Topic #6: The Psychology of Investing

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  • Many plan participants approach their retirement accounts with an attitude of “I just hope everything works out”. The challenge for plan sponsors is how do they make the results more reachable.
  • This portion of the presentation will focus on these three issues that plan sponsors can consider when determining how to improve their plan structure.
  • A recent white paper from the Vanguard Center for Retirement Research by Stephen P. Utkus and Jean A. Young sheds some light on the behavioral mindset of employees and how they approach retirement savings. Industry and academic research underscores the point that individuals differ significantly in their planning abilities. Some are skilled at saving and investing for the future; others are not.
  • Much of participant behavior in their retirement plans has traditionally been considered part of what is normal for everyone. However, with the new DOL rulings about fiduciary responsibility and Qualified Default Investment Options (QDIOs), there are other choices that plan sponsors can choose. The challenge for plan sponsors is to determine which type of employee behavioral mindset do they wish to address through plan design and which to approach through education.
  • This automatic plan concept is based on research findings from the field of behavioral finance, which blends economics and psychology in an effort to understand the nature of individual decision-making. This research suggests that it may be possible to improve savings and investment behavior by redesigning the nature of the default decisions within the plan.
  • Traditionally, retirement plans have been do-it-yourself plans which best serve the decision-makers and planners. However, the reluctant savers don’t want to make the wrong decision, and they often end up not even participating in the plan or choosing an option that doesn’t match their risk tolerance or time horizon.
  • By becoming more aware of how their employees think, plan sponsors can make more informed decisions in helping their employees reach retirement goals.
  • This chart compares some of the characteristics of the typical defaults in place in many retirement plans today with those of the automatic plan. In both plans, the decision tends to be the default option.
  • Many plans and providers have developed excellent education and communication materials that provide all the necessary information and tools to help participants make informed decisions. But it gets back to the old phrase, you cal lead a horse to the best watering hole, but you can’t make him drink. The automatic plan, by providing pre-set defaults, makes the choices easier for the reluctant saver. In the automatic plan, the decision-maker and planner can still opt out of the defaults to manage their own strategies.
  • Education is still required for the automatic plan. However, the focus is shifted away from should I participate to how I should participate.
  • Researchers also concluded that automatic enrollment added to savings by encouraging more people to save in their plan. At the same time, it subtracted from savings by encouraging individuals to remain at too conservative savings rates and in too conservative investment defaults. Some people saved more, while others saved less. Even when individuals acknowledge or understand the need to make a behavioral change, inertia and procrastination frequently keep them from taking action.
  • In 2007, the Investment Company Institute surveyed recent retirees who had actively participated in defined contribution plans about how they used plan proceeds at retirement. 71% of respondents report having more than one option for how their plan assets are distributed at retirement, including the options to take a lump sum, to take installment payments, or to leave the assets in the plan and delay taking any distribution. 20% who reported having more than one distribution option chose to delay taking some or all of their balance; about 20% annuitized some of their balance; 11% chose to take installment payments and 57% took some or all of their balance as a lump sum.
  • Learning about how people make investment decisions is key in designing a plan that can benefit the most employees.
  • The choice for employers is to consider addressing the needs of the majority who are reluctant savers as opposed to the current method of providing the tools and education for the decision-maker/planners.
  • Topic #6: The Psychology of Investing

    1. 1. Be sure to sign the “Sign-In/Sign-Out” sheet outside of the room when applying for Continuing Education Credits for the following certifications. (Check the appropriate certification) <ul><li>CFA </li></ul><ul><li>CFP </li></ul><ul><li>CPE </li></ul>Important Reminder!!!
