Helping People Make Wise Decisions for Retirement Income

Nudges, long aimed at saving behavior, are needed for people converting a nest egg into income

Fewer than 1 in 5 workers report they’re “very confident” their retirement income will enable them to actually live comfortably. So, in recent years, the financial service industry has rolled out a variety of “nudges” designed to encourage people to save more for retirement.

Yet there are few nudges in place to help people as they graduate from saving to figuring out how to convert their nest egg into a reliable income stream in retirement. The conversion of savings into retirement income is a problem known as “decumulation.” The choices around decumulation are often complex, clouded by behavioral biases and the urgings of those selling financial products, so policymakers are newly focused on how to help older Americans make smarter decumulation decisions.

A 2017 General Accountability Office report detailed how fundamental changes to the retirement system over the past 40 years has made it “increasingly difficult” for people to “effectively manage retirement.” Baby boomers are the first generation given the opportunity to save for their own retirement in 401(k)s and individual retirement accounts (IRAs) rather than depend on guaranteed pension income. And now comes the even harder part: living off their savings and Social Security through what could be a very long retirement.

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For instance, faced with too-small retirement savings and greater longevity, more individuals should consider delaying when they begin to take their Social Security benefit, as the payout for starting at age 70 will be 76 percent more than the benefit for starting at age 62. Yet more than 30 percent of recipients grab their benefit at age 62. Just 3 percent of women and 5 percent of men wait until age 70.

And though many individuals near retirement say they crave guaranteed lifetime income, very few are willing to consider using a portion of their retirement savings to purchase a life annuity, which provides just that.

The GAO report noted that even individuals who have managed to accumulate substantial retirement savings are not out of the woods, as they “face a series of complex decisions,” not least because they may be at the mercy of financial advice that is not always focused on their best interests.

In an article published in the journal Policy Insights from the Behavioral and Brain Sciences, UCLA Anderson’s Suzanne Shu and City, University of London’s Stephen Shu review the psychological forces that can make it so hard for individuals to make the best decumulation choices, and present five areas where public policymakers might deploy nudges to help retirees.

Why Decumulation Is So Hard to Get Right

Shu and Shu call out behavioral differences that can steer individuals to make suboptimal decisions on how to manage their retirement income:

Self-Control: While Walter Mischel’s famed “marshmallow test” established the upside of being able to practice delayed gratification, not all the 5-year-olds could wait 15 minutes to earn a reward of an extra marshmallow. And self-control issues affect many people throughout life. For those who can afford to delay claiming Social Security, each year of delay after so-called full retirement age (between 66 and 67), until age 70, equates to approximately 8 percent more in income from Social Security.

Temporal Discounting: We often make choices that appeal to us right now, rather than make decisions that will better serve our future selves. Pair that with the self-control issues and it becomes even harder to delay when you start claiming Social Security.

Loss Aversion: When we experience a loss, the level of pain for the average person is about 2.5 times the pleasure we feel when we experience a gain. Loss aversion can create tension that leads to earlier Social Security claiming and results in aversion to retirement income products like life annuities, which could actually be useful to many under certain circumstances.

For example, one of the biggest hurdles in educating retirees on the potential value of a life annuity is getting past the feeling that “Yeah, but if I die next year I (or my heirs) will have lost all that money.” People perceived the same problem with delaying Social Security benefits. The “risk” of dying before you “get back” what you paid in can trigger loss aversion sensitivity too powerful for many to overcome. In each case, loss aversion obscures the fact both Social Security and a life annuity are powerful insurance against the risk that you will outlive your assets.

Fairness: When we don’t think we’re getting a fair deal, or if we can’t figure out if we are getting a fair deal, we aren’t going to be eager to engage. In separate research, Suzanne Shu, along with UCLA Anderson’s Robert Zeithammer and Duke University’s John W. Payne, found that the issue of “fairness” was the one variable that best determined who would likeliest consider an annuity.

Psychological Ownership/Endowment: We are protective of what we view as being in our possession. While we never have a discrete Social Security account that is, in fact, our own, the desire to claim early can be compelled by loss aversion meeting psychological ownership: “I want to get what’s mine, before I die.” Psychological ownership also ramps up the potential for the endowment effect to muddy decision making. This is the bias that finds an object is valued more highly by individuals who believe they “own” it than by a non-owner. When you’re clinging hard to what you’ve saved in your 401(k), trading in some of that balance on an annuity becomes an ask that’s tough to honor.

Nudges for the Decumulation Age

In its early incarnation, behavioral economics was consumed with showing how our brain messes with our decision making. A welcome evolution in the field: Now that behavioral obstacles and individual behavioral differences have been identified, the focus is shifting toward solutions.

