It is paramount that retirement income systems and the advisers, trustees and other fiduciaries responsible for their management strike a fine balance between individual freedom and subtle nudges or paternalistic interventions.

1. 1
FS Advice THE AUSTRALIAN JOURNAL OF FINANCIAL PLANNING•
Retirementwww.fsadvice.com.au
April | 2017
THINK AGAIN
Behavioural Finance Retirement Incomes
Jonathan Steffanoni
Behavioural Finance Retirement Incomes
It is paramount that retirement income systems and the advisers,
trustees and other fiduciaries responsible for their management
strike a fine balance between individual freedom and subtle nudges
or paternalistic interventions. While a life cycle savings economic
model provides a sound foundation, there is a need to consider the
key decision points from a behavioural perspective if outcomes are to
be best directed towards promoting an adequate and dignified retire-
ment for ageing populations.
In the early 1950s, Nobel prize winning economist Franco Mod-
igliani and student, Richard Brumberg theorised the Life Cycle
hypothesis, suggesting that individuals make spending and saving
decisions based on the resources available to them over their lifetime
and on their current stage of life. Modigliani asserted that individuals
made rational spending and saving decisions to build up assets at the
throughout the middle stages of their working lives, before drawing
down on these in retirement. It is a model of lifetime self-sufficiency
and responsibility with roots in neo-classical economic theory which
is rational, reasonable and removed from reality.
Few would disagree with the notion that it makes good economic
sense to save for retirement — yet a cursory observation of the world
will confirm that there are an awful lot of people whose decision-
making behaviour is inconsistent with their rational views. Scarcity
of income for saving, and legitimate expectations of dependence on
state funded or occupational age pensions or family support in retire-
ment are important factors in shaping decision making. However,
there are also more fundamental behavioural biases which skew deci-
sion making when it comes to retirement income planning. It is im-
portant that there is an awareness of these biases not only in individu-
als, but also in the design of retirement income systems, products and
services, and those trusted to manage them which are increasingly
responsible for providing retirement income.
Dividing decision making
The fact that individuals often fail to make decisions to smooth their
spending and consumption over their lives in saving for a self-sufficient
retirement has long been known. Paternalistic systems have developed
to accommodate this, relying on family structures, governments, em-
ployers and fiduciaries such as trustees and advisors making various
retirement income focused decisions on behalf of individuals.
Jonathan Steffanoni, QMV
Jonathan Steffanoni is a lawyer, principal consultant - legal and risk at QMV and a Fellow of ASFA. He advises and
consults on a broad range of projects with Australia's most prominent superannuation funds. Jonathan has completed
a Juris Doctor, Diploma in Financial Services, and Graduate Diploma in Legal Practice. He also holds undergraduate
degrees in Business and Arts.
Figure 1.
Figure 2.

2. This division of decision making responsibilities between indi-
viduals, fiduciaries and governments has typically been reflected in
the three-pillar model which remains common across much of the
world. Governments rely on public policies using taxation powers
to finance age pensions, fiduciaries are responsible for the manage-
ment of occupational pensions and individuals remain responsible
for private savings.
While such a characterisation is neat, it is more nuanced and the
subject of continued change. The role of individual decision making
in the management of occupational pensions is playing an increas-
ingly important role, particularly in Northern America and Australia
where individual control over investment and other decisions is on
the ascent.
Irrespective of the distribution of decision making powers, it
is important that decision making is prudent and responsible in
ensuring that retirement incomes are adequate, manage risk ap-
propriately and costs are efficient. Neo-classical economic theory
provides rational models such as that proposed by Modigliani to
inform what such decision making might look like, yet recent ad-
vances in behavioural science have shone a light on why individual
decision making is often far removed from the rational agent model
in practice.
Behavioural Finance
The human mind is wonderfully complex, and this article has no
intention of attempting to reproduce the insights which behav-
ioural scientists have illuminated workings of the human mind.
However, it is worth briefly touching on some basic characteristics
of the human mind which have profoundly unsettling yet familiar
implications for rational agent economic models of decision mak-
ing behaviour.
Our mind is of limited capacity, and has developed wonder-
ful ways of efficiently processing information to make decisions.
The associative, intuitive and heuristic adaptability of our minds
enables us to avoid paralysis from information overload that a
strictly considered and logical approach would entrench. Yet,
the brilliant efficiency of the associative, intuitive and heuristic
mind has a downside.
