Category Archives: Dr. basu

Rethinking Distribution Planning

May 17, 2012 6:01 amLeave a Comment

How well do our models fit actual behavior in retirement?

AgeBander Retirement SoftwareI’ve seen a lot of new research and thinking recently that, taken together, threatens to upend everything we think we know about retirement distribution planning. I think this may be important as more clients march into retirement under the guidance of their financial planner.

At the AICPA Personal Financial Planning conference in January, Jim Shambo, president of Lifetime Planning Concepts of Colorado Springs, Colo. – an out-of-the-box thinker if ever there was one – asked a deceptively simple question. Our Monte Carlo engines assume that clients will spend a certain percentage of
their total retirement portfolio in the first year (4% is the safe harbor amount), and then require that same dollar amount, going forward, for the rest of their days, adjusted for inflation. Analyses by Jon Guyton, a principal of Cornerstone Wealth Advisors in Minneapolis, and others show that we can adjust that safe harbor upward a bit if clients are willing to freeze their spending in down markets and limit their raises.

But what Shambo wondered is this: Is the constant-dollar spending goal an accurate or reasonable assumption?

 

UNEQUAL COSTS

To find out, he looked at inflation calculations by the Bureau of Labor Statistics and found something interesting: Inflation tends to strike retirees harder than preretirees. Most notably, health care costs are rising faster than the inflation rate.

Beyond that, the CPI calculation factors out cost increases that are attributable to improvements in the goods and services you purchase. A car may cost 4% more
this year than last, but if there are new fancy electronics in the standard model, the government may decide that inflation only counts for a half-percent of the increase. Of course, if you buy the car, you still have to pay the full higher cost. Add it all up, and people aged 65 to 74 appear to be experiencing an inflation rate that is a remarkable 1.11 percentage points a year higher than CPI, and this grows to 2.09 percentage points (a year!) when retirees get past age 75.

 

MAKING A MODEL

A sophisticated retirement spending model, created by California Lutheran University Professor Somnath Basu, combines Shambo’s revised inflation estimates with these revised expenditure figures. Each line item gets its own estimate of higher or lower consumption, and that’s multiplied by an individualized inflation factor.

Health care spending will tend to go up as clients age, and medical costs rise faster than CPI. Food expenditures tend to go down as people age and
food inflation is typically lower than the average, and so forth.

I asked the audience of my Inside Information newsletter what they thought of all this, what their experience has been with retired clients, and how (or whether) this more sophisticated retirement spending model would change their advice to clients. The most common response is that generalizations have to be pushed aside when you’re dealing with an individual client.

When David Jacobs, who practices in Honolulu, estimates a client’s retirement spending, he takes into account such driving factors as the size of the house and maintenance expenses, a habit of providing significant financial assistance to children, a dependent parent, and/or costly activities on the bucket list. This latter line item gets particular attention from Tom Murphy of Temaa Financial, who practices in Dallas. After studying the behavior of his clients closely, he has started planning for a spending blip in the first two years of retirement. That, he says,
is when clients take full advantage of their newfound freedom.

Elyse Foster, of Harbor Financial Group in Boulder, Colo., builds a larger portfolio buffer for what she calls “spendy” clients. Meanwhile, both Neal Van Zutphen of Delta Ventures Financial Counsel in Phoenix and Cindi Conger of Conger Wealth Management in Little Rock, Ark., are pioneering a detailed budget planning service for their clients.

Each expenditure is assigned its own line item and there are projections both for spending increases or decreases and individualized inflation rates. Clients get in the terrific habit of tracking their expenses against the projections before they enter retirement, and are far less likely to get off-track when their paycheck runs out.

At the other end of the spectrum, Pat Raskob, who practices at Raskob Kambourian Financial Advisors in Tucson, Ariz., finds that some retirees who were champion savers in preretirement are unaccustomed to the frivolity of leisure activities. She has to coax
them along, brainstorming fun things for them to do, helping them purchase trips and plan activities with their children as well as their grandchildren.

This suggests new services for planners to offer their clients. Raskob has been called a memory creator because she helps her clients plan activities and family events that they can enjoy recalling over and over again. They need the advisor to help them fully enjoy retirement without the guilt or fear associated with spending.

Others, who have trouble understanding why they can’t safely spend a bigger chunk of their multimillion dollar retirement portfolio, will need advisors like Van Zutphen and Conger to help them track their budgets. Tools like Mint.com are making these services much easier to provide.