Eliminating a bias is not always the goal, as changing who we are may not be appropriate for the situation. But the world of nudges has proven to be both powerful and cost-effective in helping individuals achieve better results across a multitude of personal challenges, from saving for retirement to getting the flu vaccine. (However, nudges can fail because of poor design and other factors.)

Shu and Shu synthesize the “solution” research into five potential areas that could be important decumulation nudges.

Adult Retirement Education: Many should be educated in advance and in a timely way to make complicated financial decisions, such as those regarding decumulation. A 2012 study documented that the 55-and-over-population has a low level of “financial literacy.” (For that matter, so does every age group; but it’s the 55-and-over crowd that has to figure out decumulation ASAP.)

Prior to 2008, Social Security fed the loss aversion bias by touting an individual’s “break even” age, namely, when the benefits collected would be as much as what the person had paid into the system over his or her working years. Research found that this break-even frame causes people to claim earlier. Continued low percentages of people waiting until their late 60s, or until age 70, to claim their benefit suggest that education on the benefit of delayed claiming is still needed.

Decumulation Defaults: Automatic enrollment in retirement plans, and automatic increases in the contribution rate, have been effective nudges that are increasing the number of people saving for retirement and helping them save more each year.

Research suggests that applying the same default nudge on the decumulation side could improve retiree financial security. For example, automatically converting a portion of a 401(k) saver’s account to an annuity at retirement would nudge them toward creating more guaranteed income. Right now, few 401(k) plans offer in-plan annuities, and it’s usually voluntary and opt-in.

Precommitment: One way to potentially coax more people to accept delayed gratification (waiting to claim Social Security) would be to dole out some small earlier gratification. Shu and Shu suggest that if the Social Security Administration wanted to encourage more people to delay, they might offer a small lump-sum payout at age 62 for people who have committed to waiting until they begin their regular payout at a later age.

Research also suggests that precommitment might work with annuities. Younger workers are more open to the concept of annuities than older workers. Yet annuities are typically only marketed to pre-retirees, whose bigger account values make loss aversion and psychological ownership big hurdles to overcome, and who are at an age where they would likely need to make a large lump-sum investment if they wanted an annuity.

Nudging younger workers to purchase annuities in smaller chunks could help them create guaranteed income for a retirement that is decades off, similar to a “personal pension” created for a single individual.

Better Framing and Disclosure: There are subtle messaging opportunities that the financial services industry could use to nudge people into better decumulation choices. For example, one study Suzanne Shu co-authored found that asking people how long they expect to “live to” elicited a median age that was 10 years older than asking people what age they expected to “die at.” That frame holds intriguing potential to help nudge people to delay Social Security or consider a fixed annuity.

Shu and Shu note that future research might also help determine whether, when displaying an individual’s claiming options, the Social Security Administration’s use of the jargon “ full retirement age” (FRA) isn’t another frame with a negative unintended consequence.

Everyone has an FRA between the age of 66 and 67, and when you claim Social Security at your FRA, you receive, by definition, 100 percent of FRA benefits. The FRA is a reference point. If you claim earlier than your FRA you receive a reduced benefit. For instance, someone with an FRA of 67 who claimed at age 62 would receive only 70 percent of her FRA benefit.

But the use of the term “full” may suggest that the FRA correlates with the maximum benefit that can be claimed. It doesn’t. Someone with a 67 FRA who waits until age 70 (currently framed as “delayed benefit”) would be paid 124 percent of the sum correlated to her FRA.

Shu and Shu add that there is also a possible role for regulators to improve decumulation choices. Requiring financial service providers to articulate key information — with attention to specific framing — could make it easier for individuals to make smarter decisions.

Personalized Interventions: Shu and Shu propose that personalized advice based on an individual’s actual behavioral differences could be even more effective.

Such a personal approach is indeed scalable, thanks to the growing field of fintech that has spawned the growth of roboadvisors.

For example: Wondering about your degree of loss aversion? There’s already an app for that, developed by UCLA Anderson’s Shlomo Benartzi and Duke University’s John Payne. Make it through the free calculator and you will be delivered an assessment of how intensely you experience loss aversion. If you happen to be on the precipice of decumulation, that might help you course-correct to make sure your plan has the best shot of providing the income you want (and need) for a retirement that could last decades.

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About the Research

Shu, S.B, & Shu, S.D. (2018). The psychology of decumulation decisions during retirementPolicy Insights from the Behavioral and Brain Sciences, 5(2), 216–223. doi: 10.1177/2372732218790034

Shu, S.B., Zeithammer, R., & Payne, J.W. (in press). The pivotal role of fairness: Which consumers like annuities? Financial Planning Review.

Payne, J.W., Sagara, N., Shu S.B., Appelt, K.C., & Johnson, E.J. (2013). Life expectancy as a constructed belief: Evidence of a live-to or die-by framing effectJournal of Risk and Uncertainty, 46(1), 27–50. doi: 10.1007/s11166-012-9158-0

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