately save.

What to Do About It: We can reduce our discounting rate and promote more-patient, future-oriented financial decisions by working with the principles of psychological distance. When something is psychologically distant, we tend to think of it in broad, abstract terms. When it is psychologically close, we see it in fine detail, focusing on the concrete rather than the abstract. Psychologists refer to this as the construal level. High-level construal is an abstract mental representation of an event; low level construal is a concrete, detail-oriented view.

The connection between psychological distance and construal level is so strongly established in our minds that researchers often use construal level to impose or shrink psychological distance in laboratory studies. For example, by asking research subjects to think about an event in fine detail (low-level construal), they can make that event feel psychologically closer. Some encouraging work has already been done in this area to encourage retirement savings.

Improving Future-Self Continuity
By picturing your future self in fine detail, you can make that future feel more real, more likely, and more important. That sense of importance reduces or counters the tendency to discount the future, leading to more future-oriented financial decisions. One famous study illustrating this phenomenon had college students interact with an age-progressed avatar of themselves, and the vivid image of their future self significantly reduced their discount rate (Hershfield et al., 2011). Several financial institutions have already developed tools to use this phenomenon to encourage greater retirement savings. For example, Merrill Edge has a free age-progression tool on its Face Retirement website based on this work.

Visualization and Mental Contrasting
Similar to the future-self continuity phenomenon, picturing one's retirement in fine detail can have a powerful effect on savings goal attainment. TD Bank recently conducted a study showing that people who use pictures and visualization techniques were more satisfied and confident in their ability to budget and reach their goals than those who did not (TD Bank News, 2016). People who imagine life in retirement are much more likely to save than those who do not (Farkas, Johnson, and Kernan-Schloss, 1994).

Asking clients to picture a happy retirement may not be enough to help them reach their goals, however. Gabriele Oettingen studies self-regulation, goal-setting, and goal disengagement at NYU's Motivation Lab. Oettingen developed a method of visualization called mental contrasting in which people picture their future goals and then identify an obstacle in the present moment that they feel confident they can overcome (Oettingen, 2014). Oettingen found that this technique is superior to positive visualization alone, but she warns that it is not for everyone. Mental contrasting is only beneficial when a person is confident that they can overcome the obstacle in their way. If their belief in their own success is low, it can have a negative effect. So, if investors have trouble believing in their own chances of reaching retirement, positive visualization can help. If, on the other hand, they believe they can overcome their personal obstacles, mental contrasting can give them a boost toward achieving their goals.

3. Knowing What We Don't Know
Few people will admit that they have very little knowledge of basic investment concepts. But studies of financial literacy show a shockingly low level of knowledge among U.S. adults. Contrast this dearth of knowledge with the complexity of most financial products, and it is not hard to understand why so many people feel overwhelmed by information to the point of choice paralysis.

What to Do About It
Advisors and asset managers can help clients by recognizing that the U.S. population is largely financially illiterate. At the same time, we need to keep in mind that people are extremely hesitant to admit to any financial difficulty. As Brad Klontz said in a recent article in The Atlantic, "You are more likely to hear from your buddy that he is on Viagra than that he has credit card problems." We need to address the issue of financial illiteracy, and the resulting financial insecurity it engenders, with respect and tact (Gabler, 2016).

Advisors are in a unique position to overcome these obstacles by using two types of financial education that have shown great signs of effectiveness in empirical studies.

Just-In-Time Financial Education
Research has revealed very positive effects of financial education efforts that teach principles of finance at the precise time in life when that knowledge is needed (Fernandez, Lynch and Netemeyer, 2014). People who are planning to buy a home in the near future are more likely to learn and retain information about loan options than their peers who are not buying a home, for example.

The trouble with a just-in-time approach is that educators often have no way of knowing when a person will be facing a specific financial milestone, so the task of connecting teacher and student is left to the uninformed consumer who has no way of knowing where to find the most reliable information.

Advisors, however, are positioned to ascertain when their clients will need to learn specific financial concepts. By anticipating the major life events and financial decisions their clients will be facing, advisors have the opportunity to employ just-in-time financial education very effectively.

Rules of Thumb
A second area of financial education that shows real promise is an instruction method that rejects complex and detailed concepts in favor of simple rules of thumb. (Drexler, Fischer and Schoar, 2014).