 

A DIFFERENT APPROACH

Some advisors willing to brainstorm see an easier way to manage the running-out-of-money risks. Vince Schiavi of Schiavi + Dattani in Wilmington, Del., pays particular
attention to a client’s core expenses – those needed for survival – and then trusts clients to adjust their discretionary spending as market circumstances dictate. Kevin Kroskey of True Wealth Design, who practices in Akron, Ohio, uses Mint to identify those core expenses, then uses his own system to estimate how those life-sustaining expenditures will rise over time. He also looks for ways to reduce unpleasant surprises. Getting all debts paid off before retirement, and having both good long-term care and Medigap policies in place are all ways to narrow the range of possibilities.

We still don’t know if data from the Bureau of Labor Statistics’ Consumer Expenditure Survey data – which covers the spectrum from the impoverished to the ultrawealthy – is a good measure of how financial planning clients will behave as they age in retirement. But there is clear anecdotal evidence that it might be reasonably accurate.

According to Conger’s voluminous spreadsheets, clients spend more on travel and
hobbies in early retirement, and less on clothing and food over time. She reports that, somewhere around age 75, people start spending less on groceries.

 

THE ANNUITY ARGUMENT

Why does any of this matter? Because some of this analysis rebuts the key argument against recommending immediate annuities to clients in retirement.

Most annuities don’t adjust their payments for inflation. But if these core life-sustaining expenditures tend to go down as clients age, rather than rise at or (per Shambo) above the inflation rate, then this is not a problem – and might, in fact, be the simplest way to give clients peace of mind that they won’t be eating dog food in their later years.

Also, if the profession is overestimating those core expenditures in retirement habitually, particularly after age 75, then the standard pre-retirement (Monte Carlo) calculations may be overestimating how much a client needs to accumulate by as much as 25% – a substantial amount.
Once we see a flood of new thinking about an aspect of planning, it’s only a matter of time before we see a major shift in the way the service is provided.

Posted in CIF Faculty, Dr. Basu, Retirement PlanningTagged ,

Will Retirement Be a Bust for Boomers?

May 7, 2012 1:04 pmLeave a Comment

If you’re a Baby Boomer, or your parents are, here’s a ray of sunshine to brighten your day: Boomers have so severely underfunded their retirements that Congress may turn to their children to bail them out.

This is the gist of an article in the April issue of Financial Advisor magazine by Dr. Somnath Basu, professor of finance at California Lutheran University. He notes, “The problem could be as big, if not bigger, than the 2008 financial crisis.”

A new study by the Center For Retirement Research, Boston College, detailed on CNBC.com, finds the retirement years for
Boomers will be much leaner than for their parents. An estimated 51% of them will be unable to maintain their current lifestyles in retirement.

Ironically, one major contributor to this bleak picture is the Boomer generation’s own optimism and positive thinking. Raised in a society of abundance with expectations of prosperity, Boomers have over-spent and under-saved for decades. Many of them assume they will receive ample inheritances. They see increased life expectancy as a wonderful thing, forgetting to factor in the higher medical costs that will come with it. They expect to work well into their 70′s, disregarding statistics that show many of them will be forced to retire sooner due to health problems or job layoffs.

Let’s look at some decidedly pessimistic numbers from the Center For Retirement Research study. The median 401(k) and IRA balance for Boomers nearing retirement is $78,000. Only around half can expect to inherit from their parents, with the median inheritance amount $40,
000. That adds up to a total nest egg of $118,000, which at a 4% withdrawal rate provides less than $400 a month for life. Combining that with the average Social Security check of $1,077 means retiring on an income just above the poverty level.

What’s the solution? Many Boomers say they plan to never quit working. Unfortunately, this is delusional. According to a new survey by the Society of Actuaries, “The 2011 Risks and Process of Retirement Survey,” over one-third of Boomers think they will never retire and only 10% say they will retire by 60. Statistics show, however, that 50% have actually retired before age 60. The main reasons are health and downsizing, which boomers discount. Well over 90% of them maintain they have a healthy lifestyle and won’t get sick. Boomers are so out of touch with reality I wonder how many, if asked, “Will you ever die?” would answer, “No,” or “Maybe.”

