Sunday, May 28, 2006

Procrastinating Away Your Retirement Savings

Recently a Stanford finance professor asked me how to save for retirement.

He told me, "It's so hard to save for retirement."
"What do you mean it's hard?", I asked.
"Well, I'm in about 50% mutual funds and 50% cash. I know I should be further in stocks since I'm in my mid-thirties, but I can't seem to get around to it."

I was intrigued. A Stanford finance professor, one of the world's elite finance specialists, was unable to set up an "optimal" retirement portfolio. Couldn't bother with it.

I was curious, "So are you saving the max every year?"
"Not really. And I'm not even in index funds."

I figured there were two related issues crying out here:
1) He wasn't optimizing his portfolio (he had too much cash).
2) He was reluctant (or somehow unable) to save enough towards retirement.

I asked him, "What seems to be the problem?" Curious if he had some psychological insight into his predicament.
"I'm kind of a nervous person with my money. I don't want to lose it."

So that explained his high cash level, but not necessarily his reluctance to save for retirement. His anxiety induced catastrophic thoughts about potential losses, and he was overestimating his risk in the markets. I could address that when I figured out the other issue.

"So what's the trouble with saving for retirement?"
"I just keep putting it off. Like I spend the money on a car or send it back to my parents in the Ukraine ... I never really get around to setting aside the money. I always find something else to do with my savings, and then I know I need to save twice as much the next year, but then I don't, and I then I'm further behind."
I responded, "You've got a lot of other things to use the money for."
"Yes, but when I get a paycheck, I can't seem to set any aside."
"So you're procrastinating saving for retirement."
"I guess."

Most of us have seen the terrifying statistics that financial planners love. For example, assuming an 8% rate of return, if you save $3,000 each year into a tax-deferred IRA beginning at age 25 and stop saving after contributing $30,000 by age 35, you would have $535,434 at age 65. If you began saving for retirement at age 35 and continued to invest $3,000 every year for the next 30 years you would retire with $331,462 at age 65. Overall, in the first scenario you would have contributed 1/3 as much cash as the second, and you would have 62% more money to retire with.

Clearly, procrastination can cost you dearly. The wealth-maximizing Stanford professor in front of me was very distressed by his procrastination in saving for retirement.

Procrastination affects all us to some degree. Whether it's studying for a big test, doing one's taxes, asking for a promotion, or launching that new business, we all have areas of life where we perpetually delay, shrinking from moving forward. Regardless of where you're falling behind, there are both psychological and neural (brain) causes of procrastination, and their often closely related. Each of the culpable brain regions can give rise to certain emotional or impulsive feelings, thoughts, and behaviors.

Procrastination arises from 3 psychological causes: fear, disorganization, or perfectionism/obsessiveness. Fear can be tackled by discovering what you are afraid of. See the list below for examples. Disorganization is best addressed by a slow process of re-organizing. The process should be slow and incremental, because otherwise it'll be abandoned. Get a To-do list and break down your tasks into very small pieces. Make sure that you can do each piece in the alotted time (this is the hardest part). Don't give up if you can't, simply re-do your schedule. See this site for more detail.

Perfectionism and obsessiveness is characterized by such extreme attention to detail that one becomes paralyzed. The Stanford professor above was perfectionistic - whenever he thought about his retirement savings, he was overwhelmed by all he thought he had to do. He couldn't buy more funds because he didn't want to be "wrong" if the funds went down in value. He wanted everything to be perfect. But the markets aren't perfect, and occasionally they're painful.

The neural core of procrastination is a process that economists call discounting. Here's a paper by neuroscientists (McClure and Cohen) and economists (Laibson and Loewenstein) that addresses the neural origins of discounting.

Discounting: Most people prefer larger distant losses to smaller immediate ones. This means that we would rather feel the pain later, even if we know it's going to be more severe, than taking it on now. We push it off until later, and we hope that it goes away. The limbic system (the brain's emotional centers) appear responsible for discounting, while the rational, planning prefrontal cortex prevents us from irrational discounting decisions. To attack procrastination, we've got to address the limbic emotions that overwhelm rational planning.

Get motivated to make a change

First, you've got to get motivated. Realize that retirement procrastination is destroying your potential for wealth. If you don't believe this is important, see the statistics about when you save, and how much, 5 paragraphs above -- print them out and paste them to your computer.

