Humans already use what’s called mental accounting in their day-to-day lives, but the concept could be used much more effectively when it comes to planning retirement outcomes.
We routinely earmark money into different notional accounts – for example, the mortgage payment or private education savings – instead of thinking in terms of our whole portfolio. It can be irrational, but it has aided our self-control and helped us keep track of important goals for generations. The banks have developed various products to support mental accounting, but how well is the super system managing this bias to deliver optimal retirement outcomes?
In the 1999 Journal of Behavioral Decision Making article “Mental Accounting Matters”, Richard Thaler recognised that households routinely organise and evaluate their finances using a cognitive system of mental accounting to aid self-control. But this system can lead to irrational outcomes. For example, an individual saving for a specific goal, such as Christmas presents, might set up a monthly direct debit to deposit money into a savings account earning 1.5 per cent a year, even though they have credit-card debt that’s generating an interest bill of more than 20 per cent a year. Clearly, if approached from the perspective of the total portfolio, the rational individual would pay down the debt first and then allocate residual money into the savings account.
The banking system has embraced this human bias. Suncorp allows you to link up to nine sub-accounts to help you “see how your savings goals are tracking” and “with three pots of money, the AMP Bett3r Account (Bett3r) helps you automatically pay bills, save and know what’s left to spend”.
It all changes at retirement
All through our working lives, the financial system supports our need to engage in mental accounting: we receive a periodic wage, we segregate our short and medium-term finances into different buckets, and we have a long-term pool of retirement savings that we can’t touch. We don’t need to worry about our whole portfolio moving up and down in line with market fluctuations, as there are segmented pieces all designed to serve different purposes. But as soon as retirement hits, this structure changes. Suddenly we have a large, tempting lump sum of capital. And to manage it effectively, we need to take a whole-of-portfolio approach to it, which we aren’t well equipped to do.
A few advice techniques and products have been developed to address this. For example, part of the goals-based advice approach segregates clients’ wealth into short-, medium- and long-term buckets. Defining these can help clients stay the course during volatile markets. If the short-term bucket isn’t moving around (because it’s invested in short-term cash and fixed interest), clients feel comforted by this stability and may be more likely to keep their medium- and long-term buckets invested. Some of the larger super funds have adopted this strategy. Equip’s MyPension uses a bucketing strategy to help manage its members’ emotional drivers.
The bucketing approach isn’t a panacea, it can often lead to a client being too conservatively invested and can create a cash drag on returns. The advancements in managed accounts may help advisers handle the buckets systematically (like a diversified portfolio) and reduce some of the investment imperfections of the strategy, but I’m yet to see evidence of this. The imperfections of the bucketing strategy need to be weighed up against why we engage in mental accounting. One of the main reasons for it is to aid self-control. A cash drag on a portfolio may not be optimal over time, but worse is a client panicking at the bottom of a cycle, selling all of their growth investments, and not re-investing until the market has substantially recovered.
A better solution to retirement is more sophisticated reporting that could disaggregate a well-diversified portfolio into appropriately labelled mental accounts that match goals and timeframes. This would overcome any investment-related issues with managing separate buckets as a whole portfolio and enable meaningful advice conversations. While this is on the radar of some of the more progressive platforms, I’ve not seen it done well.
The government has acknowledged that behavioural biases at retirement need to be addressed and comprehensive income products for retirement need to deal with this issue. It’s clear the super system is grappling with mental accounting, but we’ve got a way to go yet. Product development, client reporting and member communications need to be mindful that we have biases that can lead to sub-optimal outcomes if not well managed. And we need to provide an appropriate set of crutches after work years to support better retirement outcomes.
Annika Bradley is a financial services consultant and a director of the CIMA Society of Australia.