Sadly, only one-third of Boomers have a plan for financing their retirement, other than
planning to work until the day they die. What’s the solution for the remaining two-thirds who are unprepared?

Unfortunately, for many older Boomers it is already too late. Their lack of planning for their retirement years may mean forcing their children and grandchildren to decide whether taxpayers can afford to pick up the tab.

Younger Boomers can take control of their retirement by radically downsizing their lifestyles and increasing their income. This means selling expensive homes, cars, and toys and living as frugally as possible. The resulting savings should first go to pay off high-interest debt, then to fund to the max every available retirement plan. Another possibility is to consider various employment options, including government jobs which offer pension plans unavailable in most private sector jobs.

Wise Boomers will also encourage their own
children to emulate the frugality and money skills of their grandparents. The kids will need those skills for their own futures—especially if they have to help their Boomer parents pay the bills.

Visit the California Institute of Finance’s Website to learn more about our MBA In Financial Planning.

Rick Kahler

 

 Rick Kahler is a Certified Financial Planner, President of Kahler Financial Group, author of the “Financial Awakening” blog, and a featured contributor to the “Advisor Blog”.

Posted in Current Events, Dr. Basu, Featured Contributors, Retirement Planning, Rick KahlerTagged

Professor’s Program to Help Seniors Find Ways to Live within their Means

March 16, 2012 11:23 amLeave a Comment

The following article was written by Alicia Doyle, and appeared in the March 15, 2012 edition of the VCStar (Ventura County Star).

Senior womanFinancial management is difficult for anyone with a limited budget but is even more difficult for a senior whose only source of income is Social Security, said Elizabeth Renteria, public outreach coordinator with the Ventura County Area Agency on Aging.

“It becomes necessary to find new ways to make ends meet,” Renteria said. “Many seniors may not be aware of the connection between exercise, good
health and finances or that there may be alternatives to spending.”

To help seniors understand their finances, the agency is presenting “Living Within Your Means” featuring Somnath Basu, professor of finance and director of the California Institute of Finance at California Lutheran University. Basu also wrote “Investment Planning for Financial Professionals,” published by McGraw-Hill in 2006.

The free program designed for those 60 and older took place this week at the Moorpark Active Adult Center. The next programs will be April 17 at the Santa Paula Senior Center and April 18 at the Simi Valley Senior Center.

The goal “is to educate seniors about their own personal finances and to empower them with knowledge, dignity and respect,” Renteria said. ”
Having a clear grasp of one’s finances will allow for that.”

Two aspects of the program together create a unique offering, Basu said.

“First, the people we serve are from the poorest sections of our society, barely eking through their lives in trailer homes, etc.,” Basu said. “The second is that they are all senior citizens who have little outside lives, live mostly by themselves and try to stretch their moneys as much as possible.”

Basu says he offers financial solutions that can help improve a senior’s quality of life.

“Sometimes, seniors don’t realize that there are savings from things that they feel they must have, like, say, cellphone and cable TV basic,” Basu said.

Having a voice-over-IP land line can save lots of money, since cellphones are expensive to maintain, Basu said.

Renteria said: “Every day, we see on the news about budget cutbacks, decreasing services and the increased cost of living, and we worry about the impact it is having on
our elders. Our objective is to find smart and innovative ways of making ends meet during these hard economic times.”

