Mental Barriers to Saving
Why is it so difficult to save for the future? Answer: psychological stumbling blocks. If you’re like most Americans, you probably don’t know how much you need to save to achieve your financial goals.
Lack of planning is widespread, unfortunately. Professors Anna Maria Lusardi and Olivia Mitchell, of Dartmouth College and the Wharton School of Business, conducted a study that concluded that the vast majority of Americans over 50 failed to plan for retirement. Their survey found that only 31% of Americans ever tried to figure out how much they will need in retirement. Of those that did this, only 58% actually prepared a retirement plan.
How is it possible that less than one in five Americans over 50 have a retirement plan? This evidence flies in the face of the conventional economic wisdom that people achieve the proper mix of savings and consumption by balancing the benefits of current consumption against the benefits of saving for the future. According to this theory, everyone diligently follows a retirement plan.
Do You Know the Future Value of Savings?
But the Lusardi-Mitchell study also indicates that many Americans lack a basic understanding of compound interest, which can help explain why so few people save enough money for retirement. Compounding interest rewards long-term saving. It’s one of the key ways that folks gradually build wealth. In the two economists’ survey, about one third of participants incorrectly answered the following question:
Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow: More than $102, exactly $102, less than $102?”
It is alarming that so many people couldn’t answer this question. This underscores one of the major problems with standard economic theory, which assumes that people rationally balance consumption and savings. Without a basic understanding of compound interest, how is it possible to know the future value of your savings? Even people nearing retirement tend to choose the tangible benefits of consumption over the uncertain value of saving.
The Windfall Experiment
Another experiment by behavioral economists Hersh Shefrin and Richard Thaler also runs contrary to the standard economic theory of saving. Shefrin and Thaler asked participants what they might do with a $2,400 windfall in three different scenarios.
The first scenario was a new bonus that pays $200 per month for the next year. The average participant opted to consume $100 each month, resulting in total spending of $1,200. The second scenario was a $2,400 lump sum, where the median subject decided to spend $400 immediately along with an extra $35 per month for the next 11 months. As such, spending under the lump sum scenario totaled $785. The last scenario was an inheritance of $2,400, held in an interest bearing account for five years, after which the participant gets the original sum plus earned interest. In this case, the most common response was to refrain from spending the money in the current year.
Standard economic theory dictates that the amount you save should be the same under all of these scenarios, because the present value of the bonus is the same in each. Nonetheless, empirical evidence indicates that this is clearly not the case.
These results indicate that psychological factors influence the decision-making process. In these cases the respondents created what economists George Akerlof and Robert Shiller call “mental accounts” for current income, current assets and future income. The timing and circumstances of how you receive money lead you to look at the same sum differently.
Clearly, the human brain is ill-equipped for making good decisions about savings and consumption. This is why it’s important to seek professional money advice. If you need help formulating a retirement plan so that you know exactly how much you need to save to accomplish your financial goals, you should consult a financial advisor with the experience and expertise necessary to guide you.
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David Zuckerman, CFP, CIMA, is principal and chief investment officer at Zuckerman Capital Management LLC in Los Angeles, Calif. He serves as CFP Board ambassador and director at large for the Los Angeles chapter of the Financial Planning Association.
The preceding content was originally published on the Financial Planning Association website: http://www.fpanet.org/ToolsResources/ArticlesBooksChecklists/Articles/Savings/TheChallengeofSaving/
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