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.
