According to Investopedia, behavioural finance combines social and cognitive psychology with economics and finance to explain why people make irrational decisions. It recognises that there is a human side to financial decision-making which often – and repeatedly – leads us to do things which are not in our best interests. By understanding how our emotions influence our decisions, we can avoid making costly mistakes that could affect our future financial well-being.

For financial planners, understanding the mindsets of clients planning for retirement – and the numerous emotions influencing them – is an important part of the job. Providing a thoroughly researched financial plan should help to prevent clients from being unduly influenced by biases that may damage their investment portfolios and harm their retirements.
Behavioural biases
There are numerous biases that people have when it comes to choosing how to manage their finances, especially when planning for their retirement. One, ‘present bias’, is a behavioural finance term that reflects how, when given a choice of two options, people are more likely to choose the one that provides instant (or near instant) gratification than one that will provide a longer-term benefit. In this case, the present bias is for having money available now for spending rather than growing in a pension fund.

Savers and investors have traditionally been offered financial encouragements to help them overcome present bias – higher interest rates in the case of savings, or tax relief for pensions. But a two-year experiment involving 2,700 people in Chile found that peer pressure can be a very effective way to reduce present bias. The experiment compared the effectiveness of weekly self-help peer groups, text message reminders and the more traditional approach of a high interest account that paid 5% compared to the 0.3% paid to the other two groups. The higher interest rate had no effect on most people, but those in the peer groups, who had to announce their savings targets to other members, deposited money 3.5 times more often. The text messages were almost as effective.

According to the ebook 12 Principles of intelligent investors by Bob French CFA, for US-based financial planning firm McLean, there are six behavioural biases that investors and planners need to be aware of when putting together a retirement strategy. These are loss aversion, overconfidence, recency, herd mentality, confirmation, and sunken costs. 
Bob describes recency as a bias where people are often tempted to be swayed by new information as opposed to sticking with an original plan, in a similar fashion to present bias. While flexibility with an investment strategy may be useful in some instances, it can detract from a well-thought out plan that has been devised through thorough research. For example, investors might suddenly choose to sell off certain stocks based on market fluctuations, despite the advice of a financial planner who has looked at the long-term prospects of that stock. 

There is also the trouble of people following the herd. Large market shifts can lead to investors sensing an opportunity that they don’t want to miss out on. Bob adds: “Herd mentality also influences large groups of investors to abandon ship when things look risky. In both cases, this bias leaves investors vulnerable to damaging their portfolio by buying high or selling low.”

Another bias to be aware of is ‘sunken cost’, where an investor is reluctant to let go of a past loss. He says: “When an investment fails, sunken-cost logic leads to the desire to hang on until prices go up again. Sometimes they do, but in other cases, investors just end up throwing money at bad investments.”

Loss aversion – the tendency for people to strongly prefer avoiding losses than acquiring gains – is a key part of behavioural finance too. It can manifest itself when investors hold onto supposedly low risk assets like cash or bonds during bear markets, says Bob, “even though the evidence demonstrates that long-term returns would go up if they would buy stocks while prices are low.” He adds: “Fear of losing their capital is a bigger motivator than the hope of seeing strong returns later.” This becomes particularly acute as retirement approaches, with people worrying about potentially jeopardising their pensions. 

By contrast, overconfidence – where an investor believes their knowledge and skills are better than what the market is saying – can jeopardise portfolios designed to see people into retirement. This is perhaps more likely to happen to younger people that see retirement as a distant prospect.  

These biases are factors that people trying to manage their long-term finances will need to overcome, and are ones that qualified and experienced financial planners should be aware of when devising a long-term plan for their clients.
Auto-enrolment
Behavioural finance research is being used by governments to encourage people to make financial plans, helping people to take seriously their retirement plans well in advance of the end of their careers.  

The idea of auto-enrolment is a classic example of applying an understanding of behavioural finance to pensions policy. Since 2012, more than six million people in the UK have been automatically enrolled in workplace pension schemes, and are now saving towards their retirement. According to the Behavioural Insights Team (BIT), a social purpose company partly owned by the government, auto-enrolment is a “text book example of applying behavioural insights to government policy”. It adds that behavioural research has consistently shown that resetting the default option from ‘opt in’ to ‘opt out’ is “likely to dramatically increase enrolment rates”. This ‘default’ behaviour relies on the inertia of those who are enrolled: although they would not actively have sought to join a scheme, once they are members, they are unlikely to leave.

BIT cites research conducted in 2001 in the US by Brigitte Madrian and Dennis Shea, where pension participation rates rose from 49% to 86% for workers who had been automatically enrolled in 401(k) tax plans. 

Playing the long game
Investors are also likely to suffer present bias and loss aversion when they come to use their pension fund. A recent research paper by Suzanne Shu, of the UCLA Anderson Graduate School of Management, and John Payne, of Duke University’s Fuqua School of Business, looked at the decisions made by US citizens when claiming social security, an American pension scheme similar to the UK’s basic state pension. Claimants can start drawing social security between the ages of 62 and 70, but the longer an individual leaves claiming, the higher the income they will receive. The scheme can provide a hedge against “longevity risk” – a substantial risk given that a healthy 65-year-old American male has a 30% chance of making it to age 90, while a healthy woman of the same age has a 40% chance. Yet 50% of Americans start collecting social security at age 62 or within two months of leaving the labour force, and 80% claim before the normal retirement age of 66. Only 2% are estimated to delay claiming to the maximum age of 70.

The report’s authors say: “The possibility that people may not make this important financial decision wisely perhaps should not be too surprising. The decision to delay claiming of Social Security benefits involves evaluating a complex option with multiple outcomes occurring over time contingent upon several uncertain events.” These include how long they expect to live and loss aversion. In this case, the loss would be not collecting social security at age 62, and the gain would be getting a higher income by waiting to claim.

