Plan retirement like Mr. Spock, not Homer Simpson
Financial planners and writers know that logic doesn't always prevail when it comes to making retirement decisions. Human emotions prompt mistakes, even when we know better.
5 biggest retirement planning mistakes
So is there any hope for us illogical humans? Even if we fall short of the clear-thinking Mr. Spock from "Star Trek," can we do better than the impulsive Homer Simpson of "The Simpsons"? Certainly. But to make better decisions, we need to understand the process behind them; in fact, there's plenty of documentation on the behavioral science of financial decision-making.
A good place to start is an excellent paper, "Behavioral and Psychological Aspects of the Retirement Decision", recently published by Melissa Knoll, a research analyst with the Office of Retirement Policy at the Social Security Administration. I'll summarize some of the paper's conclusions and recommendations in this and future posts.
Let's start by examining two well-researched phenomenon: loss aversion and framing.
Loss aversion refers to the tendency for people to feel the pain of losses more than they feel the thrill of gains. So we make decisions that prioritize avoiding losses over the possibility for gains.
Framing refers to how we describe a decision. Research shows that using different ways to describe the same decision can result in different outcomes.
Now let's put these two concepts together to examine a very important retirement decision: When should you start Social Security benefits? Many writers, including me, have repeatedly demonstrated the financial advantages of delaying the start of Social Security benefits. Yet half of all Americans start Social Security benefits at age 62, the earliest possible age with the lowest monthly income.
When should you start Social Security benefits? Do the math!
Let's look at one example to demonstrate this decision. Suppose you've worked enough to earn a monthly retirement income from Social Security of $2,000, starting at age 66, your Full Retirement Age. You have the option of starting a reduced monthly for retirement before age 66, or you can increase your retirement income by delaying the start of benefits until after age 66. Here's a table that summarizes the monthly retirement income you'd receive at a few different starting ages:
Start at age 65: $1,867 per month
Start at age 66: $2,000 per month
Start at age 68: $2,320 per month
Note that the difference between starting benefits at age 65 and 68 is $453 per month. Whether you describe that as a gain or a loss affects the choices you might make. When researchers described the decision to start benefits at age 68 compared to starting benefits at age 65 as a gain, only 38 percent of respondents chose age 68 as the preferred retirement age. But when they described the decision to start benefits at age 65 compared to starting benefit at age 68 as a loss, 57 percent of respondents chose age 68 as the preferred retirement age. This is classic loss aversion and framing at work!
Interestingly, when researchers presented the choice of starting Social Security benefits at age 62 vs. age 65, they didn't find any affects of framing. They speculated that loss aversion might be at work again -- that is, that the perceived "loss" of extra years of leisure by retiring at age 65 might outweigh the perceived gain of a higher monthly benefit by retiring at age 65.
How could these results effect decisions on when to start Social Security benefits? Social Security's website and its benefit statements present the "estimated income at age 62" benefit first, then the age 66 income, then the age 70 income. This encourages people to think of the age 62 benefit first, then calculate their potential gains in income if they wait until age 66 or age 70. In this case, loss aversion works against you. If the age-70 income was presented first, people might instead think of the loss in income if they start benefits earlier, and then loss aversion would work for them and make them want to delay taking benefits so they could draw a higher monthly income.
When it comes to retirement planning, I would encourage you to look beyond loss aversion and framing and use a more rational approach. Prepare a budget for the living expenses you expect to have in retirement, and see at what age your retirement income from all sources, including Social Security, will result in generating enough income to cover your expenses. It's the magic formula at work: I > E
The magic formula for retirement security
If you think more like Mr. Spock, you'll increase the chances that you'll live long and prosper!
Stay tuned for future episodes of Mr. Spock vs. Homer Simpson and how we can use behavioral science to make better retirement planning decisions.