    2. 2. The Psychology of Investing Moderator: Lori Doyle, CalPERS Panel: David Edwards, Dodge & Cox Janet Kendall, ING, NAGDCA Industry Vice President Curt Morrow, Nationwide Retirement Solutions
    3. 3. <ul><li>Why do participants make certain investment choices? </li></ul><ul><li>How do we understand an investor’s behavior? </li></ul><ul><li>How may we assist our employees to better prepare them for retirement? </li></ul>
    4. 4. <ul><li>The Psychology of Investing </li></ul><ul><li>Janet Kendall, ChFC, CEBS, CRC, CRA </li></ul><ul><li>VP, Industry and Consultant Relations </li></ul><ul><li>ING </li></ul>GEN.H.S.MS.687
    5. 5. <ul><li>Behavioral Finance </li></ul><ul><li>Why do people make the decisions </li></ul><ul><li>they make about retirement? </li></ul><ul><ul><li>Participation </li></ul></ul><ul><ul><li>Contributions </li></ul></ul><ul><ul><li>Investment Decisions </li></ul></ul>
    6. 6. <ul><li>Who is Making Retirement Decisions? </li></ul>Seniors (Ages 63-83) Baby Boomers (Ages 44-62) Generation X (Ages 32-43) Generation Y (Ages 18-31)
    7. 8. <ul><li>We Need Help! </li></ul><ul><li>Four generations agree that </li></ul><ul><li>more advice is needed. </li></ul><ul><li>*Schwab Study, Plan Sponsor Magazine, July 15, 2008. </li></ul>
    8. 9. <ul><li>Participation </li></ul><ul><li>What is the state of participation </li></ul><ul><li>today in DC Plans? </li></ul><ul><li>Why is it the way it is? </li></ul><ul><li>Some theories… </li></ul><ul><ul><li>Inertia </li></ul></ul><ul><ul><li>Information Overload </li></ul></ul><ul><ul><li>Lack of Understanding </li></ul></ul><ul><ul><li>Low Priority </li></ul></ul>
    9. 10. <ul><li>Contributions </li></ul><ul><li>What is the state of participation </li></ul><ul><li>today in DC Plans? </li></ul><ul><li>Why is it the way it is? </li></ul><ul><li>Some theories… </li></ul><ul><ul><li>Fear of Losing Principal </li></ul></ul><ul><ul><li>Procrastination </li></ul></ul><ul><ul><li>Analysis Paralysis </li></ul></ul><ul><ul><li>Can’t Afford </li></ul></ul><ul><ul><li>Lack of Understanding </li></ul></ul>
    10. 11. <ul><li>Investment Decisions </li></ul><ul><li>What is happening with regard to investment decisions today in DC Plans? </li></ul><ul><li>Why is it the way it is? </li></ul><ul><li>Some theories… </li></ul><ul><ul><li>Loss is Feared More than Gain is Appreciated </li></ul></ul><ul><ul><li>Impulsivity – Market Timing </li></ul></ul><ul><ul><li>Complexity </li></ul></ul><ul><ul><li>Job Mobility </li></ul></ul><ul><ul><li>Unrealistic Expectations </li></ul></ul><ul><ul><li>No Time </li></ul></ul><ul><ul><li>Familiarity Effect </li></ul></ul>
    11. 12. <ul><li>Potential Solutions </li></ul><ul><ul><li>Review Overall Plan Design </li></ul></ul><ul><ul><li>Communication, not just Education </li></ul></ul><ul><ul><li>Life Cycle Investment Options </li></ul></ul><ul><ul><li>Decrease Complexity/Reduce Choices </li></ul></ul><ul><ul><li>Automatic Enrollment* </li></ul></ul><ul><ul><li>Contributions Tied to Pay Raises </li></ul></ul><ul><ul><li>Free Money/ER Match </li></ul></ul><ul><ul><li>Immediate Vesting </li></ul></ul><ul><li>*(anti-wage garnishment laws may prohibit) </li></ul>
    12. 13. <ul><li>Remember Motivators </li></ul><ul><ul><li>Social Relationships </li></ul></ul><ul><ul><li>External Expectations </li></ul></ul><ul><ul><li>Social Welfare </li></ul></ul><ul><ul><li>Personal Advancement </li></ul></ul><ul><ul><li>Escape/Stimulation </li></ul></ul><ul><ul><li>Cognitive Interest </li></ul></ul>
    13. 14. <ul><li>Psychology of Investing Resources </li></ul><ul><ul><li>Books of Interest </li></ul></ul><ul><ul><li>Advances in Behavioral Finance </li></ul></ul><ul><ul><li>by Richard H. Thaler </li></ul></ul><ul><ul><li>Behavioral Finance and Decision Theory in Investment Management </li></ul></ul><ul><ul><li>by Arnold S. Wood </li></ul></ul><ul><ul><li>Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing </li></ul></ul><ul><ul><li>by Hersh Shefrin </li></ul></ul><ul><ul><li>Nudge: Improving Decisions About Health, Wealth and Happiness </li></ul></ul><ul><ul><li>by Richard H. Thaler and Cass R. Sunstein </li></ul></ul><ul><ul><li>Web-Sites of Interest </li></ul></ul><ul><ul><li>www.Hewitt.com www.EBRI.org www.ING.com/us/sponsorIIRR </li></ul></ul>
