The Illusion Of Wealth

Would you prefer a lump sum of $300,000, or its equivalent monthly income stream of $1,000 for life? If $300,000 seems larger and more appealing to you than the monthly amount then you might exhibit a phenomenon known as the illusion of wealth.

A 2014 study looked at the illusion of wealth and how it might drive retirees to claim social security benefits too early, avoid purchasing an annuity, or to cash-out their defined benefit pensions.

The Illusion of Wealth

The Illusion of Wealth

People are more sensitive to changes in wealth when expressed in monthly terms. That’s because everyday financial obligations such as rent, car payments, and utility bills are expressed in monthly amounts and so any change in monthly income would simply mean identifying which monthly expenses to add or eliminate.

You might easily judge $1,000 per month to be too little to live on in retirement if your current rent alone is $1,200. Similarly, you might judge $5,000 per month to be more than adequate, since it would allow you to upgrade your apartment, for example, while keeping other expenses constant.

But it is not as straightforward when judging a lump sum like $300,000 in terms of adequacy for retirement. According to the study, one might hope to translate the lump sum into a monthly income amount and compare it to current expenditures, but doing so would require an annuity calculator.

The study goes on to say that without the ability to understand what various lump sums mean in terms of giving up or adding identifiable expenditures, people are predicted to be less sensitive to changes in wealth in the critical region of $100,000 to $1,000,000.

The Annuity Puzzle

This illusion of wealth might explain why retirees are so reluctant to purchase an annuity – exchanging a lump sum amount for a guaranteed monthly income stream.

“If people perceive small lump sums as much bigger than they are, then exchanging them for what seems to be very-small monthly payments would be unappealing.” 

The authors predict that annuities become more attractive the larger the amount at stake. Their analysis from defined benefit plans shows that retirees are less likely to cash out their benefits as a lump sum payment if their total benefits are rather large.

The illusion of wealth might also contribute to the tendency of Americans to claim their social security benefits early, with 40-50 percent claiming at 62, the earliest possible age (Canadians have the same tendency to take CPP early).

Until recently, the social security administration had a tool that attempted to help older Americans decide when to claim their social security benefits by displaying the amount forfeited by not claiming at 62 and waiting a year to age 63 (say $21,492) versus the monthly increase for those waiting till 63 (say $119 per month). Applying the illusion of wealth, the lump sum loss of $21,492 is perceived much larger than the monthly increase in lifetime payments of $119.

So What Does This All Mean?

The purpose of the illusion of wealth study was to look at how information is presented to people in hopes to get them to save more money for retirement.

In Dan Ariely’s book, Dollars and Sense, the author describes an experiment in which some people were given a salary of $70,000, while others were given the equivalent earnings of $35 an hour.

When framed as hourly earnings, people saved less than when earnings were defined as a yearly sum of $70,000. Apparently we take more of a long-term view when our salary is presented as a yearly amount, and consequently we save more for retirement.

Ariely says that while the illusion of wealth might seem like a flaw in our thinking perhaps it can be something that we can use to design saving systems to our advantage.

For example, stating retirement income in monthly terms should make us feel that we are saving less than we need, and make us think we should increase the amount and save more.

Similarly, we could put projected monthly income at our expected time of retirement before any other information on our investment statements, making it obvious that the need for savings is still high.

That speaks to the appeal of dividend investing, particularly in the accumulation years. It can be motivating to see those quarterly payments climb; at first enough to pay a utility bill, then a car payment, a mortgage payment, and more.

Once your dividend income is large enough to cover all of your expenses, then you know you can afford to retire.

So, while I like to say I switched from dividend investing to indexing for behavioural reasons, there ARE behavioural advantages to dividend investing that can help investors save more for retirement.

Weekend Reading: Your Trusted Advisor Edition

The financial services industry is in dire need of change. It’s such a me-too industry brainwashed to believe that all you need is a regular meeting with your trusted advisor and your financial literacy problems will be solved. Look no further than the 100+ comments to Rob Carrick’s question on LinkedIn, wanting to hear fresh advice from financial planners and advisors on the one thing they’d change about how Canadians manage money.

Predictably, most replies were self-serving drivel that talked about the benefits of working with a planner, how people should stop making decisions based on fees, understand the importance of downside protection, or get MOAR INSURANCE!

The industry still clings to the idea that advisors can add value picking winning investments, like somehow they can deliver market beating returns in good times (and bad!).

Weekend Reading: Your Trusted Advisor Edition

I don’t link out to Garth Turner that often but he absolutely nails this post where a reader presents her advisor’s arguments for why she shouldn’t switch from mutual funds to ETFs. The trusted advisor’s argument included this gem:

ETFs are cheaper but that is because they have a much lower rate of return. So if you compared mutual funds to ETFs, Mutual funds are far better.

Ugh. And Canadians have $1.4 trillion invested in mutual funds. We have a long way to go before any real change happens.

For the record, my answer to Rob Carrick’s question:

“To work with me, your trusted advisor.” 🙄

How about: To understand that while your advisor might be a nice person, he or she works within a system designed to sell you products that aren’t in your best interest, extracting annual fees higher than anywhere else in the world. These fees will have the biggest impact on your long-term investment returns and greatly affect your ability to reach your retirement goals.

This Week’s Recap:

On Wednesday Marie continued her ‘Building Your Wealth’ series with a look at how to evaluate potential stocks.

On Friday Kyle Prevost stopped by to talk about Canada’s robo advisors and how simple beats sophisticated.

Weekend Reading:

Bitcoin has dominated the news recently, with the volatile cryptocurrency surging in ‘value’. One Bitcoin is now supposedly worth more than $19,000.

In a true act of irrational exuberance, this couple has invested more than $100,000 in the machines, electricity, and space to mine new Bitcoins.

Here are seven lies Bitcoin fans tell themselves (and anyone else who will listen).

Moving on from the Bitcoin chart, Maclean’s is back with its year-end Chartapalooza – the 91 most important economic charts to watch in 2018.

Dan Bortolotti answers a reader question:

“I’m moving investments to an online broker. Will they cover my fees?”

Jonathan Chevreau presents a strong case for early RRSP drawdowns. This is something I’ve considered for the decade between age 55 and 65.

Jason Heath with some terrific insight: Here are the six biggest mistakes retirees make with their investments.

Two conflicts of interest that can prevent you from getting the best financial advice — one blatant and one hidden.

Michael James shares a story about helping an elderly relative sort out her finances after her husband died.

“A lot of pain could have been avoided if Bob had either made Carol pay attention to the finances, or had at least left an up-to-date list of institutions, account numbers, and other contact information.”

Is an RRSP worth it if you’re retiring abroad? Jason Heath says it can make sense from a tax perspective but might make investing a hassle.

Canada Revenue Agency confirmed this week that the 2018 TFSA limit will remain at $5,500.

Rob Carrick says it’s time for a frank discussion of your excuses for not giving to charity.

Frugal Trader explains how to maximize PC Plus Points.

Air Canada earned more than $1 billion from ancillary fees last year, charges for items such as ticket changes, upgrades, baggage, seat selection, sales of food and beverages, entertainment and wireless internet access, etc.

Finally, a behavioural finance expert writes about aging, providing for future generations, and the tough transition that many face.

Have a great weekend, everyone!

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