Behavioural biases can creep into decisions which would result in
better outcomes if they followed a strictly considered and logical ap-
proach. There are a broad range of biases which have been scien-
tifically proven, and we’ll only consider a few which are relevant for
retirement income decision making:
The popular publications of Nudge from Richard Thaler and Cass
Sunstein in 2008 and Thinking, Fast and Slow in 2011 by Daniel
Kahneman (the first psychologist to win the Nobel prize in eco-
nomics) have helped to popularise Behavioural Economics. Behav-
ioural finance extends from the same behavioural science founda-
tion, connecting traditional models based on neo-classical economic
theory with the findings of psychologists in behavioural science.
If understood and applied effectively, behavioural finance can
assist in promoting better decision making to ensure that the un-
derlying objectives of the rational agent model such as Modigliani’s
are met.
There are also challenges in balancing behavioural finance with
the neoclassical model, in ensuring that decision making can ac-
commodate psychological realism without collapsing into a mess
of special cases. To achieve this balance in the context of retire-
ment planning it can be useful to characterise the key aspects of
the rational agent retirement planning and look at how behaviour-
al biases might interfere and importantly how these biases might
be managed.
Retirement planning decision making
Governments, fiduciaries and individuals make decisions about re-
tirement income. The distribution of decision making responsibil-
ity differs between nations, yet there are a series of central themes
which when combined can be said to represent retirement income
decision making.
2 www.fsadvice.com.au
April | 2017
Retirement
THE AUSTRALIAN JOURNAL OF FINANCIAL PLANNING• FS Advice
Figure 3.
Figure 4.
Figure 5.
Figure 6.
Disposition
Effect
Illusion of
Control
Mere
Exposure
Effect
Dunning-Kruger
Effect
Optimism
Bias
Peltzman
Effect
Attention
bias
Framing Bias
Status Quo
Zero Risk
Bias
IKEA Effect
Gambler's
Fallacy
Normalcy
Bias
Hyperbolic
Discounting

3. 3
FS Advice THE AUSTRALIAN JOURNAL OF FINANCIAL PLANNING•
www.fsadvice.com.au
April | 2017
Retirement
In making decisions in these key areas, there are a broad range of
behavioural themes which might afflict rational decisions. Themes of
consistency, over-confidence, anchoring, social herding, loss aversion,
framing and emotion are caused by underlying behavioural biases
which in turn tend to skew rational decision making by both individu-
als and agents such as fiduciaries or advisors.
If we were to consider the expected decision making of a rational
individual in these key areas, we could expect the decisions to cor-
relate somewhat to those in the chart below:
However if we were to look at how the decisions might be formed in
the case where an individual exhibited some behavioural biases, then
it might look something like this:
The remainder of this article is directed towards understanding
how these biases might impact of the key retirement income decisions
made by individuals and fiduciaries, with the hope of promoting the
development of approaches to improve retirement income system de-
sign and decision making by individuals and fiduciaries.
Engagement control
The level of control that individuals have over their retirement sav-
ings is a decision which is becoming increasingly important. It is es-
sentially a decision (or non-decision) about how much of the decision
making responsibility the individual wishes to assume. This is par-
ticularly prominent in the occupational pension and private savings
pillars, with the availability of products and services with various
levels of control and flexibility.
These decisions which go to the level of control an individual has
over their retirement income making generally relates to the balance
between an individual and a fiduciary such as a trustee or an adviser.
There is no correct level of control, rather decision makers should
make decisions based on aligning the level of control with the level of
engagement of the decision maker.
In making decisions about the level of control which the decision
maker intends to exert, there lies a challenge in ensuring that be-
havioural biases don’t afflict the decision maker to choose a level of
control which is not aligned with the level of engagement. Research
in behavioural science has identified traits which are common in in-
dividuals and may contribute to decisions which misalign the level
of control over a fund or product and the level of engagement of the
decision maker.
The Dunning-Kruger Effect is the tendency for unskilled individ-
uals to overestimate their own ability, while experts underestimate
their own ability. When making decisions about the level of control
over retirement income planning, there may then be a bias towards
individuals choosing products which provide a large amount of flex-
ibility and control to the individual, when the individual does not
have the required skills to effectively make prudent decisions about
their retirement income planning. This may also explain the allure of
product which provide a high degree of control and flexibility. While
a high level of control may be appropriate for many individuals, there
is certain to be large segments of the population who do not have the
interest or aptitude to involve themselves in the complexities often
involved in diligent retirement income planning.
The IKEA effect is the tendency for individuals to place a dispro-
portionately high value of objects that they have contributed to the
construction of, regardless of the quality of the outcome or result. In
the context of decisions over the level of control that an individual
has over their retirement income decisions, there is a risk that such
tendencies may see individuals who have chosen to exercise a greater
level of control over their retirement planning being unable to objec-
tively assess the performance and hence value relative to alternate
options. This may result in individuals remaining in self-managed
accounts or similar occupational pension products longer than they
objectively and rationally should.
