Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 246

Overcoming loss aversion in retirement income

Many retirees are hampered by their own loss aversion in the challenge to generate cash flows to spend in retirement. Some behavioural tools can help to overcome this loss aversion while still leaving a larger estate for the next generation.

The difference between loss aversion and risk aversion

It is standard practice for financial advisers to determine a client’s risk profile by measuring risk aversion and linking it to an appropriate asset allocation. Loss aversion is a related issue that was first highlighted in Kahneman & Tversky’s 1979 paper on behavioural issues in finance.

The premise of loss aversion is that people dislike losses more than they like gains. The interesting fact is that loss aversion trumps risk aversion. Research has shown that people who are normally risk averse will become risk seeking to avoid a certain or likely loss.

The following example is adopted from Kahneman’s 2011 book, ‘Thinking Fast and Slow’ and highlights the strength of the loss aversion.

Participants are given $1,000 which they are allowed to keep and not required to wager. They are then asked to choose between the following ‘bets’:

1A

1B
50% chance to win another $1,000

Get another $500 for sure

The majority in this case prefer the certainty provided by choice 1B, reflecting risk averse preferences.

The alternative comparison then describes a loss.

Participants are given $2,000 and asked to choose between the following bets. This time they are wagering part of their gift:

2A

2B

50% chance to lose $1,000

Lose $500 for sure

Now the majority prefer to take the gamble, 2A, in the hope of avoiding any loss, even though the net outcome under both scenarios is exactly the same. The choice is between:

A

B
50% chance of +$1,000 and

50% chance of +$2,000

+$1,500 for sure

The difference in behaviour reflects how people think and manage their money.

Endowments, life savings and avoiding capital reductions

There is a related issue for retirement planning around the so-called ‘endowment effect’. It is evident in the example above as participants immediately view the $1,000/$2,000 as their own (and not a separate ‘win’ or gift) and make subsequent decisions on that basis. Building up a lifetime of savings has a similar, and probably more powerful, effect. Retirees often view their retirement savings as capital that should be preserved.

In reality, these savings are just deferred wages and ‘interest’ that should be spent down to support the retiree’s desired lifestyle in retirement. However, there is an endowment effect so that once the balance is highlighted as ‘capital’, many retirees react negatively to any reduction in the capital. They regard it as a loss, which they would prefer to avoid, rather than being part of the lifecycle plan of building up and running down savings.

The annuitisation puzzle and loss of capital

Most retirees expect to spend down some (or all) of their savings through retirement. A report by National Seniors Australia in 2017 noted that only 3% of retirees expect to preserve all their savings for the next generation, while living solely off the income generated. Nearly half would prefer to preserve some capital, but the clear majority of Australians expect that they will use up some capital to enjoy the lifestyle that they desire in retirement.

The perceived loss of capital is sometimes stated as a reason for retirees preferring return-seeking investments over annuities. Academics dating back to Yaari (1965) have demonstrated that the lifetime annuity is the most efficient way to turn some capital into a stream of lifetime income. However, because of loss aversion, many clients will see the possibility of their premature death as a potential loss of capital. This can be a barrier to using an annuity for retirement income. The challenge is to overcome this fear by adding some flexibility features to the lifetime annuity to remove the prospect of a loss of capital.

A flexible approach to a lifetime annuity

With many people seeking the peace of mind that is provided by a guaranteed lifetime income stream, there is a benefit in overcoming a retiree’s loss aversion to lock into an annuity or other guaranteed income stream. The key to helping them is to provide additional flexibility by:

  • Using only part of their accumulated savings to guarantee a layer of income
  • Providing capital access and a death benefit, particularly in the early years of retirement.

The first element of this is central to a ‘layering’ strategy and a similar concept has been adopted in the Government’s Comprehensive Income Product for Retirement (CIPR) framework. Some of the retiree’s savings are used to generate guaranteed income, and some of the savings are used to provide flexibility.

The second element has been a part of the rejuvenation of the lifetime annuity market in Australia. By including a death benefit with the annuity, retirees are no longer worried about losing capital if they die early. Indeed, the estate of those unfortunate few who only spend a few years in retirement can have 100% of their capital returned. Just like any consumer product that offers a 100% money back guarantee, the return of capital to the estate (which could just be a dependant spouse) is a relief to those loss averse retirees who are also risk averse and value a guaranteed lifetime income stream.

 

Aaron Minney is Head of Retirement Income Research at Challenger Limited, a sponsor of Cuffelinks via its subsidiary, Accurium. This article is for general educational purposes and does not consider the specific circumstances of any individual.

RELATED ARTICLES

Schemes designed to deal with longevity risk

Retirement income products - what's ideal?

The comprehensive income product for retirement

banner

Most viewed in recent weeks

Australian house prices close in on world record

Sydney is set to become the world’s most expensive city for housing over the next 12 months, a new report shows. Our other major cities aren’t far behind unless there are major changes to improve housing affordability.

The case for the $3 million super tax

The Government's proposed tax has copped a lot of flack though I think it's a reasonable approach to improve the long-term sustainability of superannuation and the retirement income system. Here’s why.

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

The super tax and the defined benefits scandal

Australia's superannuation inequities date back to poor decisions made by Parliament two decades ago. If super for the wealthy needs resetting, so too does the defined benefits schemes for our public servants.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Latest Updates

SMSF strategies

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Superannuation

The huge cost of super tax concessions

The current net annual cost of superannuation tax subsidies is around $40 billion, growing to more than $110 billion by 2060. These subsidies have always been bad policy, representing a waste of taxpayers' money.

Planning

How to avoid inheritance fights

Inspired by the papal conclave, this explores how families can avoid post-death drama through honest conversations, better planning, and trial runs - so there are no surprises when it really matters.

Superannuation

Super contribution splitting

Super contribution splitting allows couples to divide before-tax contributions to super between spouses, maximizing savings. It’s not for everyone, but in the right circumstances, it can be a smart strategy worth exploring.

Economy

Trump vs Powell: Who will blink first?

The US economy faces an unprecedented clash in leadership styles, but the President and Fed Chair could both take a lesson from the other. Not least because the fiscal and monetary authorities need to work together.

Gold

Credit cuts, rising risks, and the case for gold

Shares trade at steep valuations despite higher risks of a recession. Amid doubts that a 60/40 portfolio can still provide enough protection through times of market stress, gold's record shines bright.

Investment strategies

Buffett acolyte warns passive investors of mediocre future returns

While Chris Bloomstan doesn't have the track record of his hero, it's impressive nonetheless. And he's recently warned that today has uncanny resemblances to the 1990s tech bubble and US returns are likely to be disappointing.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.