Overconfidence Versus Extreme Caution: Irrationality in Retirement Planning

by on Oct 02, 2019

Couple Enjoying Retirement Confidence and caution are generally sensible characteristics. However, when it comes to retirement planning, an excess of either can be disadvantageous. Further, neither is usually based on a person’s true readiness. If recordkeepers, sponsors and employers understood the disconnect between retirement confidence and preparedness and its consequences, they could better identify those who need assistance and provide more targeted outreach.

People often act in ways that appear economically irrational, with emotions like fear, anxiety and worry overriding logic. In a recent American Institute of Certified Public Accountants survey, approximately half of respondents reported feeling worried about outliving their retirement funds. Concerned future retirees sometimes invest conservatively in order to protect their savings, but the over-cautious can miss out on growth opportunities available in a riskier asset mix, as their portfolios may ultimately buckle under inflation, stunting their savings. Experts recommend diversification to safeguard against market volatility and grow wealth, but it is also important for individuals to start with an aggressive portfolio mix and readjust to safer mixes as they age.

Once in retirement, some people are extremely cautious with spending. Asset manager BlackRock reported that most current retirees have only spent 20% of their nest egg two decades into retirement. Indeed, frugality seems warranted: current retirees have likely experienced the pitfalls of several recessions, including the recent Great Recession. Retirees in BlackRock’s survey also expressed concerns about uncertain longevity and future costs of living. Yet, experts still recommend budgeting and smart spending over “stashing wealth under your mattress.” This helps ensure that retirees don’t needlessly lower their quality of life in retirement.

On the opposite end of the spectrum, some retirement planners are overly confident. According to Corporate Insight’s study, A Roadmap of the Financial Wellness Ecosystem, 25% of respondents claim that they are “very confident” in their ability to afford their desired retirement lifestyles. Millennials and Generation Z are the most certain; 72% of Gen Zers report being “very confident” or “confident”, while 55% of Millennials report the same. Baby Boomers and Generation X members appear less confident—about 57% of Gen X members and 62% of Baby Boomers consider themselves “somewhat,” “not very” or “not at all” confident in their ability to afford their desired retirement lifestyle.

Retirement Confidence by GenerationRetirement Confidence by Generation

High confidence rates may reflect employees’ tendency to disregard retirement industry guidelines, simply assuming they can maintain their desired retirement lifestyle. For example, experts recommend total retirement plan contribution rates of at least 10%; yet, 34% of our survey’s respondents reported contribution rates between 4% and 6%. Moreover, an emergency fund is another important retirement readiness factor—when a market slumps at the same time a retiree begins withdrawing from their savings, they can spend through their funds much faster than anticipated, and emergency funds help alleviate losses. However, only 55% of our survey’s respondents indicated having an emergency savings fund. Such a fund should cover at least three months’ worth of expenses, but around 37.5% of those with an emergency fund either believed their savings would last less than two months or did not know how long they would last.

Importantly, insufficient retirement education and financial literacy contributes to the confidence-preparedness gap in retirement planning. When individuals feel uninformed about a subject, they tend to avoid seeking advice or taking actions to improve their circumstances. Therefore, recordkeepers, plan sponsors and employers must understand the types of cognition that lead to damaging financial behaviors and provide those in need with targeted advice and education. Helping retirement savers make accurate financial decisions can help motivate those falling behind to save more and encourage those with adequate savings to enjoy their golden years.