Posted in Dr. Basu, Financial PlanningTagged ,

Making Money, Getting It Right

February 15, 2012 10:59 amLeave a Comment
This article was written by Dr. Somnath Basu, Director of the California Institute of Finance at California Lutheran University. It originally appeared in the February 2012 edition of FA (Financial Advisor) Online
The greatest fallacy is that you have to find the winners to make money. But really you need to find the winners, losers and sideways movers.
By Somnath Basu 
How easy is it to make money? If you immediately answered “not easy,” you must be thinking of the current times. In other eras, when you were flush and heady making money (say, from 2005 to 2007), you may have spontaneously given
the opposite answer. The question seems to take on different meanings at different times.
But if you stepped back and looked at the question hard enough, the answer ought to be the same at all times.
Consider the odds of making money in a coin toss game. If you played the game many times, you would almost certainly come away with nothing—you would have played a “fair game.” But then again, entering the game to begin with meant you thought you knew something your opponent didn’t, something that would bowl her over. You thought you had asymmetrical information. Of course, she entered the game with a similar idea. And without this conflict of expectations, the game would never have taken place.
Does such a long-term zero sum game sound too far-fetched? Too much like some academic theory developed in a void? Well, think again. Long-term currency market speculators face scenarios very close to these “fair games,” or gambles, all the time. The proper
term for such games in the ivory towers is “martingale” processes.
It is probable that a fair game may produce different results in the short run. For example, in coin toss games, you could encounter winning streaks in heads or tails. If you catch a wave, fortune certainly favors you. It’s the scenario favored by the fantasy in movies about Las Vegas gamblers. But if you were playing such a game in Vegas yourself, i.e. playing against the house, then the fortune would certainly turn to disaster, as the difference in wealth of your opponent would almost certainly lead you to what is known in statistics as “gambler’s ruin.”
At every point in time, we investors face a very similar situation. Consider the first significant outcome of your next investment. You may win, lose or draw. Figure 1 shows these expected outcome possibilities. If these outcomes followed the chance structures of fair games, then we could expect that the chances of winning or losing from
the next move would be equal. In other words, assume there is an approximately 50% chance of either winning or losing from the next move in your portfolio. The expected return of 0% could then be translated to a rough rule where the chance of losing may be subtracted from the chance of winning to lead to an expected return. Thus, in a fair game, expected return equals zero as a sum of 50% – 50% = 0%. By the same token, if you could call the outcomes correctly 55% of the time, then you could expect to earn a 10% (55% to 45%) rate. Now, ask yourself this question: How easy (or difficult) is it to make 10%? Even being right just 55% of the time doesn’t sound so easy anymore, does it?
Fig 1 Basu
To make money, therefore, the first step is to predict the directional change in your investment correctly. If you can do so, i.e. predict an up, down or
a sideways move, and if you can be consistently correct in your predictions about 55% of the time, then you will end up earning 10% over the long term. (The only other way to consistently make 10% is to be Bernie Madoff.) Furthermore, note that being correct in your predictions does not mean finding winners only; it will be equally lucrative to find losers and no-changers. Instead of buying the winning stocks or their call options, you can also short sell the stock or buy put options on them. If you expect no change in the next price movement, you can make money by writing both a put and a call (a short straddle) and you will make money just as you would in the other two scenarios.
The main point to understand is that if you are right (or wrong) in your predictions, then you will make (or lose) money. Making it or losing it hinges solely on whether you are calling the price changes correctly.
So far, we have looked only at the direction of the first price change. Next
you predict the magnitude of the coming price change. Figure 2 shows both the direction and magnitude of all possible price changes. In a sense, bringing up the magnitude refines the original prediction in a very precise way by magnifying our money-making possibilities. The better our prediction, the more often (more than 55% of the time) we are right and the higher our expected profits. Being correct implies that we understand which path (in Figure 2) our investment will follow. That is, we must understand the “path dependency.” If we are consistently correct in identifying these paths, then we are one step away from the Midas touch of a Buffett or a Lynch. It does not matter if the predicted magnitude is small or large, but only that such precision in path identification is exploited for unlimited gain.
It is easy enough to see
