Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 79

Investor behaviour and lump sum bias

Australian superannuation funds face a number of barriers in providing an adequate and sustainable level of retirement income for their members. This article looks at one such barrier, an investor behaviour known as ‘lump sum’ bias.

What is lump sum bias?

Public superannuation funds accumulate capital for people to retire on. But most people find it difficult to calculate how much retirement income their capital can reliably produce from year to year. They tend to over-estimate the amount of annual income it can reliably produce.

Anecdotes about such behaviour are common place. Retirement expert, Don Ezra, suggests that if you ask an intelligent, but non-mathematical, person how much yearly income a lump sum of $100,000 could reliably generate for the rest of their lives, their usual response would be in the range of $10,000 to $20,000. Most experts would put the correct figure at around $5,000 per annum, perhaps even less.

Lump sum bias is where people place a higher value on a lump sum than the actuarially fair and sustainable income stream it could produce.

In rational economic theory, a person should choose the payment outcome that has the highest discounted value. Behaviourally, however, people have a bias towards a lump sum payment. There are a number of factors that explain why people exhibit such bias, including:

  • wealth illusion – one simply looks bigger than the other
  • affect heuristic – people make a rapid, intuitive judgment because it feels like a good amount
  • simple temporal discounting – people generally prefer dollars today over dollars tomorrow
  • preference for certainty – people perceive the future as uncertain, and by taking a lump sum payment today, they eliminate a degree of uncertainty, even if they potentially sacrifice some ultimately higher value
  • opportunity cost – people believe that having a single large sum might enable them to create or exploit an otherwise unavailable opportunity
  • utility of money – people expect the utility of money to decrease as they age and that they will have fewer and less attractive opportunities to enjoy the money.

Evidence of lump sum bias

United States academic Dan Goldstein conducted an experiment where participants were asked to rate their satisfaction with either a $100,000 lump sum or monthly payments of $300, $500 or $900 for life. For a 65-year-old, such a lump sum is roughly equivalent to $500 a month for life.

Respondents had clear preference for the lump sum, even compared to the much more actuarially valuable $900 monthly payments. In fact, Goldstein calculated that the ‘indifference point’ (ie where people would take either) between monthly payments and a $100,000 lump sum was $1,065 a month, nearly twice what it should have been.

Australian financial research firm Investment Trends conducted a similar survey in Australia. They asked people 40 years of age and over how much minimum guaranteed annual income they would need for the rest of their life, in return for a $100,000 investment. Figure 1 outlines the results. The average response was $8,200 per annum, with $10,000 per annum being the most selected option. This is well above the actuarially fair amount of approximately $5,000 per annum.

Figure 1 Lifetime annual income required for a $100k lump sum

Summary

When it comes to developing an income plan for retirement, lump sum bias can negatively impact the planning process. People who are unable to determine an equivalent income stream from a lump sum might not be saving enough. In particular, people with smaller amounts of retirement savings feel that a lump sum is more adequate for retirement than an equivalent income stream.

Most super fund members get their periodic statement with their latest account balance on it. If they also received a projection of their annual income in retirement in today’s dollars (while highlighting the likelihood of a range of outcomes deviating from the average) it would help prevent them from falling short of retirement adequacy by over-estimating the value of their lump sums.

 

Aaron Minney is Head of Retirement Income Research and Phil Sainsbury is a Research Analyst at Challenger Limited.

 

3 Comments
David M
September 12, 2014

Well written article, have known and seen this in action but wasn’t aware it had a label. I think some form of additional reporting about the possible income stream is a good idea; this might encourage people to help grow their superannuation.

Warren Bird
September 12, 2014

To me, the answer to the poll question that is related to this article is: "it depends on the credit rating of the institution promising me the income."

What I mean is this. If faced with a choice between a $100,000 lump sum or $4,000 a year from the Government, I'd take the income stream. But if the promise of $4,000 a year was from a BBB rated financial institution with no clear investment process, I'd take the lump sum and invest it in a portfolio of my own choosing.

If the BBB rated institution offered my $7,000 a year I might think about it. Even then, if this was all I had saved up, I'd be worried about the concentration risk and would prefer a more diversified source of income.

So I'm curious whether any of the research took this into account? What was the actual nature of the income promise that people were asked to compare with the lump sum? Clearly if people like me responded, it would bias up the break-even income level!

Stuart Barton
September 17, 2014

Ceteris paribus would be the answer, wouldn't it? The research is expressly solving for one variable, so doesn't take into account the issuer's creditworthiness, nor the actual or self-perceived skill level of the respondent. A separate experiment would be required to test for sensitivity around the perceived creditworthiness of the income stream issuer, Even so I am not sure that the theoretically risk-free Government is an appropriate foil, as not even Australia's A-rated life companies/annuity providers will have higher perceived creditworthiness.

 

Leave a Comment:

     

RELATED ARTICLES

Putting off that retirement speech

10 years on from the GFC, retirees still jittery

Time to build a super system fit for retirement

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 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. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). 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.

Website Development by Master Publisher.