    14. 15. <ul><li>&quot; Even if you're on the right track, you'll get run over if you just sit there.&quot; </li></ul><ul><li>- Will Rogers </li></ul>
    15. 16. <ul><li>Thank You. </li></ul>
    16. 17. <ul><li>The Psychology of Investing: </li></ul>The Impact on Plan Options David J. Edwards Vice President Dodge & Cox
    17. 18. <ul><li>&quot;…the bull market made most equity investors look good. …2003 was a good reminder that 'the majority of 401(k) participants would benefit by professional help in managing their portfolios'.&quot; Source: Wade Armstrong, President of American Express Retirement Services </li></ul>
    18. 19. <ul><li>Preview: </li></ul><ul><li>The “Typical Line-up” </li></ul><ul><li>The Effect of Legislative Changes </li></ul><ul><li>The “New Environment” </li></ul>
    19. 20. <ul><li>Investing Principles & Beliefs </li></ul><ul><li>Risk & Return are related </li></ul><ul><li>Diversification is key </li></ul><ul><li>Portfolio Structure affects performance </li></ul>
    20. 21. <ul><li>The Sponsor’s Greatest Threats… </li></ul><ul><li>Participant’s wealth accumulation fails to meet retirement needs </li></ul><ul><li>Participant has insufficient wealth preservation close to retirement </li></ul><ul><li>Participant opts out of the plan and stops saving for retirement due to a loss or setback </li></ul>
    21. 22. <ul><li>Legislative Changes </li></ul><ul><li>Market Timing Rules </li></ul><ul><li>Pension Protection Act of 2006 </li></ul>
    22. 23. <ul><li>Market Timing Rules </li></ul><ul><li>Restriction of frequent trading by limiting the total number of exchanges that an investor may make within a certain time period, or by limiting the number of &quot;round trip&quot; transactions </li></ul><ul><li>Restricting exchange privileges </li></ul><ul><li>Imposing redemption or exchange fees on shares that are redeemed or exchanged within a certain time period following their purchase </li></ul>
    23. 24. <ul><li>Pension Protection Act of 2006 </li></ul><ul><li>Encouraged the use of automatic enrollment </li></ul><ul><li>Defined a list of strategies considered appropriate as default options - known as “qualified default investment alternatives” </li></ul>
    24. 25. <ul><li>Qualified Default Investment Alternatives </li></ul><ul><li>“ The New Environment” </li></ul><ul><li>Targeted Retirement or “Lifestyle Funds” </li></ul><ul><li>Balanced funds </li></ul><ul><li>Professionally managed accounts </li></ul>
    25. 26. <ul><li>Targeted Retirement or “Lifestyle Funds” </li></ul><ul><li>Benefits to Participants: </li></ul><ul><li>One-Stop Investment Shopping </li></ul><ul><li>Professional Asset Allocation </li></ul><ul><li>Retirement Investing Made Easy </li></ul>
    26. 27. <ul><li>Balanced Funds </li></ul><ul><li>Benefits to Participants: </li></ul><ul><li>Exposure to a combination of equity and fixed income </li></ul><ul><li>Professional Asset Allocation </li></ul>
    27. 28. <ul><li>Managed Accounts </li></ul><ul><li>Benefits to Participants: </li></ul><ul><li>A professional investment manager constantly adjusts the allocations in the portfolio to attain an appropriate asset mix </li></ul><ul><li>Risk and reward decisions for each asset class are based on current market and economic conditions and not historical information </li></ul>
    28. 29. The Psychology of Investing Curt Morrow CFP ® , ChFC ® , CRC ® Investment Service Consultant Nationwide Retirement Solutions NRM-5237 AO (07/2008)
    29. 30. Nirvana for a Public Employee
    30. 31. Objectives <ul><li>How does participant behavior affect plan structure? </li></ul><ul><li>How can education help? </li></ul><ul><li>What can plan sponsors and providers do to help participants? </li></ul>
    31. 32. Lessons From Behavioral Finance <ul><li>Research from the field of behavioral finance suggests that many defined contribution plan participants are not active, self-motivated decision-makers, as is often assumed. </li></ul><ul><li>Plan sponsors must learn to focus more effectively on these reluctant savers. </li></ul>Source: The Vanguard Center for Retirement Research, April 2004. “Lessons From Behavioral Finance and the AutoPilot 401(k) Plan”
    32. 33. What Can Plan Sponsors Do? <ul><li>Increase education efforts </li></ul><ul><li>Make education meetings mandatory </li></ul><ul><li>Provide investment advice </li></ul><ul><li>Offer target maturity funds </li></ul><ul><li>Offer managed accounts </li></ul>
