Financial Planning, Retirement

Retirement, Procrastination, And Present Bias

4/19/16 8:00 AM

iStock_000021081474_Small-2.jpgIncreasing life expectancies are creating a situation where many Americans could wind up having to finance retirements that are longer in duration than the number of years spent in the workforce. Add to this the challenges of eroding Social Security benefits and rising healthcare costs and it becomes quite clear that people need to start saving for retirement as soon as possible. Unfortunately, many people do not start early and the costs of such procrastination can be significant. For example, a study from Boston College’s Center for Retirement Research (CRR) estimated that a medium earner in America who did not start saving until the age of 45 would have to set aside 27 percent of his or her annual salary in order to retire at 65 and still attain a 70 percent income replacement rate. Middle income workers who started saving at age 25, though, would only need to set aside 10 percent of their annual wages if they want to retire at the traditional age of 65, and just 4 percent if they continue working until age 70.

Some people may believe that outsized stock market returns can help them make up for any delay in when they started saving for retirement but a J.P. Morgan analysis estimated that an annual inflation-adjusted return on equity of more than 10 percent would be required for median-income adults to offset even just a 3-year delay (or early retirement). That is well-above the “typical” real return for the benchmark S&P 500 and therefore shows that most savers should not count on being able to "invest their way out of" a late start or other potential setback. Why do some people wait so long to start saving for retirement? Near-term financial constraints are an understandable excuse but for other individuals the main thing preventing them from achieving a comfortable and financially secure retirement is cognitive bias. Indeed, many people will procrastinate with something that could provide a long-term benefit because they give more weight to the short-term costs that such an activity would entail.

A new academic study explored how this “present bias,” combined with a lack of understanding of the wealth-building power of compounding investment returns, can affect a person’s retirement preparedness. After controlling for age, income, education, and other factors that could influence savings behavior, the researchers found that individuals who did not appear to suffer from such biases had amassed about 19 percent more on average in retirement savings than those who were found to value near-term tradeoffs more than long-term benefits. Sadly, the researchers also discovered that the vast majority of people suffer from such biases. However, many recent surveys suggest that more and more employers are starting to incorporate automatic enrollment and auto-escalation into their 401(k) plan design, tools that have been repeatedly shown to have a positive impact on retirement savings behavior by helping individuals overcome procrastination.

 


 

Sources: Boston College (CRR), Squared Away, J.P. Morgan, NBER

Post author: Charles Couch