With this in mind, advisors can help clients to gain critical financial knowledge by recognizing the time when that knowledge is needed and presenting the concepts in the simplest terms possible, taking care not to be demeaning or "dumb it down" to the point of insult.

Our lack of financial knowledge is not a lack of intelligence. It is far more likely that no one has explained the basics of investment (risk, diversification, interest rates, and the like) to the client in a way that makes sense. Advisors can be that missing link for clients by helping them to learn about their money as they work alongside clients as partners working for a common goal.

References
Anderson, C.J. 2003. "The Psychology of Doing Nothing: Forms of Decision Avoidance Result From Reason and Emotion." Psychological Bulletin, Vol. 129, P. 139–167.

Bernartzi, Shlomo, and Thaler, Richard 2007. "Heuristics and Biases in Retirement Savings Behavior." Journal of Economic Perspectives, Vol. 21 (3), P. 81–104.

Broniarczyk, S.M., and Griffin, J.G. 2014. "Decision Difficulty in the Age of Consumer Empowerment." Journal of Consumer Psychology, Vol. 24 (4), P. 608–625.

Doyle, J. 2013. "Survey of Time Preference, Delay Discounting Models." Judgment and Decision Making, Vol. 8 (2), P. 116–135.

Drexler, A., Fischer, G., and Schoar, A. 2014. "Keeping it Simple: Financial Literacy and Rules of Thumb." American Economic Journal: Applied Economics, Vol. 6 (2), P. 1–31.

Farkas, S., Johnson, J., and Kernan-Schloss, A. 1994. "Promises to Keep: How Leaders and the Public Respond to Saving and Retirement." (New York: Public Agenda, in collaboration with the Employee Benefit Research Institute).

Fernandez, D., Lynch, J., and Netemeyer, R. 2014. "Financial Literacy, Financial Education and Downstream Financial Behaviors." Management Science, Vol. 60 (8), P. 1861–1883.

Gabler, Neal 2016. "The Secret Shame of Middle-Class Americans," The Atlantic, May.

Hershfield, H., Goldstein, D., Sharpe, W., Fox, J., Yeykelis, L., Carstensen, L., and Bailenson, J. 2011. "Increasing Saving Behavior Through Age-Progressed Renderings of the Future Self." Journal of Marketing Research, Vol. XLVIII, P. S23–S37.

Iyengar, Sheena S., Huberman G., and Jiang W. 2004. "How Much Choice Is Too Much: Determinants of Individual Contributions in 401K Retirement Plans." Pension Design and Structure: New Lessons from Behavioral Finance, ed. O. S. Mitchell and S. Utkus, P. 83–95. Oxford: Oxford University Press.

Laibson, D. 1997. "Golden Eggs and Hyperbolic Discounting." Quarterly Journal of Economics, Vol. 112 (2), P. 443–477.

Mazur, J.E. 1987. "An Adjusting Procedure for Studying Delayed Reinforcement." Quantitative Analysis of Behavior: The Effect of Delay and of Intervening Events on Reinforcement Value, Vol. 5, P. 55–73.

Morrin, M., Broniarczyk, S.M., and Inman, J. 2012. "Plan Format and Participation in 401(k) Plans: The Moderating Role of Investor Knowledge." Journal of Public Policy & Marketing, Vol. 31 (2), P. 254–268.

Oettingen, G. 2014. Rethinking Positive Thinking: Inside the New Science of Motivation. (New York: Penguin Random House).

Pompian, M. 2006. Behavioral Finance and Wealth Management—How to Build Optimal Portfolios That Account for Investor Biases. (John Wiley & Sons, Inc.) T.D. Bank News 2016. "Visualizing Goals Influences Financial Health and Happiness, Study Finds." (Press Release: https://mediaroom.tdbank.com/pictureperfect).

Trope, Y., Liberman, N., and Wakslak, C. 2007. "Construal Levels and Psychological Distance: Effects on Representation, Prediction, Evaluation, and Behavior." Journal of Consumer Psychology, Vol. 17 (2), P. 83–95.

This article originally appeared in the June/July 2016 issue of Morningstar magazine. To subscribe, please call 1-800-384-4000.