I will live longer than average, social security will enable me decent living in retirement and if I will need more income, I will just take up a part-time job or delay my retirement for a few years. These are just some optimistic thoughts that many of us think about our retirement. The culprit? Optimism bias, or our tendency to overestimate the probability of positive future events and underestimate the probability of negative ones.
Optimism bias is considered to be one of the most prevalent and robust cognitive biases observed in behavioral economics that transcends gender, race, nationality, and age . But like most things in life, even optimism has its negative sides that can have huge impact on our lives. According to the FED 40% of Americans, today can’t cover an unexpected $400 expense and the majority approaching retirement have no or inadequate savings bringing the nation to a retirement saving crisis .
Mortgage and student debt are at record heights and mounting studies suggest our over-optimistic outlook of the future is partly to blame, making further research in this field crucial for the financial wellbeing of future generations.
Why is the glass half full?
Tali Sharot, one of the leading neuroscientists in this field, describes optimism bias as a cognitive illusion to which we are blind to and live with, though without realizing its impact on our behavior. She provides a chilling explanation for its development. Since humans possess, as one of the few species, a unique ability of conscious foresight (mental time travel) this also means we are aware that somewhere in the future death and other bad things await us. Without developing positive biases during our evolution, we could not function normally every day knowing death is around the corner .
Biologist Ajit Varki argues that the awareness of mortality on its own, would for humans have led evolution to a stop, thus making our biggest evolutionary advantage – self-awareness, also our greatest weakness . Haselton et al explain that cognitive biases like optimism are not necessarily design flaws as most perceive them—instead, they could be design features that evolved because they positively impact our health .
Sharot argues further that a brain that could consciously travel through time would be an evolutionary barrier and not an asset and that it is this combination of conscious prospection and optimism that made most of humanity’s achievements possible. Our brain’s ability to underestimate the likely hood of negative future events reduces our levels of stress and anxiety which is good for our health and without it, we would be grounded to a halt by all the worries of life . From our childhood into our adulthood, we constantly simplify in our minds how the future will unfold and overestimate how successful we will be, and by that the optimism bias gives us certainty .
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What the research says
The latter theory is confirmed by recent neuroscientific research that suggests optimism bias has deep cognitive roots. We encode undesirable information in a distorted manner, which leads to the other side to the relative amplification of desirable information . We exhibit selective attention to incoming positive information concerning the future and our beliefs are then selectively updated in favour of this preferred positive information .
Sharot et al (2012) call this selective updating. It occurs in the brain regions known as the frontal cortex which is involved in monitoring prediction errors. Signals to code prediction errors for negative updates have been discovered to be much weaker than for positive ones, thus enabling selective updating for positive information . Because of these findings, researchers focused on the brain’s reward system which involves the caudate nucleus and limbic system and discovered that the neurotransmitter dopamine has a central role in the reward stimuli processing . But what does this mean in a wider context?
Why optimism is good for many things, but not pension savings
As the above theories suggest, optimism bias seems to be, from an evolutionary point, one of the keys behind human success that is driving us to pursue various goals. However, as Puri and Robinson nicely put it, “optimism is like red wine, a glass a day is good for you, but a bottle a day can be hazardous .”
The same optimism that drove us to explore the oceans also fuels our belief that nothing bad will happen to us, meaning we often fail to act in our best interest, such as putting some money aside for an unexpected expense and our retirement. We are inclined to see ourselves moving happily toward professional success, financial security, and stable health. Unemployment, divorce, debt, Alzheimer’s, and other common misfortunes are rarely factored into our projections .
One of the reasons 40% of Americans today can’t cover an unexpected $400 expense is that they think they won’t have to. Similarly, in our rosy-eyed view of retirement saving, we believe that social security in the future will not be so low and that we will just work a bit longer to bridge the gap between retirement needs and resources, although the Health and Retirement Study reveals roughly 37% of those working at age 58, in the end, retired earlier than they were planning . The gap between when active workers expect to retire and retirees say they actually did is also clear from the latest Retirement Confidence Survey where workers continue to report an expected median retirement age of 65, while retirees report they retired at 62.