that when one is confident about the direction and magnitude of price changes, then it is much more lucrative to speculate with derivatives than to use the underlying security. In Figure 3 if the expected change is very small, not only could you buy calls (up paths) or puts (down paths), but also sell their opposites. For example, when we expect upward movement, we can also sell (write) puts and use the money earned from writing to buy the calls. In this way, we can speculate at zero cost to create profit schemes (arbitrage) as long as we are sure of our predictions. If we were to be wrong in our predictions, of course, the consequences would be dire—dire in that it magnifies the effect of buying losers. So if you are faint of heart about your predictions and expectations, these approaches are not for you. The operations described here are for stronger gutted women and men.
fig 3 Basu width="455" height="284" />
In Figure 3, we reasoned that positive and negative price changes would be close to 50%, but not exactly, since we wanted to leave open the possibility that the next price change has a zero value—in other words, a sideways price movement. If we are superb in our predictions, then writing a put and a call would lead us to profit from the sidewise movement. Figure 4 shows the payoff from such a positional move, the so-called short straddle.
The straddle and the exploitation of a sideways change temporarily closes the discussion about exploiting the first price change. Now consider the second significant price change for your portfolio. Note that from the current perspective, the second price change would imply a total of about five outcomes with nine possible price paths. Figure 5 shows these
nine possibilities.
Note the directional changes portrayed in Figure 5. For us to consider volatility, we need at least two significant price changes that are not simply the result of a hit on the bid and offer. Observe that of the nine paths, there are two changes that represent the greatest volatility, four changes of medium volatility and three changes signifying the lowest volatility. This means that volatility is the least common outcome of our predictions, as it should be. At any time, the observations of heightened market volatility in security markets must then imply the dominance of uncommon or tail region outcomes. These conditions exist when we cannot reach the outcomes through more predictable paths, as shown in Figure 6, a tabular version of Figure 5.
figs 5 6 7 Basu
Continuing in the same vein, if we introduce the magnitude
of changes against these two periods, then we will also specify all possible price paths, illustrated by Figure 7.
Now we are in the realm of the adventurous. There are a few ways in which we can try to identify the most likely path to the most expected outcome. It’s important to note that each price path is equally probable and the sum of all path probabilities must equal one, since one of those paths will be actualized with certainty (i.e., the probability is 1). A second methodology is the Monte Carlo simulation, which tries to ascertain from the nature of the path shapes (statistical distributions) the most likely path with the associated dispersion. If the paths are normally distributed, then there is an expected (mean) path and around that path there is dispersion (with a certain standard deviation) and volatility. If the distribution is non-normal (for example, it’s a chi-square distribution or beta or another one) then the most likely associated outcomes may be in the
form of ranges and scales. Now we would need a statistician to interpret their meanings before we could rattle off fancy terms such as “z-stats,” etc. Finally, we can also use mathematics of normal distributions (integration) to arrive at the same calculations, such as Black-Scholes calculations in option pricing. Nonetheless, it is obvious that if we can determine the most likely price paths, we can also reap the maximum benefits.
To summarize, let us now tabulate all possible two-period price paths and look at their speculative trading counterparts for broad path regions. Figure 8 shows these possibilities and their trading solutions. (Note: To reduce option premiums, you may buy options that are out-of-the-money. They work just like deductibles in auto insurance.)
These ideas would likely never be palatable to readers without real life examples. As luck would have it, I came across two articles in the Financial Times of December 12 as I was putting the
finishing touches on this article. One, called “Fat-Tail Fears Catch Oil Traders Between $50 and $150 Bets,” by Javier Blas, the commodities editor, offered a perfect illustration. The report starts with the salvo, “Investors and traders are buying large numbers of oil (option) contracts that would profit from a price super-spike—and a collapse.” (I urge my readers to read the entire story.)
If you’re thinking of investing in the ways I’ve described, you might look out for hypothetical events that offer opportunities:
1. A downturn in the U.S. markets with a correction of about 12% in the next three to six months;
2. A European embargo of Iran, which could threaten a spike in oil prices, since much oil is shipped through the Persian Gulf; and
3. A downturn in European markets lead by the FTSE 100 and then the CAC 40 and the DAX. Nothing says we can’t profit from European woes and spats.
Now, form your own
expectations and go trade! The only way you’ll lose is if you are wrong. I’ll leave the rest to your imagination. Happy scalping!
Posted in Dr. Basu, Investments