Try the following exercises. If the following thought exercises are not useful for you, then try some of the behavioral strategies listed at the bottom of this article. To use neuroscience principles to stop procrastination, try the following.

Reasoning with your limbic system

1. Enhance your perception of long-term pain. In order to disrupt the discounting equation, you've got to see so much potential long-term pain as a result of not saving now, that you become terrified -- you'll gladly accept the short-term budget squeeze to prevent poverty and unhappiness in retirement.
* Think of a poor, unhealthy, unhappy retiree. And then think of a smiling, sun-tanned, golfing, and world-traveling retiree. Which would you rather be?
* Do you feel financially insecure? If so, do you want to feel that way the rest of your life?
* Remember that many pension funds are underfunded and are going to go broke over the next 50 years. if you're under 40 and relying on a pension for your retirement, you should be very careful.
* Don't count on your house to provide you wih retirement equity. Markets and environments change in unforeseen ways (hurricanes, earthquakes, etc...)

2. Decrease your perception of the short-term pain.
* Even if you save only the cost of 1 latte per day, you could have a sizable retirement fund.
* Try saving only a small fixed percent of your income now. Then start saving, for example, 25% of every raise into a retirement account. If your salary increases 50% over the next 10 years, then you'll be saving 8.3% of your salary per year by the end of the 10 year period.

3. Increase your pleasure in saving:
* By saving for retirement, you are increasing the endowment that you can leave to your children and grandchildren, your place of worship, or your university, for example. Your savings can become a legacy that does a lot of good for a lot of people.
* Do you enjoy being responsible and doing the right thing? Savign for retirement requires discipline and persistence. If you like the feeling of challenge and achievment in life, then you can turn that energy towards securing a solid financial future.
* IRAs are tax-deferred, and the Roth is tax free. You can save a lot of money on taxes this year (IRA) or when you retire (Roth). Does saving money make you happy?

4. Expand Your Time Horizon: Get out of emergency mode - that's never a healthy place to be. Focus more on what's truly important in life, not on your latest emergency. Try to sit back and get comfortable with takign a long-term perspective now.
* Think about the generations that will follow you. Do you want to contribute something to them?
* Your life is likely to be long (longer than current life expectancies).
* There is no hurry in planning for retirement. It is simply a necessity, and should be a part of your monthly plans, like paying a mortgage or rent.

5. Identify the internal block
What do believe will happen if you save more for retirement?
Some common responses are:
- Everything will work out for the best anyway, it always does.
- I'll make more money later, so I'll start saving then
- If I save now then I'll have to live like a miser - I'm barely getting by now.
- I have to pay off my debts first
- If I save more for retirement, then my lifestyle will suffer, and I earned this lifestyle.
- I don't want to be stingy like Scrooge.
- I'm not like everybody else, I live differently - I'm a creative person - so I dont need to save.

Now, ask yourself, if you identify with one of these beliefs. Do you really think it is true? Is it so important that you would you bet you future happiness on it?

6. Correct mistaken beliefs- If I plan for retirement,then that means that I'm going to die someday
(yes, you are).
- Thrift is uncool
(so is a $600/month social security check) and
(many great historical persons were frugal)
- I need to maintain a certain lifestyle where I live
(the "keeping up with the Jones'" defense. what about when you retire, what type of lifestyle do you want then?)
- Investing is too complicated. I don't understand it.
(Take baby-steps. Get an "Investing for Dummies" book or meet with a financial planner. Read one chapter per week. Plan on meeting your goals by one year, not in the next week)

7. Automatic Behavioral Interventions
If you have trouble relating to the advice about beliefs and emotions, then try the following techniques. Many people use these to bypass procrastination. These are especially helpful if you're anxious and you over-analyze.
- Use automated paycheck or bank account withdrawals to ensure that the same amount goes into a protected account each month.
- Scale up you savings amount over years. I'll repeat this because it's proven to work: Try saving only a small fixed percent of your income now. Then start saving, for example, 25% of every raise into a retirement account. If your salary increases 50% over the next 10 years, then you'll be saving 8.3% of your salary per year by the end of the 10 year period.
- Use the services of a financial planner (that will keep you out of the loop entirely) Here's one I recommend: Ken Winans, Novato, CA, USA

Hope this helps!


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