Applying Behavioral Finance to Decumulation

The study of behavioral finance has provided valuable insights into how individual behaviors can frustrate investment success. Recognizing the inherent biases that adversely affect investment decision-making has led to strategies and actions that have promoted better behavior and improved investment outcomes.

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    Applying Behavioral Finance to Decumulation

    Applying Behavioral Finance to Decumulation

    The study of behavioral finance has provided valuable insights into how individual behaviors can frustrate investment success. Recognizing the inherent biases that adversely affect investment decision-making has led to strategies and actions that have promoted better behavior and improved investment outcomes.

    We’ve seen the impact of behavioral insights in investment products like target date funds and in 401(k) plan features like auto-enrollment. Much of this behavioral research, however, is discussed in the context of asset accumulation.

    In a recent study, Managing Misbehavior: Rational Choice in an Uncertain Retirement, the authors explore how behavioral finance can be applied to the decumulation phase of retirement to help investors make better choices and maintain their standard of living throughout retirement.

    Research Highlights

    Despite the complexity and uncertainty of planning for a 30-plus year future, most affluent retirees are confident or very confident about being able to meet their future spending needs. This self-assurance stems from the confidence they have in their investing knowledge and skill—89% rate themselves as above average.1

    Confidence is a wonderful and important trait, but overconfidence can be dangerous. The study showed that one in five respondents had no specific plan for withdrawing their retirement savings. Yet, individuals without a plan are every bit as confident as those retirees with a plan.

    For retirees with a withdrawal plan, nearly one-third of respondents describe their plan as a withdrawal of a consistent dollar amount or percentage of assets. Others (21%) expect to spend from savings only in an emergency, while 15% describe their plan as spending only interest, dividends and capital gains.

    Loss aversion (a behavioral challenge in accumulation) looms large in retirement. Many retirees equate spending with “losses” despite the fact that the whole point of building a retirement nest egg is to spend it. Such loss aversion may lead to a reduced standard of living in retirement.

    More profound, however, may be the impact loss aversion has on the longevity of savings. Loss aversion can prevent retirees from taking reasonable risks to ensure long-term growth or cause them to sell assets during down market periods and compound that mistake by delaying a timely re-entry into a recovering market.

    While retirees may rank market risks and longevity as their top concerns, their health is likely to be the principal risk in retirement, as illness and disease are likely to extract the heaviest financial and family costs.

    Advisors can play a critically important role in helping their retired clients avoid the worst behaviors through education, a comprehensive retirement income strategy, regular communication and periodic plan reviews.

    Sources:

    1. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4017997

    Please reference disclosures: https://blog.americanportfolios.com/disclosures/

     

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