Behavioral Barriers: The Role of Biases in the Public’s Aversion to Fixed Annuities

December 13, 2011 10:59 amLeave a Comment
by Dr. Somnath Basu and Brian J. Barclay
This paper was originally published in the Fall 2011 issue of the Retirement Management Journal, then re-published in the November 30, 2011 edition of the Morningstar Perspectives.
Dr. Basu is a Professor of Finance at California Lutheran University and the Director of its California Institute of Finance. Dr. Basu is well published and is an award winning teacher. He has significant consulting experience with US Fortune 100 companies, advising institutional money managers and in developing proprietary finance and planning software. Brian J. Barclay, CFP, holds a Masters Degree from the California Institute of Finance at California Lutheran University. He is also a member of the Financial Planning Association, Los Angeles chapter.

Slick SalesmanYou could call it an anomaly of human cognizance; the strange phenomenon of how a seemingly rational investor can flip a mental switch and instantly become so bigoted towards a product/solution designed to provide them with the relief from financial burden that they so desperately seek. Whether it be the trusted family advisor or the slick salesman wearing alligator loafers, initiating a conversation that includes an annuity solution is cause enough for many clients to not only balk at the recommendation, but even go as far as to reconsider their entire planning engagement altogether.

Perhaps it is the lost link in Maslow’s Hierarchy, or Pavlovianly ingrained in our psyche by constant media bombardment; regardless, the issue
remains that fixed annuities are scrutinized for everything they are not and cast aside for everything they are. Putting aside the controversies surrounding their variable counter-parts, it is apparent that the publics’ aversion to these products is rooted in something much deeper than inappropriate distribution by a questionably motivated sales force, but largely psychological factors, rooted deep in personal biases and manifested in specific behaviors. It is the role of these negative biases and the corresponding mental conditioning that prevents the average investor from even considering a fixed annuity as a viable option for a portion of their overall retirement plan, despite exhibiting the exact behavioral symptoms that such a solution seeks to alleviate.

The Mounting Challenges

Increased cause for financial anxiety and concern surrounding retirement needs is most certainly warranted. As the baby boomers continue to grey, and their
needs shift from accumulation to distribution/decumulation, the demand for sustainable sources of income that can last throughout a prolonged period of retirement become paramount. With Social Security (a system never intended to provide for more than a fraction of income needs) growing more and more strained, coupled with the paradigm shift of employers moving from traditional defined-benefit plans to more predominantly defined-contribution plans, more and more pre-retirees are forced to reevaluate what their impending retirement will look like.

Include advancements in medical care with an increasing standard of living, clients now find themselves having to stretch their incomes even further than originally expected. Increased longevity has dictated to the prudent advisor that a client reaching age 95 is no longer an anomaly, but rather a reality, or in some cases, a distinct possibility. Thus a rational person would think that such circumstantial uncertainty would be the ally of a
solution that promises fixed payments for a set duration (potentially for life), however in the case of fixed annuities, that correlation is missed more than made and aversion to such a solution continues to exist.

Health Implications

Despite this seemingly irrational repugnance, the demand for a consistent and reoccurring retirement income scheme remains prominent. If we were to breakdown and simplify fundamental retirement expenses into three general baskets; needs, conveniences, and luxuries, we find that client tend to mentally account for the economic decisions that go into addressing such concerns. The satisfaction of the most basics of needs is prioritized first, as it translates into good health, both physical and mentally.

Nutrition, exercise, adequate shelter, proper medical care, and a comfortable family situation are all the components required for good health, and are necessary for a person to continue to enjoy their
retirement with a true sense of human dignity.  We also observe that a great deal of non-medical mental impairments can be traced back to the stresses associated with the management of personal finances. Thus not having to worry about continued service of those basic needs through consistent income is crucial to preserving good physical and mental health, and should be uncompromisingly planned for before conveniences and luxuries can be taken into consideration.

Real Retirement Satisfaction

What is the rationale behind this cognitive impairment? Why does such apathy exist in the potential exploration of a solution that seeks to provide the level of retirement satisfaction universally sought? To the average pre-retiree, large amounts of assets or high degrees of liquidity are not necessarily all that are needed for them to feel safe and secure to enter retirement. Research into the emotional aspects of the retirement mindset illustrates
that retiree’s prefer the comfort of knowing they have a steady stream of income into perpetuity, rather than being relatively “rich” at retirement (defined as a large amount of their own money readily available to be spent as they wish). In addition, the heavier the reliance on the social insurances, the less satisfaction they have with their own retirement.

 
When personal consumption is financed with guaranteed streams as opposed to liquid savings, those with greater levels of annuitization tended to be more satisfied during retirement and maintained their satisfaction levels longer throughout.[1] Greater satisfaction was also expressed by individuals who engaged in long-term planning; from attending a retirement-planning meeting, or through the purchase of product, such as an insurance policy for long-term care. Retirement satisfaction itself is derived from employing the correct behaviors, not simply achieving or maintaining a certain asset level.

It is
the behavior itself that was identified as the root of given retirement satisfaction. Note that the opposite is true as well. A study from the Boettner Center for Pensions and Retirement Security at The Wharton School of the University of Pennsylvania tabulates the strong positive relationship between the lack of a fixed retirement income distribution scheme (explicitly a fixed annuity) and the number of depression symptoms. It is not difficult to understand why an uncertain retirement income plan for a pre-retiree can have such dire consequences.

