Gambling with your Retirement Nest Egg

In April of 2013, PBS Frontline aired a documentary titled “The Retirement Gamble” (available online). It offers a sobering report on the problems with 401(k) type retirement plans in the U.S. and the obstacles facing working Americans in their quest to achieve a secure retirement. If you were already suspicious of the motives of some in the financial services industry, watching this documentary is unlikely to alter your opinion. There have been both vocal critics and defenders of the show. Here are my observations.

At the outset, the filmmakers highlighted the fact that too many Americans including the show’s producer, Martin Smith, have failed to save enough money to maintain even a modestly comfortable lifestyle after they stop working. They offered personal commentaries from those who simply failed to adequately plan for retirement and those who lost their jobs and savings as a result of the recent financial crisis.

In the second part of the show the producers transitioned to the role that financial institutions and their representatives have played in the retirement savings crisis. They unleashed a scathing exposé of the high and opaque retirement plan fees charged by the financial institutions and the conflicts of interest that exist between their salespeople and investors. Although “The Retirement Gamble” focused on workplace retirement plans, the problems of high fees and conflicts of interest which go hand in hand are rampant throughout the investment industry. So, even for those fortunate and diligent enough to be earning and saving sufficiently for a comfortable retirement, the program contains important lessons and has significant implications for their financial futures.

Not surprisingly, the shift in the show’s focus from the responsibility of the investor to save aggressively and invest wisely to that of the financial institutions and their representatives to act fairly and transparently sparked outrage from the financial services community. Their central argument is that: the accusations of unnecessarily high fees imbedded (i.e. buried) in many retirement plans and the conflicts of interest between them and the investors they serve are greatly exaggerated.

This argument is simply not credible. The evidence is overwhelming and the facts do not support their claim. Furthermore those making the claim clearly understand this. It was revealing to watch executives of the firms featured in the documentary looking visibly uncomfortable and struggling to formulate a plausible response when asked by Frontline to explain the obvious conflicts of interest inherent in a system they have fought vigorously to defend. This is the same system that allows their representatives to sell high commission, high margin and inappropriate investments to unsuspecting and trusting investors.

The unfortunate reality is that these firms which represent the overwhelming majority of those in the brokerage, banking, and insurance industries have no legal fiduciary obligation to their clients, which would require them to place the interests of those clients ahead of all others including their own. Instead, they operate on a much lower (so low as to be meaningless)”suitability” standard. Their representatives are commissioned salespeople who are incentivized to sell products, especially the ones that generate the highest earnings for themselves and their companies.

I’ll conclude with two points. First, don’t make retirement planning any more complicated than necessary. There is little doubt that saving more during your working years and controlling spending during your retirement years is the most important factor in achieving a successful retirement. This responsibility to forgo some spending today in order to save for the future falls squarely on the individual, not on the financial institutions. Furthermore tax-advantaged accounts like the 401(k) are powerful tools to build wealth because the investments inside them grow without the drag of taxes. Most working Americans would benefit from taking maximum advantage of these plans. In my opinion, Frontline could have done a better job communicating this in a simple, straightforward way.

Second, successful investing has more to do with avoiding inappropriate investments and building a diversified, low-cost portfolio than trying to identify the next” hot” investment. The program made clear the fact that all advisors do not operate under the same standard of care and the type of advisor you work with can have big implications for your finances primarily as a consequence of the types and costs of the investment recommendations made. The term “financial advisor” is broadly applied not only to Registered Investment Advisors who are fiduciaries and are mandated to place the client’s best interest ahead of all others, but also to salespeople who are not required to operate under such a fiduciary mandate. Under current laws it is again the responsibility of the investor to understand the distinction between the two and select the one who will better serve them. The principle of “buyer beware” is a smart one to follow when seeking financial advice.


Compound Consequences

Underestimating the impact of compound growth on a household’s finances can lead consumers to make poor economic decisions including borrowing too much and saving too little. There are three main engines that drive compound interest on an investment made or a loan taken out. They are the amount invested or borrowed, the time horizon of the investment or loan, and the interest rate earned or paid. The longer the time horizon and the higher the growth rate, the greater the financial impact.

