Behavioural pitfalls can affect investors at all life stages, including when they are accumulating assets for retirement. Morningstar head of retirement research David Blanchett explains some of the key aspects of retirement planning that can be problematic from a behavioural perspective.
Hyperbolic Discounting
Hyperbolic discounting is the notion that people value consuming today much more than consuming tomorrow. They think of the future as some far-off place and so saving for retirement isn’t a high priority. If someone is thinking about saving for retirement, well that could be 30 years from now and that just seems a lot less real than going out and buying that new iPad today. And so the discount rates required to actually make people save can sometimes be relatively extreme.
This focus on the cost of saving and the rate of return you are required to earn decreases over time. The older you are, I think the better people become at realising, "Hey, I need to kind of save for retirement." So time preference becomes less of an issue over time.
Bounded Self-Control and Inertia
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 even though I shouldn’t. I know that I lack self-control. That same concept applies to people saving for retirement: they want to save for retirement, but they just don't; they know that it's the right thing to do, but they just can't bring themselves to do it.
This concept ties in with inertia. Inertia is the tendency of an object to resist any change in its motion. Once you've started not saving for retirement, you’re likely to stay not saving. But once you’ve entered a pension scheme, it's 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.
Excessive Loss Aversion
People, particularly those in retirement accumulation mode, tend to want to be quite loss-averse and position their portfolios more conservatively than they probably ought to be given their life stage. Loss aversion ties into risk aversion. People perceive and feel what just happened in the marketplace and they respond to that in their portfolio. 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 respond to investing based upon the current market. But even though you may have 20, 30 or 40 years to invest for retirement, having a good long-term plan is better than reacting to the market as it changes over time.
Performance-Chasing
People tend to want to look at a fund or stock that has performed really well and extrapolate that into the future and believe that it will continue. When someone is looking at a menu of investment options, perhaps in their company pension plan, 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. The best portfolio for most people is going to be a balanced portfolio. A balanced portfolio by definition never has the highest return; many of the investment options are part of a line-up. People often need to take a step back and recognise that 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. Thinking "If I bought this fund a year ago or five years ago, it would have performed better,” doesn’t help anyone.
Employer Stock
If you go back about 15 years about 5% of all company pension plans in the US had more than half of their assets in employer stock. Today it's less than 1%. In the past there were a lot of behavioural issues associated with why people purchase employer stock. One of the biggest is what was called the ‘endorsement effect’’ whereby companies matched employees’ pension contributions with company stock and the plan participant would assume that it must be a good investment because it came from their employer. Also, some companies have offered company stock at a discount to employees, which account for some of the large employer stock holdings we’ve seen in the past. Another reason was the herd mentality: people think, "Well, if everyone else is buying employer stock, I should."
From the employer’s point of view, it can be a good thing to have some buy-in from employees. From the employee’s point of view, having most of your company pension plan in employer stock is not a good investment for most people. Your salary likely accounts for the vast majority of your income so your finances are already closely tied to the future of the company, there’s no need to put more of your assets in the same company. I would say that an employee needs no more than 10% of their pension plan in company stock, on average, though there are lots of exceptions to the rule.
Saving Too Little
There has recently been a great uptick of auto-enrolment, of individuals being automatically invested in their company plans and their contributions being stepped up as their salary increases. This notion of automatic enrolment and progressive savings has done a great deal to help the average person because people like to go with the flow. I think the one mistake with respect to automatic enrolment is that the initial number—the percentage of salary invested—is too small.
There has actually been quite a bit of a research that shows there is very little drop off in plan participation if you move from a 3% default contribution rate to a 6% default. Obviously if the default was 20%, a lot of people might baulk at that, but there will be a sweet spot at which enough people will automatically pay into the plan. I don't know if that’s 6%, 8%, 10%, but it's definitely higher than 3%.*
*In the UK, the government’s auto-enrolment plan starts in phase 1 with a minimum contribution level of 2%, rising to 5% in 2017/18 and to 18% from October 2018 onwards. http://www.dwp.gov.uk/docs/auto-key-facts-enrolment-booklet.pdf
