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FA Center: 4 ways we don’t make rational money decisions as we reach retirement

Nudging people to make more rational decisions as they enter retirement is more challenging than nudging them to save more while working. Read More...

No one lives forever. So why, 18 years into retirement, have individuals generally spent only 20% of their nest egg? Why, if people want to conserve their assets, do nearly half of Americans take Social Security benefits at the earliest possible age of 62 — receiving only about 70% of the full benefit available at age 67?

Money and rationality don’t always mix, of course. That’s especially true with retirement. The issue is complex and uncertain and can trigger feelings of fear and anxiety that may interfere with rational decision-making.

One way to address these issues is for the industry — consultants, advisors, plan sponsors and asset managers — to apply insights from behavioral finance. We believe this could encourage smarter, more rational decisions as people enter retirement.

Indeed, behavioral insights have played an important role in helping people save for retirement. Automatic enrollment into company-sponsored retirement accounts and default investments such as target-date funds have jump-started asset accumulation and prompted use of more-disciplined investment strategies. These “nudges” transform a cognitive bias — inertia — from a negative to positive.

However, nudging individuals to make more rational decisions as they enter retirement will be more challenging. The decisions that one needs to make at or near retirement, which significantly affect one’s ability to enjoy the “golden years,” are arguably more complex than those made during the accumulation phase. Not only are these decisions complex in isolation, but the complexity is amplified because each decision is interrelated to all of the others, as we outlined in recent research. Indeed, key questions — such as when to take Social Security, how to invest assets, whether to buy an annuity and how quickly to spend savings over an unknown remaining lifetime — can befuddle the most sophisticated minds in finance, let alone individuals with modest savings and limited financial knowledge.

Here are four decisions where insights from behavioral finance may promote more rational decisions and help to improve retirement security for millions of Americans:

Social Security

Our research indicates that individuals with average health and moderate affluence would likely be better off deferring Social Security benefits until age 70.

Nonetheless, about 90% of those eligible claim Social Security before the full benefit age of 67. Without doubt, there are rational reasons to take Social Security early — including poor health, limited financial resources, spousal considerations and concern over the survival of Social Security. Yet it is clear that the vast majority of individuals are not optimizing this decision.

This mass early election may partially be explained by the “present-bias” — the human preference to take an immediate reward over a future one.

Academic research suggests that modifying this behavior may be difficult at best. Nonetheless, solutions may include improved financial literacy and improved communication around the consequences of early election, especially if it intensifies the very powerful human emotion, regret.


One of the greatest complexities with retirement planning lies in not knowing how long you will live and therefore how long your assets will need to last. Certain types of annuities, such as deferred annuities, seek to address the risk of outliving one’s assets, commonly known as longevity risk, and therefore greatly simplify the retirement planning problem. Deferred annuities provide guaranteed income for life and commence their payout at a future time. For instance, a retiree at 65 years of age who purchases a deferred annuity with payments beginning at 85 may have greater confidence in consuming a portion of their nest egg.

So why do so few individuals buy annuities? For most defined contribution participants, annuities are simply not made available. And even when available, few buy them, finding annuities expensive and complicated.

Moreover, behavioral science suggests that emotion also may play an important role. Specifically, the best predictor of whether someone will consider an annuity is sensitivity to issues of fairness, according to research by Suzanne Shu, Robert Zeithammer and John Payne — in particular, the belief that the insurance company will keep excess funds when the policyholder dies.

The old adage that annuities are sold, not bought, suggests that personalized education and advice will be required to overcome cognitive biases against annuities.

Of course, it is unlikely that the rate of annuity adoption will change any time soon. Therefore, in order to simulate the relative stability that some types of annuities provide and hedge longevity risk, one must assume a more conservative asset allocation, favoring fixed income over equities.

Asset allocation

Prospective retirees must determine how to invest their savings between stocks and bonds. A key assumption in our modeling is that individuals strive for a stable retirement income stream. Holding more in equities may generate higher retirement income and allow for a higher quality of life, but it comes with greater uncertainty. Conversely, holding more in bonds may increase the certainty of income but likely at a lower level.

Our research finds that those with more wealth should hold less equity exposure than those with less wealth. This is not because of growing risk aversion as one ages. Rather, it’s because as wealth grows, Social Security — which mimics the role of bonds in providing an income stream — represents a shrinking percentage of total income. It follows that wealthier people need to replace that missing fixed-income exposure with bonds within their financial portfolio. Therefore Social Security may be one of the most important factors driving the asset-allocation decision.

Empirical data, however, show that few individuals de-risk their portfolios. Whether viewed through the lens of age or wealth, data suggest that most individuals simply hold portfolios with approximately 60% equities and 40% bonds.

Consumption rates

What is a reasonable level of principal drawdown for a retiree? Too aggressive a pace may deplete assets and impair the retiree’s lifestyle. Conversely, if one spends too little, their quality of life may suffer unnecessarily. Complicating this question is Pimco’s belief that returns from equities and bonds will be lower going forward than in recent decades

With the goal of maximizing high quality, stable income in retirement, according to our framework, most individuals can afford to consume roughly 3.5%–5.0% of their savings every year, adjusting for inflation, depending largely upon one’s willingness to consume from both portfolio returns and principal as well as address longevity risk. If one is willing to allocate a significant portion of their assets to address longevity risk in the form of a deferred annuity, consumption at the higher end of the range can be justified.

Interestingly, regardless of one’s wealth level at retirement, most retirees prefer to consume only income derived from Social Security, their pension or investment portfolio, but not principal. After 18 years, the typical retiree has used only 20% of their assets.

These reasons are far from irrational, of course. The aversion to consuming principal is strong and may reflect one’s desire to self-insure against future expenses, medical concerns, longevity risk and, for a limited few, a wish to pass wealth to heirs.

Clearly, the human preference to spend income and preserve principal should be incorporated into retirement income portfolio design to help overcome this mental accounting bias. Specifically, portfolios favoring returns sourced from income over capital gains may create more stable portfolios, and stimulate greater consumption in retirement commensurate with one’s means.


Making optimal decisions for retirement is inherently difficult. Human emotion and cognitive bias lead many of us to make suboptimal judgments. It’s time for the industry to make better use of behavioral science to nudge retirees toward improved decisions and retirement outcomes.

Richard Fulford is head of Pimco’s U.S. retirement business. Steve Sapra is part of Pimco’s client solutions and analytics team. This was first published by Pimco.

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