Behavioural finance and its impact on retirement outcomes

By Andrew Rumbelow, Segment Head, Institutional  Business

May 2015

Behavioural finance is a new area of financial research that explores the psychological factors affecting investment decisions.
The fundamental basis of behavioural finance is that investors are not rational, they are prone to cognitive and behavioural biases. These psychological factors affect investment decisions, distorting information and causing investors to reach incorrect conclusions even if the information is correct. Whether we are active members, pension fund trustees or asset consultants, we are all prone to the same biases and decision-making foibles, says Andrew Rumbelow, Segment Head: Institutional Business at Sanlam Investments.

“Being aware of our behavioural quirks and the ways we can let emotions irrationally influence our behaviour can help us make better decisions, and limit the probability of engaging in destructive behaviours.”

A deeper understanding of behavioural finance is therefore key to addressing savings inefficiencies in modern economies, and how this impacts retirement outcomes.

Retirement overconfidence
According to Michael Falk of Focus Consulting, saving does not come naturally to us – spending does. As humans, we’re just not wired to save. Add to this the considerable demands placed on our income and saving becomes virtually impossible for many. Compounding this is that financial literacy is tremendously lacking and as research suggests, is not as easy to improve as one might think.

“Saving does not come naturally to us – spending does.”

Overconfidence is a common behavioural bias that can lead to higher portfolio turnover and lower returns. Sadly, most people suffer from over-confidence (95% of all people believe they are above-average drivers) and investors are no different. Findings by the Employee Benefit Research Institute (EBRI) 2014 Retirement Confidence Survey provide interesting insights on global retirement market trends, and shows that people all have the same decision shortcomings the world over. When they ask people, “Do you think you’re going to have enough money for retirement?” worker confidence is as high as 51%. So, roughly half of the people interviewed were confident. Of the 51 percent, 13 percent of those were very confident.

In examining their behaviour, 16% of them weren’t saving at all, which is fascinating. Despite the fact that they were not saving a cent, they were very confident they were going to have enough money for retirement. This often relates to financial literacy: what is it going to take for me to retire comfortably? How much will I need?

It seems that a lot of this confidence was based on the blind assumption that somebody else would take care of them, which is disconcerting. Michael Falk refers to this as the ‘rich uncle approach’ to retirement planning.

“The fact that people think someone else is going to take care of them means they’re not preparing and planning ahead. And that’s the behavioural reality.”

This is the foundation of EBRI’s current research, and highlights the inverse relation between an individual’s ability to earn money over time, and their actual savings at retirement:

How will the default savings debate help?
The retirement landscape has changed significantly over the past three decades, with the most dramatic change being the shift from defined benefit (DB) plans to defined contribution (DC) plans as the primary workplace retirement offering. The shift from defined benefit to defined contribution retirement funding mechanisms is a dominant global trend that is here to stay. The problem, though, is this shift has resulted in a dramatic increase in individual self-responsibility with regard to saving adequately for retirement and to investing appropriately. And it isn’t working as well as it should because people just aren’t saving enough, for the reasons outlined earlier.

This has contributed to a feeling of growing insecurity amongst individuals about their retirement. To address this pervasive insecurity regarding retirement, financial services firms globally are developing new retirement products, and here in South Africa, we’re no different. As we know, Treasury have recently introduced tax-free savings accounts and are looking to develop default preservation products in the near future.

“Because of the massive disconnect between rational and normal behaviour in humans, resulting in retirement overconfidence and other poor savings habits, Falk emphasized the importance of introducing ‘default savings’ products.”

Simply put, this is the automatic enrolment in investments and savings products, setting members up to win.

Default savings products can help overcome:

• Status quo bias (inertia; people tend to be biased towards doing nothing or maintaining their most recent decision)
• Hyperbolic discounting (this refers to the tendency for people to choose a smaller-but-sooner reward over a larger-but-later reward)
• Self-control bias (resisting the impulse to spend).

“Financial decision-making,” says behaviourist Daniel Kahneman, “is not necessarily about money. It’s also about intangible motives like avoiding regret or achieving pride.”

Emotion often overrules intelligence in decisions and can filter facts, where the investor may give too much weight to facts that
are agreeable and may tend to ignore facts that are disagreeable.
This highlights the enormous influence that behavioural finance has on investment decisions and savings behaviours.

There is often a lot of self-delusion that goes on when investors evaluate performance … which is why fund managers have disciplined processes (such as investment committees) in place to help reduce errors in investment decisions, and why investors have financial advisors to guide their decisions!

This is the beauty of having a professional fund manager manage your pension fund or retirement portfolio for you.

As trustees, how do we overcome learnt biases?
Trustees of retirement funds have a significant fiduciary responsibility for the large number of active members depending on them for their decisions, and ensuring there is adequate provision for their financial security into retirement. They could help communicate concepts such as behavioural finance to their members, and also put in place processes for themselves, to mitigate their own susceptibility to these biases.

Together with their asset consultants, trustees should force themselves to go through a disciplined process of research and scrutiny (like bottom-up analysis). At Sanlam Investments, we have disciplined processes in place to minimise the influence of these irrational behaviours. We focus on understanding the fundamentals of the businesses we’re investing in, we consider the market concerns and determine the fair value of the business through rigorous research and analysis. Our process is robust and helps minimise human error.

In conclusion, you cannot take the human element out of human decisions or institutions. But an understanding of how the human mind works can help all of us make better investment decisions and build better investment organizations, contributing to improved retirement outcomes.