    33. 34. What Can Plan Sponsors Do? <ul><li>Automatic enrollment </li></ul><ul><li>Contribution rates automatically increased annually </li></ul><ul><li>Participant accounts automatically invested in diversified portfolios </li></ul><ul><li>Offer an “opt out” for DIYs </li></ul>Consider an Automatic Plan
    34. 35. <ul><li>Plan sponsors and providers often act as if participants have strongly held savings and investment beliefs, and that individuals know what they are doing and what they want. </li></ul><ul><li>Thus, plan sponsors and providers design a neutral system for participant decision-making; participants implement their hard-wired savings and investment preferences within this neutral retirement plan. </li></ul>What Can Plan Sponsors Do? Plan design drives participant decision-making, often in unanticipated ways.
    35. 36. <ul><li>Plan sponsors and providers have the ability to alter participant behavior by choosing different default structures. </li></ul><ul><li>Typical neutral plans are designed for participants with planning skills. Reluctant savers will make less beneficial decisions compared with planners, reducing their chances for retirement security. </li></ul><ul><li>One solution to this dilemma is to reconfigure default decisions around the needs of reluctant savers. </li></ul>What Can Plan Sponsors Do? Plan design drives participant decision-making, often in unanticipated ways.
    36. 37. The Automatic Plan – Rethinking the Defaults Source: The Vanguard Group, 2004 Reluctant savers and avoiders Active decision-makers and planners Target Demographic Here’s help balancing the benefits of lump sum with an annuity with guaranteed payments Here’s a lump sum Retirement Default option is a balanced fund, suited to your age Default option is a fixed or money market Investments You’re enrolled Join – if you like Participation Automatic Default Typical Default Decision
    37. 38. How Does the Automatic Plan Impact Providers? <ul><li>The typical default plan participant education and communications are targeted towards joining the plan and choosing investment options. </li></ul><ul><li>The automatic plan communication spends considerable time explaining why participants are already on course and why they could simply do nothing or how they could do more. </li></ul>
    38. 39. Pros and Cons <ul><li>Advantages of the automatic plan include higher participation rates and better investment diversification. </li></ul><ul><li>A disadvantage of the automatic plan is that participants tend to remain at the default contribution levels rather than increasing. </li></ul>
    39. 40. Inertia and Procrastination <ul><li>When faced with a complex or difficult decision, individuals often employ two simple heuristics </li></ul><ul><ul><li>Keep things as they are (inertia), or </li></ul></ul><ul><ul><li>Put the decision off until tomorrow (procrastination). </li></ul></ul>
    40. 41. Participant Choice in Distributions Given the option, more than half of retirees choose lump-sum distributions Source: Investment Company Institute Defined Contribution Plan Distribution Decisions Survey, 2007 Percent of respondents who had multiple distribution options from their plans
    41. 42. Conclusions <ul><li>In the typical default plan , not all employees are active, self-motivated decision makers. </li></ul><ul><li>Most are unsure of their savings and investment decisions. Decisions often change based on how questions are framed and their plan’s default option. </li></ul><ul><li>They allow inertia and procrastination to rule their financial lives. </li></ul>Behavioral finance offers a range of insights into how individuals make financial decisions.
    42. 43. <ul><li>The autopilot plan helps employers enhance retirement readiness, especially with reluctant savers and avoiders. </li></ul><ul><li>Removes the active decision making process for most employees, allows freedom for the active decision makers. </li></ul><ul><li>Uses inertia to guide participants to a better retirement plan. </li></ul>Conclusions Behavioral finance offers a range of insights into how individuals make financial decisions.
    43. 44. Questions ?

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