Perceptions of Retirement

With systemic obstacles mounting and an explicit desire to maintain living standard levels, it would seem rational that fixed income contracts be presented in the suite of solutions available to a client. Experienced advisors know that this assumed rationale is generally missing in clients and know well the aversion (mainly due to the negative connotations of any annuity-named product) and some
have even come to accept such behavior as simply the norm.

They seek to avoid being placed in the unenviable position of either broaching the unpleasant topic with the client, or taking the path of least resistance and offering another solution. This can be a troublesome predicament for the advisor not only from an ethical point of view, but also a competency point of view choosing the sale over the solution, as well as a reinforcement of the public’s misconception of what resources will actually be required to replicate and sustain their desired lifestyle throughout their golden years. Moreover, most suitability analysis should offer such decisions as fixed streams and hence it is a competency issue as well – being psychologically forced into offering an inferior/unsuitable solution because of client behavioral biases dictate so.

The risks of outliving assets, increasing medical expenses, and the complexities of capital markets are all downplayed by this appeasement and
reinforce the view that as long as current habits are maintained (e.g. contributing to the match of one’s retirement plan, and saving cash when possible), desired retirement outcomes are achievable. This perceived lack of risk can be responsible for the inadequate allocation of resources and mar the reality of retirement with misconceptions and denial.  To the client, failure to take such actions does not in turn frighten them, nor does the anticipation of taking action in the future delight them into action either. Unless the advisor chooses to challenge the mindset and risk the relationship, cognitive dissonance continues.

Confirmation Bias

Upon experiencing a personal financial success, clients tend to find outlets to share such accomplishments with others. War-stories about incredible entry points in equity positions, or intuitions about large commodity market swings where they experienced a significant upside, are traded with other like-minded individuals
who demonstrate the same behavior and provide reinforcement.

The development of abundant social media forums has exacerbated such behavior, allowing clients to form confirmation biases, reinforced by the online community. Research in this area has again demonstrated that people will seek out information only when it is consistent with client’s prior beliefs.  This causes the client to ignore any conflicting views and data or to simply dismiss its validity because they are convinced that they are right and all who disagree are wrong. A bias (psychological name – availability heuristics) is triggered in us that our preconceived notions were actually true and real (perceptions that are now believed to be “confirmed” as correct) and that their predictions will have a greater likelihood of actually occurring. Finally, the bias becomes entrenched as a heuristics; in the case of fixed annuities, the bias will result in recalling only the negative information and not the advantages, and
conclusions that this product could possibly afford. With such an attitude, the proper product due diligence is not even performed.

Value of Discussion

Given misguided retirement perceptions and the role of such biases, we can begin to see from a behavioral standpoint, where an aversion to the product can stem from. As the goal of most retirees to secure an income stream for their remaining years, it is the role of the advisor to revisit this discussion and probe to find if the aversion is based in experience or rooted in deeply entrenched biases. The financial counseling provided by the identification, understanding, and discussion of relevant biases can be just as important to maintaining a client’s overall financial health as much as portfolio performance. Value can also be provided by not skirting the issue and addressing detrimental behaviors together, in order to move into a much deeper level of the advisor/client relationship.

If you are either
a current or former CIF student or faculty member and have a blog or article that you would like to re-post here, or if you would like to be a guest blogger for the CIF blog, please email Brent@echelonseo.com.

References

1. Ackert, Lucy L. and Richard Deaves. Behavioral Finance: Psychology, Decision-Making, and Markets. South-Western Cengage Learning, Mason OH, 2010. Pg. 96-114.

2. Mitchell, Olivia S. and Stephen P. Utkus, Pension Design and Structure: New Lessons from Behavioral Finance. Oxford University Press, New York, 2004. Pg. 28.

3. Panis, Constantijn W.A. “Annuities and Retirement Well-Being.” RAND Corporation Working Paper, DRU-3021. Santa Monica, CA. 2003. Pg. 260-270.

4. SmartMoney.com. “What’s Wrong With Variable Annuities?” Published August 1st 2010, http://www.smartmoney.com/personal-finance/retirement/whats-wrong-with-variable-annuities-9512. Accessed October 1st, 2010.

5. Weber,
Elke U. “Who’s Afraid of a Poor Old Age? Risk Perception in Risk Management Decisions.”  Oxford University Press, New York, 2004. Pg. 53-64.


 

Posted in Alumni, Annuities, Dr. BasuTagged ,