Financial planners in the UK have frequently seen similar behaviour exhibited by married individuals deciding what type of annuity to buy. Rather than buying a joint annuity which would ensure their spouse received an income after their death, they have often opted for the higher income provided by a single life annuity.  The report also found that retirees gravitated towards single life annuities because they offered higher monthly income than joint life annuities, regardless of the potential impact on their spouses - a scenario that is no doubt familiar to many advisers in the UK.  But this is not the only consideration when buying an annuity.  When considering a client’s entire asset during the planning process, planners know that if clients buy joint life annuities, the starting payments are lower.  So there needs to be consideration of the time it takes for these payments to amount to the same as a single life annuity.  In some cases, planners might calculate that it would take 10 years for a joint life annuity to ‘break even’ with a single life annuity.  When we add in consideration of the clients’ age, state of health and amount of other assets available to generate an income, it might be the best advice to indeed have a single life annuity. 

Dr Ioannis Oikonomou, Associate Professor in Finance and Director of the MSc in Behavioural Finance at the ICMA Centre, Henley Business School, says present bias can also affect the decision about when to stop working. “Many people, if given the opportunity of going for an early retirement with a smaller pension, will do that, despite the penalty of a lower retirement income,” he says.
Five common patterns of behaviour relating to financial decision-making: 

1. Buy high, sell low. The cycle of market emotions makes it psychologically easier to buy at the top of the market and sell at the bottom - the total opposite of the rational investment strategy.

2. Disposition effect. We are more likely to sell winners and hold losers. Selling the loser is psychologically painful and while it is only a paper loss there is always a chance to sell it as a winner in the future. Selling a winner makes people feel good.

3. Familiarity or home bias. Things we feel familiar with seem less risky. This skews perception and can lead to poor decisions.

4. Confirmation bias. We tend to search for opinions that back up our starting point rather than views that would make us change our mind.

5. Overconfidence. People tend to struggle to see things in terms of probability. They make black and white judgments and consequently are over-confident. In retirement planning, this could result in a retiree believing his or her pension fund will be able to support large withdrawals and still supply income for the rest of their lives.

Source: Barclays

Avoiding irrational decisions
The recent relaxation of pension rules to allow investors to take out as much money as they like from their pension funds rather than buying an annuity has provoked fears that pension savings may be squandered. Concerns about investor protection have already led to the government cancelling one part of the pension freedom reforms devised by the former Chancellor, George Osborne. The plan to allow pensioners to sell their annuities has been scrapped amidst fears that pensioners would be charged high fees and be offered poor value lump sums in return for their income for life.

Data covering the first full year of pension freedom, published by the Association of British Insurers (ABI), indicates that the majority of savers are taking a sensible approach, with 57% withdrawing 1% or less during the last quarter. But 4% of savers have withdrawn 10% or more, and the ABI warns that many customers are taking their entire pot in one go. Analysis by The Guardian last spring found that annuity sales had collapsed, with only one in eight people buying a guaranteed income for life. At the same time money has poured into buy-to-let, with The Guardian suggesting that £700m has gone from pensions to property.

Peter Brooks, Head of Behavioural Finance at Barclays, says: “There is a danger that this leaves people with important decisions to make about retirement without the knowledge and understanding they need to act in their own best interest.”

To help people come to the right decisions, he suggests “asymmetric paternalism” - providing behavioural finance “nudges” alongside education and guidance. This should help people who cannot or will not make decisions, while providing those who are engaged with the whole process with the tools they need to make the best decisions for their future well-being. A nudge might include presenting and emphasising the choices in a way that is most likely to benefit investors, just as a school canteen might offer children salad and vegetables before chips.

Not surprisingly, Brooks believes it is “absolutely essential” that wealth managers, financial planners and other advisers have a working knowledge of behavioural finance so they can help their clients make better decisions.

Martin Bamford CFP™ Chartered MCSI, Managing Director of independent financial advisers Informed Choice, has begun to use behavioural insights when analysing risk tolerance and providing advice. He says: “By the time investors reach retirement, they have a lot of experience on which to draw for making future decisions. This can sometimes result in overconfidence, which can reduce returns. Overconfidence can also cause investors approaching retirement to ignore important decisions in the belief that everything will turn out to be alright. We have an important role to play in helping our clients become more aware of the emotional factors that could undermine their long-term financial health.”

Indeed, the role that financial planners can play is one of steadying the hand of clients who are approaching retirement and being pulled in different ways by the biases mentioned above. In a white paper written in 2015, Justin Goldstein, Director of Financial Wellness Services at US firm Bronfman E.L. Rothschild, suggests that financial planners put in writing the investment strategy, taking into consideration a series of different scenarios and the strategies the investor would take in each of them. “This allows for flexibility within the parameters of a financial plan and helps avoid making decisions based on emotion,” he writes. 

However, while our behaviour may be influenced and changed by our experiences over the years, no amount of education or information is likely to change our tolerance to financial risk, according to one industry expert. Paul Resnik, founder of the risk tolerance profiling company FinaMetrica, says that an individual who has a high-risk tolerance at age 25 will still want to invest in tulip bulbs, or its 21st century equivalent, at age 80. Likewise, someone who has always put their money in cash deposits will invariably be unhappy for some of the time if common sense and good advice has resulted in them being invested in a riskier portfolio in an attempt to make their money last longer than cash deposits. The trick, he says, to enabling clients to live with their portfolio’s volatility, even if it is out of kilter with their risk tolerance, is to ensure that they are fully informed about all possible eventualities, and the consequences for their future spending. “There should be no surprises in investing,” he says.