The pandemic has been a catalyst for many rethinking workers their retirement plans. Millions of people decided to retire earlier than planned because they saw no way to re-enter the workforce. Millions more are wondering what strategies they should employ to keep their retirement accounts afloat.
You should start by considering the complex machine that makes all of your savings decisions: your brain.
Consider this sentence: “Salt and ___.” You arrived at the missing word in an instant. It didn’t take a lot of thought. It was practically unconscious.
It turns out that most of our day-to-day decisions, including how we plan our retirement, happen like this. We are almost always on autopilot. We evolved to avoid taxing our limited mental resources, and for good reason. Too much analysis often leads to “analysis paralysis,” which keeps us from moving forward.
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In Think, fast and slow, behavioral scientist Daniel Kahneman describes two thought systems. System 1 covers fast, instinctive, and automatic thinking, while System 2 handles slower, more deliberative, and more resource-intensive analysis.
Our brain defaults to System 1 for most of our daily tasks and decisions. We use intuition, intuition, rules, and heuristics (also known as “decisional shortcuts”) so that we can move forward quickly without being overwhelmed by cognitive load. An example is the “you get what you pay for” heuristic, which helps us avoid wasting money on cheap products that don’t stand the test of time. While rules like this make our lives easier (and save us a lot of time), they often come at the cost of systematic biases. For example, we often assume that cheaper items are of poor quality, which of course is not always the case.
The downside of relying on heuristics is that it often causes us to prioritize immediate results. One of the most difficult problems we face in our lives is save for retirement. It requires significant savings to pay for the last quarter of your life. Unfortunately, some of the otherwise useful mental shortcuts we use on a daily basis make it difficult to focus on what our lives will be like in the decades to come. The result is that almost 80% of Americans are not saving enough for retirement and almost 50% of Americans are not saving at all.
Here are some of the important biases that affect how we make our retirement plans and our savings habits:
- Bias present: We place less value on future rewards, making it difficult to incur a small cost today (like saving money on your paycheck) in exchange for a larger reward in the future (like a retirement nest egg that benefits from compound interest).
- Aversion to information: We naturally avoid information that we think is too overwhelming. As a result, a study found that financial education has almost no effect on people’s savings.
- Compliance bias: We often give in to social norms (aka “social proof”) and conform to what others do and think, even in financial matters. We see people’s spending, but not their savings, which means we don’t benefit from mirroring the good saving habits of others.
The good news is that if you are aware of these biases, you can overcome them and even use them to your advantage by saving for the future.
Read more: For millennials, the pandemic has helped jump-start their savings
So which of Kahneman’s thought systems should we use when it comes to making retirement decisions? Ideally, both! You can leave some decisions in your System 1 auto-basket and assign others to System 2 with careful analysis, planning, and logic. The balance will depend on how much time and interest you have to learn more about the intricacies of investing. For most of the general population, automated tools make investing more efficient, accessible, and less stressful.
When biases are made visible and prioritized, we can spend time making small corrections to counter them. If we recognize our current bias, we might be more willing to take higher deductions from our paychecks today for better returns tomorrow. If we try to overcome our natural aversion to information, we may be more willing to learn how smart and diverse investment strategies will bolster our balance. Rather than trolling social media sites, allowing our compliance bias to trick us into spending as much as our friends, we could instead make an effort to divert some of those dollars to a 401(k) account.
When it comes to retirement plans, accepting default settings that benefit savers (system thinking 1) is often the smartest strategy. To correct some of our retirement cognitive biases – which might prevent us from saving completely or introduce complexity that ultimately reduces balances – a default setting like a 6% contribution that automatically increases over time makes sense. Research shows us that more people will participate, saving billions more dollars compared to using no default settings.
Popular media has called humans irrational decision makers. I believe a more accurate way to put it is that we are built to survive, and the systematic bias built into our decision-making sometimes steers us away from the course of long-term self-interest. Artificial intelligence, automated investment tools and the incredible collective computing power we have today are invaluable tools to help us defend the resources that ensure our survival today and tomorrow, just like the spears that early humans used to repel or drive away predators. But today, we’re using this technological spear to defend against our own cognitive biases and land the biggest nest egg possible.