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

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.

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16 Comments

  1. Susan James on December 11, 2017 at 8:52 am

    If I were to take a lump sum of $300,000 would I be taxed for the whole amount in the year I receive it? Opting for a monthly amount of $3,000 a month would seem like less of a tax burden. Also health should be considered when accepting such a large payout. If I am healthly at 65 and live to 85 accepting the $3000 per month would give me $720,000. Also, being wealthy is not just about money. Good fortunes to all. Susan J.

    • Echo on December 11, 2017 at 11:48 am

      Hi Susan, it is likely that a large lump sum would exceed what you can transfer to a tax-sheltered account, which means you’d need to pay tax on the extra amount. You’re right that longevity would also play a role in the decision.

  2. Brett on December 11, 2017 at 10:01 am

    Whether the $300K lump sum or $1000/month is taxed, and at what rate determines much of the decision. However, assuming 50% of the $300K is taken as tax, if the rest is invested in a balanced portfolio (60% stocks, 40% bonds) in 25 years the portfolio will have a value of $670K. FYI, twenty-five years is the time-frame necessary to accumulate $300K in monthly, $1000 payments.

    Alternatively, if none of the $1000/month is taxed, then with the same investment parameters this option could accumulate $696K. The main difference between the two options being the presence of initial capital up-front. As with all money matters, the decision depends more on the needs and abilities of the individual.

    • Echo on December 11, 2017 at 11:53 am

      Hi Brett, the study was looking at how we view retirement savings and found that people have a hard time connecting a large lump sum of between $100,000 and $1,000,000 with how much they’d actually need to live on in retirement. Thinking about money in terms of lump sums actually caused people to save less than if they thought about retirement savings in monthly terms.

  3. Colin on December 11, 2017 at 10:48 am

    I may be missing the point of this article (taking the $1k/wk is preferable to a larger lump sum?). The future value of money would suggest that $300k today is worth more than the future payments. Further, some quick back-of-the-napkin math would suggest that the $300k invested today and paying 4% annual dividends — or even growing annually —
    would be worth about $12k a year (again, rough math). A $300k lump payment is definitely not the same as $1k/wk over many years.

    • Echo on December 11, 2017 at 11:59 am

      Hi Colin, to me the study implied that the person has retired, has no other income, and therefore has to choose between a lump sum and a monthly income stream. Forget about investing it for the future, this money is needed to live on.

      It found that people viewed the lump sum as larger and more appealing than the monthly income stream, even though they were identical in terms of value.

      Of interest to me was how to present retirees with the choice of when to take CPP. For healthy individuals it can make a lot of sense to delay taking these benefits, as you can receive up to 36% more by waiting until 70. The study suggests that by presenting people with the idea that they would lose a large lump sum by taking CPP early, that more people would decide to delay taking their benefits.

  4. James on December 11, 2017 at 1:49 pm

    This doesn’t make much sense, taking the $300,000 and withdrawing at an annual rate of 4% still works out to about $12,000 a year or $1,000 a month. Not only that but you would have the principal amount of $300,000 completely untouched and average historical mutual fund growth rates have exceeded 4%, which will help account for inflation losses.

    • Echo on December 11, 2017 at 2:50 pm

      Hi James, why do you think the $300,000 would remain untouched? You’d be withdrawing $12,000 per year…

      The 4% rule doesn’t guarantee a lifetime of income, it just gives you a pretty good chance that your nest egg will last 30+ years before being completely drained.

      • Ward on December 11, 2017 at 5:55 pm

        It’s pretty easy to find a blue chip stock portfolio that pays at least a 4% annual dividend that would leave the capital untouched.

        • Echo on December 11, 2017 at 6:39 pm

          Hi Ward, are you sure about that? I count nine stocks on the TSX with yields above 4%. Three pipelines, three telecos, one bank, one insurer, and one oil & gas company. I wouldn’t exactly call that diversity.

        • Wanda on April 15, 2018 at 11:09 am

          My thoughts about the blue chip stock. The risk would be that one would have to assume that the blue chip stock will be worth the same value (or more) than when it was purchased it. If not, the 4% dividend would be a mute point.

      • Denis on December 12, 2017 at 11:40 am

        I shudder at retired folks taking annuities in this low rate environment. A good financial advisor can get you 6% net of fees (like my wife’s) so that 300K can easily generate 1500 monthly without touching principal.

        These are as bad as all those reverse mortgages that prey on the elderly.

        I do admit that many have little financial know-how and I guess annuities could be safer. I would just give it to a good adviser with the backing of a big bank if I couldn’t handle my own finances. When I asked, I say that if I cannot beat that 6%, I would give it to her adviser and enjoy retirement.

        • Garth on December 12, 2017 at 12:18 pm

          6% average returns eh? Sounds pretty good. But what if over the past five years your actual returns were -80%, 20%, 20%, 30%, and 40%. The arithmetic average of these returns is exactly 6%. But had you invested $10,000 five years ago, it would be worth approximately $5241 today.

          • Sebastien Benoit on December 22, 2017 at 3:24 pm

            Garth, no one uses arithmetic average when calculating yearly returns over multiple years, for exactly the reason you illustrated. Look up geometric linking; that’s the simple way to calculate average annual returns.

            (1-0.8)*(1+0.2)*(1+0.2)*(1+0.3)*(1+0.4)-1=-47. 584%

            10,000 – 47.584% is, you guessed it, about 5,241



  5. sara on December 11, 2017 at 2:34 pm

    Waiting till age 70 (time risk) and geting 36% more means more income to declare to CRA and subject to clawback. For low income healthy people, it is good to wait. For high income earners at retirement It’s more like geting 20% more or less.

  6. Mr.Financial Squirrel on December 29, 2017 at 12:59 pm

    If I was given the choice, keep the $300,000 I have or invest in an annuity that would pay me $1000/month, I think I would keep the money. Reason is $1000/month, might be enough to cover my expenses now, but in 10 years with inflation it is not going to be enough. I believe the$300,000 gives me a better chance of being financially independent. I guess the only question that needs to be answered is can I get better returns than 4%.
    That said, completely agree with the illusion effect. The consolidated sum definitely feels bigger than the monthly/weekly amount.
    Would the behavior not be opposite to what you suggest. Looking at total retirement corpus should motivate more than looking at monthly retirement income? Applying this logic to investing, index investing would motivate more than dividend investing?

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