This overconfidence and disproportionate valuation of adopting a
high level of control over managing retirement income savings is of-
ten irrational yet is increasingly common. Where retirement income
products which require a high level of engagement and control are
issued, it may be prudent to establish ongoing obligations on fiduci-
aries to ensure that there is not an unacceptable risk being posed to
the individual’s retirement savings because of the disengagement or
negligence which afflicts many in a busy world.
In practice, this might look at monitoring the frequency of trad-
ing, investment decisions or even viewing information. If there is
a significant change, it may be prudent for the fiduciary to engage
with the decision maker to gently remind the decision maker that
they haven’t been engaging enough. Similarly, frequent viewing, or
switching between high level managed products might indicate that
the decision maker is incurring unnecessary costs and might be more
suited to products which require a higher level of tactical engagement
and control.
Rate of savings
The rate of savings for an individual is a central aspect of retirement
income decision making. Indeed, it is at the centre of Modigliani’s
theory of logical, self-interested decision making. While there are
mandatory minimum savings rates for occupational pensions im-
posed in some countries (like Australia), individuals typically have
the ability to decide on a savings rate or accept a default rate. Deci-
sions about the level of savings are fundamental to retirement income
planning, and similarly remain susceptible to behavioural biases
which may result in irrational and undesirable outcomes.
Figure 7.
Figure 8.

4. 4 www.fsadvice.com.au
April | 2017
Retirement
THE AUSTRALIAN JOURNAL OF FINANCIAL PLANNING• FS Advice
The quote
Few would disagree
with the notion that it
makes good economic
sense to save for
retirement.
The Peltzman Effect is the tendency for individuals to
take greater risks when perceived safety increases. Where
individuals perceive a degree of safety in retirement in-
comes due to expectations of government age pensions or
family dependency, they may be more likely to make risk-
ier decision such as not saving adequately or at all where
the perceived safety of a state funded pension is assumed.
Mandated or default rates of savings have many posi-
tive aspects, but may lead to perceptions of safety in that
the rate of savings is appropriate, even where it not align
with individual needs or expectations for retirement.
The risk of inadequate savings due to a perception of
safety can however be addresses relatively easily.
Effective projection and communication of what reli-
ance on a state funded pension or a minimum default
rate of savings may look like in terms of income and
resulting impacts on lifestyle may be quite effective in
calling out misconceived safety. Focusing on projections
of retirement incomes and the resulting lifestyle changes
that might be required are likely to be an effective way to
motivate individuals to save at rates more consistent with
their desired lifestyle in retirement.
Preservation
The preservation of saved assets is the alternate side
of the savings equation. Decisions about savings and
spending are intertwined so tightly that they can almost
be considered two sides of the same coin. Spending be-
haviour and decisions directly impact the level savings,
and vice versa.
Preservation is typically imposed on retirement sav-
ings until retirement, with individuals unable to access
savings until retirement, however there are exceptions
to this. The preservation of savings takes on additional
significance in the retirement phase, as a key factor con-
tributing to longevity risk. Behavioural biases exist which
may affect the ability of decision makers to effectively
preserve retirement savings in the self-interest or best in-
terests of retirees.
Hyperbolic discounting is the tendency for individuals
to preference immediate pay-offs rather than later pay-
offs. A dollar today is valued higher than five times the
amount next month. Essentially, choices and decisions
are inconsistent over time, with individuals making deci-
sions today that their future self would not despite using
the same reasoning. In many ways, hyperbolic discount-
ing can be regarded as the central behavioural bias which
retirement income policies and systems intend to man-
age. The fact that individuals place a greater value on the
immediate spending over future needs.
Retirement income systems are generally designed to
ensure that savings are preserved, and do a reasonable
job of managing the tendencies we have towards hyper-
bolic discounting. Yet, there remains an important role
for public policy makers and fiduciaries to ensure that
preservation decisions are adequate to manage longev-
ity risk. This could well involve prioritising a base level
of annuity type products in retirement and discouraging
lump sum payments and commutations which increase
the risk of hyperbolic discounting seeing accumulated
savings being exhausted prematurely.
Asset allocation
The investment of retirement savings is absolutely cen-
tral to the role which fiduciaries and (increasingly) in-
dividuals play in planning for retirement. The rational
agent model of self-interest dictates that investment de-
cisions should be directed towards maximising the long
term financial performance of investments, in a manner
appropriate with the horizon and risk profile of the indi-
vidual beneficiary.
