Overcoming a Major Retirement Planning Hurdle: Present Bias
Focusing Too Much On The Present Can Have Long-Term Consequences
Live in the moment, plan for the future, and thrive!
That’s a simple financial planning mantra to try and live by. But as far as our finances are concerned, this slogan may seem a little easier said than done. This is due to the fact we have some behavioral biases that create a tendency for us to focus too much on the present.
One of the biggest challenges related to managing our money is figuring out how to balance our current wants and needs with other important but more distant goals like retirement.
Another challenge is putting past financial mistakes in the past where they belong.
Do you have trouble focusing on anything other than present financial goals like paying the bills, reducing debt, building up your savings, or figuring out how to fund your weekend plans? Or, do you get caught in the seemingly never ending loop of replaying past financial decisions or regrets over and over in your mind?
How Present Bias Impacts Your Retirement
“Present bias” is a tendency for people to place a stronger emphasis on the earlier option as it gets closer when evaluating the potential tradeoff between two possible future alternatives. For example, consider a situation where an individual is anticipating a windfall of money in the next six months. A person with a present bias might express a strong desire to save money in a retirement account in six months. However, when the money is received, the individual with a present bias prefers not to save the money for retirement even though the only thing that changed was the passage of time.
Not surprisingly, individuals with a present bias will save less money for retirement than those who do not change their mind when the money is actually available.
The authors of a study published in the National Bureau of Economic Research found that 55 percent of survey respondents have a present-bias tendency.
Coincidentally the National Retirement Risk Index tells us that 52 percent of households are at risk of not being able to maintain current living standards during their retirement years.
Similar tests on present bias and time perspective have been conducted and repeated using the marshmallow test. Young children were given the choice of eating a marshmallow immediately or deciding to wait five minutes so they could receive two marshmallows. Mischel, Shoda, and Rodriquez (1989) followed up with the children later on in adulthood and found that impulse control and delayed gratification resulted in more positive life outcomes across a variety of intellectual, social and psychological measures.
The marshmallow test can also be linked to the retirement planning process where delayed gratification and impulse control are necessary to make sure we are saving enough for future financial life goals. Zimbardo and Boyd (1989) are researchers who have summarized five different time perspectives that can be measured using the Zimbardo Time Perspective Inventory. The time perspectives are as follows:
- Past-positive: individuals with this time perspective tend to focus on positive or nostalgic past events
- Past-negative: individuals with this time perspective tend to focus on negative past events
- Present-hedonistic: individuals with this time perspective tend to focus on the positive sensory, biologic, or social outcomes associated with the present environment
- Present-fatalistic: this time perspective is identified by a hopeless, helpless attitude toward the future
- Future: this time perspective is identified by a general future orientation (behaviors tend to be dominated by a desire to obtain future rewards)
Assessing Behavioral Biases That Hurt Retirement Savings
If you are curious to find out your own potential time perspective biases you can complete the Zimbardo Time Perspective Inventory.
The Power of Compound Interest
Economists are also concerned about another type of bias called “exponential growth” bias.
This is a type of bias that leads to irrational behavior and is observed when people fail to realize the power of compounding interest. Albert Einstein once said that compound interest is “the most powerful force in the universe”. Individuals who do not understand the power of compounding interest expect retirement savings to grow in a linear fashion and tend to save less. Individuals who understand compounding interest expect retirement balances to grow exponentially. See the Rule of 72 for more information on how long it will take to double your retirement savings.
According to a study published in the National Bureau of Economic Research, the elimination of “present bias” and “exponential growth” bias (a.k.a. “no clue what compound interest is” bias) would increase retirement savings by 12 percent. This Bloomberg article states that the total dollar amount of increased retirement savings is approximately $1.7 trillion.
Potential Solutions: Make Saving for Retirement Automatic
One way to help overcome present bias is to automate the process of saving for retirement. Make saving for non-retirement goals easier by setting up direct deposits from your paycheck to an account that is separate from your day to day checking account. For retirement accounts such as your 401(k) plan, see if your employer provides automatic rate increases that will give your contributions a boost on a regular basis. This “Save More Tomorrow” concept truly works and is one of the best ways to overcome present bias when good ole fashioned willpower isn’t getting the job done.
Are you interested in more information about how you can take charge of your financial life? If so, visit the Financial Independence Day site to learn more about the book What Your Financial Advisor Isn’t Telling You: The 10 Essential Truths You Need to Know About Your Money.