Over and over, behavioral finance studies reach the same broad conclusion: When it comes to money, people often behave irrationally and make poor decisions, even when fully-informed. Some attribute these mistakes to the dissonance between our logical and emotional assessments of the choices put before us.
Studies in neuroscience suggest that the left hemisphere of the brain is more active when engaged in calculations, logical evaluations, and order, while the right hemisphere is dominant when dealing with images, music, emotions and creative pursuits.
You can see how personal finance could challenge both hemispheres. On one hand, there are the left-brained details of money, things like comparative rates of return, portfolio allocation, and Monte Carlo simulations. There is also the huge emotional, right-brained impact money has on our daily lives—what we can do, whether we are satisfied and secure with what we have, and how we feel about the future.
Computers make the numbers—i.e., the left-brained stuff—easy to evaluate. There is no end to the ways a financial decision can be left-brain analyzed—for total return, tax consequences, volatility, etc. But the financial services industry often does a poor job of speaking to both sides of the brain; there is a tendency to provide left-brain arguments for right-brain concerns. Joseph Jordan, a behavioral finance expert and former senior vice president for MetLife, says, “This is a tragedy in the financial service business. We’ve developed a lot of left-brained analytic tools to solve right-brain emotional issues.”
The Facts and Fears of Spend-Downs
Consider the left-brain/right-brain challenges to creating an income in retirement. Most retirement income models are built around some version of a spend-down, a plan that methodically draws income from both earnings and principal over the course of retirement. Financial professionals develop models to determine the maximum that can be withdrawn, with minimal risk of running out of money at some point in the future.
On paper (or a computer screen), the math of these models is legitimate. But financial behaviorists find that emotional right-brain concerns often get in the way of implementing these logical plans.
In the early years of a spend-down, it is common for investment earnings to exceed the initial income withdrawals, resulting in modestly increasing retirement account balances. But as withdrawals increase (to keep pace with inflation), account balances eventually decrease; that’s the spend-down. Once principal begins to decline, many retirees get nervous; studies show they often decrease income to preserve principal instead of staying with the plan. Any period of poor investment returns only exacerbates their anxiety about not having enough income or running out of money—even though the numbers clearly show these fears are unfounded.
Soothing Right-Brain Financial Anxiety
Harold Evensky and Deena Katz are husband-and-wife partners in a financial advisory firm and co-authors of several books about retirement. One of their signature ideas is the “cash-flow reserve strategy,” an approach that seeks to ease the right-brain issues in a spend-down.
Their core idea, first formulated in the 1980s, is to allocate a percentage of assets to low-risk or guaranteed financial instruments, for the exclusive purpose of providing a secure income for a specified period (say 5 or 10 years). The remainder is invested for long-term growth. At regular intervals, this “safe account” is replenished with earnings from the long-term pool.
Over the years, the couple has fine-tuned their approach into three components: A checking account for living expenses, a low-risk portfolio with two years of reserves, with the remainder allocated to various long-term investments.
Theoretically, this compartmentalized approach, in which a significant percentage of assets may be allocated to safe investments with lower historical returns, gives retirees peace of mind about their present income, which means there is a greater likelihood that they will not make unprofitable, panic-driven decisions about their long-term assets.
The Logical Left-Brainers Disagree (And Can Prove It)
The cash-flow reserve idea is one of what are referred to as “buffer-zone” retirement income strategies. While buffer-zone plans might calm a retiree’s nerves, critics say it’s a false security, because the premise doesn’t stand historical scrutiny.
Research compiled by two professors of investments at the American College of Financial Services in a 2011 study concluded that “use of a buffer zone strategy of any sort—one year, two years, three years, or four years—is more likely than not to leave the investor worse off than if he or she simply set up an investment portfolio with a static asset allocation.”
Instead of accommodating their emotions, left-brain retirement planners urge better consumer education, believing the facts will persuade retirees that their fears of losing money are inaccurate or exaggerated. Which, from a left-brain perspective, is a perfectly logical idea. But, as financial behaviorists know, it probably won’t alleviate emotional/right-brain concerns about a diminished or insecure retirement.
Or…You Could Buy an Annuity
Another retirement income option which seems to satisfy both left- and right-brain demands? Using an immediate annuity.
An immediate annuity delivers a guaranteed income for a lifetime, no matter how long it lasts, which should effectively eliminate any worries about decreasing income or running out of money.
And from the logical side, historical studies have repeatedly shown that lifetime annuities outperform spend-down strategies. One of the reasons for the superior performance: An immediate annuity is “the only investment that provides a fourth potential return,” according to Evensky. “Stocks, bonds and all other investments provide a return from a combination of interest, dividends and capital gains. An immediate annuity offers the possibility of a mortality return…,” i.e., a return from living beyond life expectancy.
Yet very few retirees use annuities. Why? Even though they satisfy both the logical and emotional requirements for retirement income, annuities are thought to be under-utilized by retirees because they are usually irrevocable transactions. Once you give an insurance company a lump sum for a lifetime income, the agreement is locked in. There’s no return of principal if you die before life expectancy, and once they begin, there’s no changing the monthly benefits. Just like some people can’t handle decreasing principal in a spend-down, others are stopped by the one-time decision that establishes an annuity.
Retirees hand over a significant chunk of their life savings, knowing they can’t get it back, except as a monthly check (albeit, for the rest of their lives). Ten years from now, that exchange might seem like a great deal, but today, it might feel like handing over a lot to get a little. Those feelings, illogical or not, often stop many people from getting started.
For logical left-brainers, the guarantees in an annuity also preclude the selection of other investments. There will always be a hindsight scenario in which an alternative—probably not guaranteed, perhaps riskier—could have been a better choice. This compels some retirees to continually look for the next opportunity, instead of accepting the very good, guaranteed options available today.
This article was prepared by an independent third party. Material discussed is meant for general informational purposes only and is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice.
Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS), 355 Lexington Avenue, 9 Fl., New York, NY 10017, 212-541-8800. Securities products/services and advisory services offered through PAS, a registered broker/dealer and investment adviser. Financial Representative, The Guardian Life Insurance Company of America (Guardian), New York, NY. PAS is an indirect, wholly owned subsidiary of Guardian. Wealth Advisory Group LLC is not an affiliate or subsidiary of PAS or Guardian.
PAS is a member FINRA, SIPC.
Submitted by Elozor Preil
Neither Guardian, PAS, Wealth Advisory Group, their affiliates/subsidiaries, nor their representatives render tax or legal advice. Please consult your own independent CPA/accountant/tax adviser and/or your attorney for advice concerning your particular circumstances.
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