Investment decision making consists of strategic and
tactical aspects, and is the domain of significant com-
plexity and maturity within investment management en-
tities and fiduciaries. While investment managers are not
immune to behavioural biases, it is critical that particular
attention is paid to ensuring that the retirement income
products which allow individuals significant control over
the strategic and tactical asset allocation are not compro-
mised by the inherent behavioural biases which can im-
pact investment decision making. While there are a large
number of such biases which make for a messy view of
investment decision making, there are couple which are
particularly interesting and relevant.
The disposition effect is the tendency to sell an asset
that has accumulated in value and resist selling an asset
that has declined in value. Where individuals are per-
mitted or encourages to control the tactical investment
decision making, decisions can be made to buy and sell
specific assets such as equities, bonds or units in a trust.
This enhances the possibility for investment decisions to
be affected by the disposition effect. The greater trans-
parency as of buy and sell prices for particular assets
increase the likelihood that individual decision makers
will irrationally hold on to poor performing assets rather
than cutting losses and disposing of performing assets
prematurely.
Public policy makers and fiduciaries need to be par-
ticularly mindful of these risks when designing regula-
tions and products which permit an individual approach
to managing investments. Fiduciaries are well placed to
monitor individual investment decision making, and may
be able to identify such patterns in trading activity, and
communicate this to individuals controlling strategic or
tactical investment decisions.
The gambler’s fallacy also presents a behavioural
challenge to investment decision making. It is the ten-
dency for an individual to think that future probabilities
are altered by past events, when in reality they are un-
changed. The fallacy arises from an erroneous conceptu-
alization of the law of large numbers. For example, “I’ve
flipped heads with this coin five times consecutively, so
the chance of tails coming out on the sixth flip is much
greater than heads.”

5. 5
FS Advice THE AUSTRALIAN JOURNAL OF FINANCIAL PLANNING•
www.fsadvice.com.au
April | 2017
Retirement
The quote
The framing effect
is a cognitive bias
characterised by the
arrival at different
conclusions.
The same principle is often observed in the decisions
of individuals, with a tendency for investment decisions
to be directed towards investments which have per-
formed best in the recent past. To agree, this bias can be
a self-fulfilling prophecy, with the increased demand for
well performing investments impacting on the value and
therefore performance. However longer term it’s impor-
tant that a broader range of economic fundamentals are
considered when making investment decisions. Fiduciar-
ies may be better placed to do this than individuals, and
thought needs to be given to extending the regulation of
investment decision making beyond ineffective warnings
in disclosure rules.
Zero-risk bias is a preference for reducing a small risk
to zero over a greater reduction in a larger risk. In the
context of asset allocation, such a bias can result in a ten-
dency for individuals to invest in assets perceived as be-
ing risk free (such as cash) instead of alternatives which
provide a greater return for a similar level of risk. This
is particularly relevant for retirees who typically have a
risk profile with a lower appetite for investment related
risks. There is the real possibility that a low risk appetite
is irrationally afflicted by a tendency to prefer options
perceived as being risk free. There are measures which
can be effective in identifying where cash holdings may
be over invested in due to a perception of cash being a
zero-risk investment.
The Mere exposure effect is the tendency to express
undue liking for things merely because of familiarity
with them. Asset allocation may involve the selection
of equities or other investments which are overvalued
due to a familiarity of the decision maker with the par-
ticular investment. The financial media is the source
of much useful information, but it also creates infor-
mation clusters here individuals overvalue investments
in familiar equities or other investments. A filter or
lens may be able to be implemented in systems which
will mask names of companies and investments while
focusing the decision maker’s attention on quantitative
financial data such as P/E ratios. Making such tools
available to investment decision makers may prove an
effective way of promoting more rational investment
decision making.
Risk appetite and management
An aspect of retirement income planning which tends to
receive much less attention than it should is risk manage-
ment. There are a broad range of risks which a rational
retirement income decision maker would be expected to
address. The most critical risks to be considered in re-
tirement income planning include early retirement due
to death or disablement, longevity risk, sequencing risk
and market cycle investment risk. Like other decisions,
the risk appetite of decision makers is potentially afflicted
to behavioural biases which may result in irrational and
inadequate decisions being made about managing retire-
ment income risks.
Normalcy bias and optimism bias are two observable
tendencies in decision making behaviour which have the
genuine possibility of influencing decisions about the ap-
propriate appetite for risk. Normalcy bias is the refusal
to plan for a disaster which an individual has not experi-
enced before.
Retirement is an event which individuals will not gen-
erally experience until later in life. Retirement in itself
is certainly not a disaster but rather something which
should be valued; however, most people would consider
retirement without access to income required for subsist-
ence or a dignified retirement as a disaster.
