CNBC.com | Tuesday, 18 Mar 2014
If it would surprise you to learn that the choice between eating a banana or chocolate in a lab experiment has helped to redefine the way Americans save, then you’re behind on the latest thinking in “behavioral finance”—the study of how human psychology impacts investing and markets—and that could cost you on the road to a comfortable retirement.
To pioneers in the 401(k) test lab, like Shlomo Benartzi, UCLA professor and chief behavioral economist at Allianz Global Investors, the effort to outsmart our shortsighted, animal side—the one that tends to make irrational financial decisions, especially when it comes to retirement investing—has gotten off to a good start, but it remains a largely unfinished project.
The leading edge of experimentation with retirement messaging will have critical implications for savers over the next two decades, especially among less-affluent Americans.
“The needle is moving in the right direction,” Benartzi said. “We’ve been following measures adopted in the market, and there is good news, but we’re also concerned that there is bad news.”
Last week we discussed points 1 and 2. These were:
1. If you think you will sign up for a retirement plan online, think again.
2. Americans still don’t have a clue how painful it is to cash out of a 401(k).
This week we conclude with points 3, 4 and 5.
3. Blanket messaging based on fear and greed are risky …
There isn’t a study on the state of retirement in the U.S. released over the past decade that doesn’t include some version of the message that Americans aren’t saving enough and the implications are dire.
The impact of all these scare tactics? Not sufficient, said David Musto, CEO of J.P. Morgan Retirement Plan Services.
“We still have low participation rates in 401(k) plans, and the average income-deferral rates, while we’ve seen some improvement, is still around 6 percent,” he said. “Most would agree saving [at least] 10 percent would be better.”
When it comes to behavioral finance and decision-making, auto enrollment is just a start, and providing estimates of retirement-balance shortfalls fall far short of the mark in spurring participants to save more.
“One of the challenges of educating people is [that] the baseline message can be depressing,” said Don Hess, head of product development for J.P. Morgan Retirement Plan Services.
The company at one time relied more on blanket and fear-based messaging, telling employees how much they were on track to have in retirement and how much that left them to make up if they wanted to have a secure retirement—the gap was typically large. “That message worked horribly,” Musto said, because it shows the company doesn’t know their personal life situation. “Who could make up that amount?”
Hess agreed. “A simple question around what the participant will draw down in retirement will have an answer that is radically different, based on age and family history and Social Security and the tax basis of money in retirement.”
Now J.P. Morgan Retirement Services uses a less judgmental approach, focusing on the concept of “social norming” or, in plain English, showing your progress relative to your peers and, if they are on track to be successful savers, showing you how they got there.
“We don’t say, ‘This is what you need’; we say, ‘Here is what you are on track to achieve, and if you were to increase by 2 percent, that number would change to y,’” Musto said. “It’s not frightening them.”
4. … But fear and greed do still work as a motivator when tailored to the individual.
Nevertheless, if you personalize your message to certain age groups, fear and greed will indeed make an impact, Musto said. In other words, greed is a better message for the 20-year-old, and something closer to fear, if not fear exactly, is a better message for the 50-year old.
“For the 20-year-old … it is about what you could have if you participate,” Musto said. “It’s all about potential with a younger participant. But someone in their 50s, it is time to assess; they are ready at that point.”
5. Toward a unified theory of investing (i.e., investors still are not rational beings)
Even if all of this effort to get more workers to enroll in, contribute to and stay longer in 401(k) plans works, Ricciardi sees a big challenge in the concept that underlies long-term investing, known as Modern Portfolio Theory.
MPT, put most simply, is the idea that a diversified portfolio across investment asset classes reduces risk the best over the long term, but that’s not an approach that takes into account an individual’s risk tolerance, especially after the financial crisis.
Goucher College’s Ricciardi said his data shows that if someone was in stocks before the crisis and then shifted all of their money out of stocks, they remain traumatized.
“There is a high percentage of people who formerly had money in the market who now have nothing in stocks,” Ricciardi said. “It will take a long time to get those people to change their behavior. If you have a risk-averse person and try to push them into riskier assets, all you make them do is shift them to conservative assets.”
He added: “MPT is a good model to teach people the basics, but the underlying assumption is people are rational. If you help people understand their emotional baggage … that’s where it can work. Ultimately, I want to take from both behavioral finance and MPT and make a better overall theory of finance.”
Certified financial planner Tim Maurer, director of personal finance for the BAM Alliance, said his “personal” investing theology more and more is organized around one idea: Personal finance is more personal than it is finance.
“It’s hard not to marvel at studies that suggest as much as 80 percent of financial and estate-planning recommendations are not implemented,” Maurer said. “It’s either a tremendous failing on the part of the financial industry—or its clients—or both. My hypothesis regarding the foremost factors playing into the 80 percent conundrum is that financial-planning recommendations aren’t aligned enough with the highly individualized values and goals of clients.”
To Your Successful Retirement!
Michael Ginsberg, JD, CFP®