Prudential’s latest study also reveals the gap in optimistic outlooks of employees and reality as 51% of retirees in reality retired earlier than planned confirming the large gap between the age when workers plan to retire and the age when they actually do. Only 23% retired earlier than planned voluntarily, meaning they had enough money saved or wanted to retire, or were just tired of working. The majority of those who retired earlier than expected did so involuntarily. 46% because of health problems, 30% were laid off or offered an early retirement package, and 11% left work to take care for a loved one.
Retiring early has a substantial negative impact on retirement income – lower social security and lower private savings because of shorter saving period and retiring just 5 years early can reduce income in retirement by 36% which can be the difference between income that enables us decent living or not. The last few years before retirement are especially important to building our nest egg as they are on average also our top-earning years and loosing just one will reduce our retirement income substantially thus bringing a high price on our optimistic predictions about how long we will work.
Similar over-optimistic outlook is revealed regarding expected costs in retirement. 37% of retirees say their overall cost estimates turned out to be low. Healthcare costs seem to be the most underestimated, as 44% said they faced higher-than-expected costs . Combine that with other behavioral biases (procrastination, loss aversion, herd behavior, etc.) researchers identified in the last decades related to pension saving and we end up with an overlooked crisis: the majority of Americans approaching retirement have no or inadequate savings to provide for decent living . Retirement outlooks are not much better in Europe, where according to the latest ING International report 61% of Europeans, who have not yet retired, worry about having enough money in retirement and 54% expect they will need to keep earning in retirement.
Outside of retirement
Optimism also kicks in when we are buying our cars and homes or taking on student loans. Research has found most students taking on student debt underestimate the time they will need to pay back the lone and overestimate their future incomes. One of the reasons more than 40 million Americans currently owe $1.2 trillion in outstanding student loan debt . In housing markets, over-optimistic beliefs have often been cited as major contributors to the run up in house prices prior to the recent financial crisis . We see our dream home which is usually more expensive than planned, but we just take a bigger mortgage.
Of the $13.21 trillion of household debt in the U.S. in the first quarter of 2018, a staggering $8.94 trillion is comprised of mortgages according to the latest FED report. Why worry, as surely in the future we will get that promotion at work and our salary will increase, prices of real estate will rise. What if we don’t get that promotion or even lose our job? But that’s just being pessimistic, most would say and the last financial crisis has revealed the full extent of what happens, when our over optimistic beliefs don’t realize.
How can we avoid the dark side of optimism?
First and foremost, we need to acknowledge and accept that our predictions of the future are in most cases overly optimistic. That’s why we need to rely on facts and figures even if we don’t like them. Check the latest statistics on how high social security or public pensions are in your country and if the average public pension replacement rate is 50%, apply that to your current salary and ask yourself one simple question, can you live off that? And then ignore the optimistic voice in your head that is telling you it`s somehow all going to be OK and take some time to reflect on your judgement.
For our pension saving, we can take some advice from construction work. If you have ever built or renovated a house or an apartment, you probably experienced cost overruns. That’s why all experienced builders budget a bit more to be on the safe side and the British government published special guidelines for construction appraisers on how to make adjustments to estimates of project costs, benefits and duration, to counter optimism bias in planning.
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Adjustments to counter optimism bias are now factored in budgets of most government projects . The same logic can be applied to our predictions on how long we will work. If we estimate to retire at 67, rather take 3 years off and then base your calculations on that. According to Aegon, even a simple written saving plan goes a long way toward increasing our savings and those with a written retirement strategy are more likely to turn their intentions into actions. The research also establishes that the ones with a written saving strategy have on average much higher saving rates than those without it.
The role of technology
For the more tech-savvy, there is now an abundance of new mobile apps that help us save and manage our money by combining behavioral economics and the latest technology to reach our optimistic life goals without breaking the bank.