Most major financial decisions such as saving for retirement or repaying a loan involve large dollar amounts, long time periods and relatively high growth rates. Therefore, compound growth can have an enormous effect on an individual’s financial security. Even modest amounts saved can turn into substantial retirement nest eggs and small amounts borrowed can spiral into large debts over time. Read more

No time like today to save for tomorrow – Part 2

In my last post, I talked about the importance of making good financial decisions when planning for retirement. Although people have good intentions about how and when to save, left to their own devices, they fall prey to certain biases when making financial decisions. In this article, we’ll address additional obstacles and introduce some solutions to work around these issues.

Procrastination. Closely associated with self-control, procrastination is the tendency to postpone unpleasant tasks. Instead of engaging in a goal-achieving activity such as retirement planning that involves complexity and may lead to frustration, people often opt for a stress-relieving activity such as watching a favorite television program. Herbert Simon, another Nobel Laureate related procrastination to “cognitive laziness” which is the attempt by individuals to avoid the hard work of thinking through a problem.

 Inertia. Procrastination in turn produces a related psychological force known as inertia, which is the resistance to change. This resistance often is the consequence of what is known as “loss aversion”. This is the tendency of decision-makers to put more emphasis on what they could lose rather than how they might benefit. A key finding of behavioral economics is that people weigh losses significantly more heavily than gains. Some estimates peg the ratio at 2:1. In other words, losses generate twice as much psychological pain as gains yield pleasure.

Loss aversion affects saving decisions because once households become used to a particular level of take-home pay, they tend to view reductions in that level as a “loss”, even when it is the result of increased savings. Compounding the challenge, saving for retirement involves a difficult trade-off between current and future consumption. The evidence is clear that most individuals have a strong preference for the immediate rewards of spending today over the future payoff of enjoying an increased standard of living in retirement.


Fortunately, the study of the behavioral forces that result in poor decisions has enabled researchers to develop strategies to employ those forces to produce better choices and financial outcomes. A program designed by behavioral economists Shlomo Benartzi of UCLA and Richard Thaler of the University of Chicago does just that. Their program called Save More Tomorrow (SMarT) is intended for employers who want to increase employee savings rates in 401(k) type plans. One feature known as “automatic escalation” however can easily be adapted by the average person saving for any important future goal.

The idea is to automatically increase savings from the employee’s paycheck with each future salary increase. This simple tactic can avoid the psychological barriers that impede individuals from achieving what they want; minimum pain today and larger account balances at retirement. It uses what could be considered a “behavior first” approach meaning that it requires a change of behavior rather than a change of attitude or an increase in computational skills. These are some of the benefits:

  • It’s simple. It eliminates the complexity of making difficult assumptions and calculations. It is a yes or no decision. You either commit to it or you do not. Once committed, you know that 30%, 50% or more of each pay increase will be “swept” into an investment account. All of the calculations are complete, and the hard work is done.
  • It is pre-determined. Because of the psychological barriers of lack of self-control and procrastination, most of us find it easier to imagine and commit to doing something difficult in the future rather than right now. Pre-commitments are a way of avoiding the inevitable temptation of the moment (when the cash is in our hands), and our inclination to procrastinate matters that have an immediate cost but a future reward.
  • It’s painless. Inertia can be triggered by several factors, one of which is hypersensitivity to loss, or placing more weight on the pain from the potential loss than the benefits from the potential gain. In the savings context, people hate to see their take-home pay go down. The automatic increase program does an end-run around these powerful psychological forces. In their book “Nudge” authors Richard Thaler and Cass Sunstein applaud the success of the SMarT program in general and the automatic escalation feature specifically. “By synchronizing pay raises and savings increases, participants never see their take-home amounts go down, and they don’t view their increased retirement contributions as losses. Once someone joins the program, the saving increases are automatic, using inertia to increase savings rather than prevent savings.” Simply put, it is easier to keep on doing what you have been doing, than it is to change.

Behavioral economists have identified the obstacles humans face when making financial decisions involving complex problems surrounded by uncertainty and require an immediate sacrifice for an uncertain payoff in the distant future. That is to say, precisely the elements households face in planning for retirement. As humans, we fall prey to a combination of psychological forces that lead us to make poor choices.

Fortunately, the same factors that hinder individuals from making wise choices are now being employed to help people improve their chances of securing a comfortable retirement. Committing to save a substantial portion of future pay increases is one of the simplest and most effective strategies to do this. It does not require superior skills or an advanced degree, just a little common sense – and yes, also some self-control.