The normalcy bias of expecting that an income will be
available in retirement much as it is during working years
has a significant influence over the decisions individuals
about the level of savings. The identification of normalcy
bias in the decision making of governments, fiduciaries
and individuals may materialise as an understated rate of
savings. In a similar tone, optimism bias is the tendency
individuals have towards over optimism, overestimating
favourable outcomes.
The illusion of control is the tendency for decision
makers to overestimate the degree of influence over
other external events. This scientifically observed trait
may also result in a bias for individuals mistakenly feel-
ing as though they are in control of certain risks over
which they exert little or no control. This bias can see
that individuals irrationally choose not to mitigate such
risks through mutualisation or insurance of these risks,
as they believe that they are in control of the risks of liv-
ing longer than expected, early retirement or the impact
of market cycles on investments.
While there is a quantifiable risk to individuals of early
retirement due to disability, living longer than expected
or the sequence of market movements negatively affect-
ing retirement incomes, biases towards normalcy and
optimism, coupled with the illusion of control may be
contributing to irrational decisions being made by in-
dividuals and fiduciaries. Automatic acceptance into
group insurance policies has proven to be relatively ef-
fective in broadening the coverage of insurance products
designed to manage early retirement or disability risks
for individuals exhibiting lower levels of engagement and
involvement.
However, principles of risk profiling and management
are often only applied at an enterprise level. When it
comes to retirement income planning or management,
there may be significant merit to developing mechanisms
aimed at identifying the relevant risks to and controlling
within an individual appropriate appetite.
Fees, costs efficiency
It is impracticable for most individuals, and even fi-
duciaries to adequately implement a retirement income
strategy without some outsourcing. Individuals rely on
products and services supplied by third parties in im-
plementing their retirement income planning strategy,
hopefully appropriate to their level of engagement.

6. THE AUSTRALIAN JOURNAL OF FINANCIAL PLANNING• FS Advice
Naturally, this will see that fees and costs are incurred in exchange
for the provision of these products and services. It’s important that
retirement incomes aren’t adversely affected by excessive fees and
costs which might be incurred by either the individual or fiduciary.
Similarly, it is important to governments that systemic efficiency
within the financial product and service supply chains.
The availability of information about fees and costs is an important
characteristic of an efficient market, yet, there are also behavioural
biases which can result in systemic inefficiencies in the markets for
financial products and services which form the supply chains. Any
market for retirement income focused financial products and servic-
es is unlikely to take a strong efficiency form due to the existence of
behavioural biases.
The framing effect is a cognitive bias characterised by the arrival
at different conclusions based on the same information due to the
way in which it’s presented. The impact of the framing effect on deci-
sions about fees and costs means that the disclosure of retail fees and
costs to individuals, and wholesale fees and costs to fiduciaries can
significantly impact decision making and therefore the efficiency of
retirement income decisions and systems.
The presentation of fees as a percentage of a transaction or asset
value are a classic example of this, with the presentation of the costs
in a unit of currency resulting on the decision maker placing a greater
weighting or emphasis on the competitiveness of the fees and costs.
Similarly, the framing of fees as a percentage or in basis points disas-
sociates the fees and costs from the currency required to pay them
and results in a lower weighting and focus on the competitiveness of
fees and costs.
Anchoring is a tendency for a decision maker to take existing
fees and costs incurred for financial products and services and
then apply it as a subjective reference point for making future de-
cisions. This is particularly relevant with percentage based fees on
a growing asset base. The supplier of a product or service which
charges a percentage based fee will naturally be anchored at the
current price.
The anchor of the current price will result in decision makers
considering any reductions in the percentage based fee as a reduc-
tion, even where the asset base on which the fees are calculated in
growing and therefore the actual amount of the fee in increasing.
Asset based fees and costs are common in the supply of the finan-
cial products and services to retirement income systems. Ensuring
that individuals and fiduciaries are provided information about the
actual costs of financial products and services, including the cost at
projected asset values.
Think again!
The ways in which the insights from behavioural finance and eco-
nomics can translate into meaningful measures will differ signifi-
cantly between jurisdictions, entities and individuals. Yet, there seem
to be significant opportunities for behavioural science to provide in-
sights which will force lawmakers and fiduciaries to think again. As
changes to old age dependency ratios will present a daunting eco-
nomic and political challenge to many western economies, improv-
ing the performance and efficiency of retirement income systems and
pension funds is a challenge which will need to strike the right bal-
ance between dependence and independence. fs
6 www.fsadvice.com.au
April | 2017
Retirement