Acorns app has some smart behavioral science behind it – one feature known as “round-ups” automatically saves and invests your spare change by rounding up purchases to the next dollar and putting the extra change into an investment account. By doing that automatically without any mental effort people save and invest their spare change. Shlomo Benartzi, who is professor at the UCLA Anderson School of Management and co-author with Richard Thaler of the famous retirement savings program Save More Tomorrow, joined Acorns late last year as a senior academic advisor and behavioral economics committee chair. He now runs behavioral experiments to incentivize Acorns more than 4 million users to save and invest more.
His first experiment focused on whether framing savings in more granular formats – saving daily versus monthly, can encourage increased saving behavior. He asked one simple question in three different ways: Would you like to save $5 every day, $35 a week or $150 a month? Even though the total amount set aside is the same, only 7% opted to save $150 a month, compared to 30% who decided to save $5 a day.
The experiment revealed the power of framing, which is a well-known concept in behavioral economics, and in the experiment framing deposits in daily amounts as opposed to monthly, quadrupled the number of savers thus showing how a small tweak in language can convince users to save more. The reason behind it is according to Benartzi that smaller, more granular amounts, seem psychologically less painful and more feasible than larger, less granular amounts, so framing recurring deposits in terms of smaller, daily deposits should be more appealing to users across the income spectrum .
Qapital app also has some smart features that explore our behavioral biases to increase saving instead of reducing it. The app, which brought on Dan Ariely, a professor of psychology and behavioral economics at Duke, as its chief behavioral officer, gamifies spending behavior by creating fun saving rules and giving users positive visual feedback along the way. The apps goal, is according to it`s Swedish founder and CEO George Friedman, to make saving more automated and personalized.
By making saving more visual and connected to our daily life it increases our commitment towards saving goals and they found users who integrated custom saving rules, i.e. you could save a set amount every time the temperature dips below freezing, and put it towards a goal for a warm vacation, which is represented in your app by a nice picture of your future trip, saved many times more than users without custom saving rules.
Behavioral science also backs this up and as mentioned earlier in this article on the case of optimism bias, it has been demonstrated in numerous studies that our brain encodes future desirable information in a more amplified way  and we tend to experience more intense emotions about future events than those in the past. That is because in general, we have an expectation that future events will make us feel more emotional than already passed events. Additionally, we are also more likely to talk about how excited we are about something we have planned in the future compared to something we have already done . Positive future events according to a recent fMRI Study activate part of our prefrontal cortex that give us a general sense of well-being thus confirming the theory that the mere anticipation of future holiday or some other positive event make us feel good, which brings great benefits to our well-being and mental health .
The future self as a stranger
Research by Hal Hershfield and his colleagues also provides interesting insight on how we can use advanced visualizations—digital avatars of ourselves at older ages to increase connection with one`s future self and by doing that increasing our willingness to save for our pension. In a study they ran fMRI scans on participants and found that the neural patterns seen, when people described themselves 10 years in the future, were different from those when they described their current selves.
In fact they were more similar to when people described strangers, showing a disconnect people feel with their future selves. That has a negative impact on their willingness to save because their brain does not feel that they will in fact be the ones receiving the rewards of those savings, but a stranger.
Would you save money for a stranger? The answer is likely to be no. To change this behavior they experimented by showing participants digital avatars of themselves at older ages and then asked them to allocate $1,000 between four options: buying something nice for someone special, investing in a retirement fund, planning a fun event, or putting money into a checking account. The ones exposed to aged avatars put almost twice as much money into the retirement fund as the other participants.
To get ourselves out of this retirement savings crisis, we have to harness our optimism for the future towards clear visual goals that motivate and drive us (buying our dream home or travelling to Tuscany in retirement) and then let technology help us reach those goals as effortlessly as possible. In this way we should encourage people to focus on their future goals, write them down on paper or in a saving app, and provide simple tools, like the before mentioned apps, to automatically follow through on them, harnessing our optimism for the future for our own benefit. This way the glass will really be half full in the end.
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About the Author
Žiga Vižintin is an advisor to the Management Board at Pokojninska družba A in Slovenia. He has a M.Sc. in economics from the University of Ljubljana and is interested in behavioral biases related to pension saving. He is particularly interested in applying behavioral economics to help people save more for retirement.