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MAKING CENTS OUT OF THE NEWS
Blog #22
(June 10th, 2010)
The Risk or No Deal Retirement Game
By Tom McAllister, CFP®
When I lecture on cruise ships, the third talk of the series is called Seven Mistakes Retirees Make. I can usually count on this lecture being very well attended. I can also usually count on investors, during the time right before and immediately following their retirement, making the very mistakes that form the material for my lecture!
In the critical months leading up to and immediately following retirement, people often make decisions with their emotions that they ought to be making with their heads. This is particularly true when it comes to perceived investment risk. Fearful during this transitional period in their lives, many avoid keeping a meaningful portion of their dollars in the stock market. In seeking refuge from risk by focusing on fixed dollar investments in the period leading up to and immediately following their retirement, many ignore the biggest “risk” of all – their own longevity. Concerned with the “right now”, they refuse to contemplate what might happen if they live another thirty years and need to deal with the inflated costs of food, shelter, and (even more sobering) – healthcare. Imagine trying to spend 1986 dollars on health care today – that’s the equivalent of this dangerous mindset on the part of today’s retirees.
The emerging field called Behavioral Finance studies this sort of counterproductive retirement planning behavior. Insurance company Allianz has created a report related to this topic, discussing why investors make certain decisions about annuities that might not always be in their own best interests. Allianz, importantly, comments on how the cycle of poor risk choices on the part of retirees might be changed.
One interesting observation made in the Allianz report is that retiree aversion to risk is often greatly amplified, even exaggerated. Using a comparison with casino gambling, where gamblers might risk a $3 loss in order to have the chance to make a $6 gain, retirees are nowhere near making such a choice. In fact, nearly half the respondents said that they would refuse a gamble in which they had a 50% chance of winning $100 and a 50% chance of losing even $10.!
On the popular game show, Deal Or No Deal, contestants make decisions that can result in great winnings – or result in their losing prize money won in earlier rounds. Investors’ point-of- retirement planning decisions, by contrast, can have life-altering results, as risk aversion affects what they choose to do with their money. For example, faced with the choice of taking a lump sum distribution of pension money or annuitizing, Allianz found, many chose the lump sum because” handing over” the money to an insurance company seemed like “losing” it.!
Investors often think in terms of nominal dollars, as opposed to “real” dollars. Professor Jeffrey Brown of the University of Illinois found that an investment might be spurned by retirees when framed one way, but might well be embraced when it is framed another way. He took a hypothetical $100,000 savings account paying 4% interest and asked 1,300 people older than 50 if they preferred that to a life annuity paying $650 a month. (The two choices actually had an identical actuarial value.) Only 21% liked the proposal when it was positioned as an investment, while 70% preferred it when it was positioned as a monthly income stream. The notion of “investing” carried the connotation of risk.
Investor behavior has come under greater scrutiny following the financial crisis of the past two years. People tend to take a “rear-view mirror view” in the choices they make, the Allianz report concludes.
UCLA professor Alessandro Previtero finds a correlation between poor stock market returns and retirees’ choice in favor of annuitization. “After a negative trend in the stock market, individuals are more likely to take an annuity. After a positive time, they are more likely to take the lump sum.”
People make long-term binding financial decisions based on the last six months of the stock market, an unfortunate effect I have noticed hundreds of times in my forty-eight year career advising investors. I realize that the behavioral finance element of financial advisors’ work has become more and more important as investors become more and more responsible for their own decision-making relative to their 401k and other retirement accounts. One very clear and present danger is that investors will shun the stock market in favor of “riskless” and “low-risk” investment choices that in fact carry the greatest retirement risks of all.
The Allianz report includes a checklist of questions for use advisors to discuss with clients, to help ensure that the implications of today’s financial decisions are presented in such a way that employees and new retirees can see how their lives will be affected. The report touches upon the problem of cognitive impairment as people age, with a special regard for impaired math skills in people’s later years. ( I see signs of impairment more and more frequently as I, along with my clients, age!)
Unlike TV game show contestants, today’s retirees are not given the choice of “Deal or No Deal.” The realities of increased longevity, future price inflation, and market volatility are factors with which every retiree, however unwilling, must deal. Rear view mirror investing is the real “No Deal” deal!
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