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.