topic #6: the psychology of investing

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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

Why do participants make certain investment choices?

How do we understand an investor’s behavior?

How may we assist our employees to better prepare them for retirement?

The Psychology of Investing

Janet Kendall, ChFC, CEBS, CRC, CRAVP, Industry and Consultant Relations

INGGEN.H.S.MS.687

Behavioral Finance

Why do people make the decisions

they make about retirement?

• Participation• Contributions• Investment Decisions

Who is Making Retirement Decisions?

Seniors (Ages 63-83)

Baby Boomers(Ages 44-62)

Generation X(Ages 32-43)

Generation Y(Ages 18-31)

We Need Help!

Four generations agree that more advice is needed.

*Schwab Study, Plan Sponsor Magazine, July 15, 2008.

Participation

What is the state of participation

today in DC Plans?

Why is it the way it is?

Some theories…

• Inertia• Information Overload• Lack of Understanding• Low Priority

Contributions

What is the state of participation today in DC Plans?

Why is it the way it is?

Some theories…

• Fear of Losing Principal• Procrastination• Analysis Paralysis• Can’t Afford• Lack of Understanding

Investment Decisions What is happening with regard to

investment decisions today in DC Plans?

Why is it the way it is?

Some theories…

• Loss is Feared More than Gain is Appreciated

• Impulsivity – Market Timing• Complexity• Job Mobility• Unrealistic Expectations• No Time• Familiarity Effect

Potential Solutions

• Review Overall Plan Design• Communication, not just Education• Life Cycle Investment Options• Decrease Complexity/Reduce

Choices• Automatic Enrollment*• Contributions Tied to Pay Raises• Free Money/ER Match• Immediate Vesting

*(anti-wage garnishment laws may prohibit)

Remember Motivators

• Social Relationships• External Expectations• Social Welfare• Personal Advancement• Escape/Stimulation• Cognitive Interest

Psychology of Investing Resources

Books of Interest

Advances in Behavioral Finance

by Richard H. Thaler

Behavioral Finance and Decision Theory in Investment Management

by Arnold S. Wood

Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing

by Hersh Shefrin

Nudge: Improving Decisions About Health, Wealth and Happiness

by Richard H. Thaler and Cass R. Sunstein

Web-Sites of Interest

www.Hewitt.com www.EBRI.org www.ING.com/us/sponsorIIRR

" Even if you're on the right track, you'll get run over if you just sit there."

- Will Rogers

Thank You.

The Psychology of Investing:

The Impact on Plan Options

David J. EdwardsVice President Dodge & Cox

"…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'."

Source: Wade Armstrong, President of American Express Retirement Services

Preview:

• The “Typical Line-up”

• The Effect of Legislative Changes

• The “New Environment”

Investing Principles & Beliefs

• Risk & Return are related

• Diversification is key

• Portfolio Structure affects performance

The Sponsor’s Greatest Threats…

• Participant’s wealth accumulation fails to meet retirement needs

• Participant has insufficient wealth preservation close to retirement

• Participant opts out of the plan and stops saving for retirement due to a loss or setback

Legislative Changes

• Market Timing Rules

• Pension Protection Act of 2006

Market Timing Rules

• 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 "round trip" transactions

• Restricting exchange privileges

• Imposing redemption or exchange fees on shares that are redeemed or exchanged within a certain time period following their purchase

Pension Protection Act of 2006

• Encouraged the use of automatic enrollment

• Defined a list of strategies considered appropriate as default options - known as “qualified default investment alternatives”

Qualified Default Investment Alternatives

“The New Environment”

1. Targeted Retirement or “Lifestyle Funds”

2. Balanced funds

3. Professionally managed accounts

Targeted Retirement or “Lifestyle Funds”

Benefits to Participants:

One-Stop Investment Shopping Professional Asset Allocation Retirement Investing Made Easy

Balanced Funds

Benefits to Participants:

Exposure to a combination of equity and fixed income

Professional Asset Allocation

Managed Accounts

Benefits to Participants:

A professional investment manager constantly adjusts the allocations in the portfolio to attain an appropriate asset mix

Risk and reward decisions for each asset class

are based on current market and economic conditions and not historical information

The Psychology of Investing

Curt Morrow CFP®, ChFC®, CRC®

Investment Service Consultant

Nationwide Retirement Solutions

NRM-5237AO (07/2008)

Nirvana for a Public Employee

Objectives

1. How does participant behavior affect plan structure?

2. How can education help?

3. What can plan sponsors and providers do to help participants?

Lessons From Behavioral Finance

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.

Plan sponsors must learn to focus more effectively on these reluctant savers.

Source: The Vanguard Center for Retirement Research, April 2004. “Lessons From Behavioral Finance and the AutoPilot 401(k) Plan”

What Can Plan Sponsors Do?

• Increase education efforts

• Make education meetings mandatory

• Provide investment advice

• Offer target maturity funds

• Offer managed accounts

What Can Plan Sponsors Do?

• Automatic enrollment

• Contribution rates automatically increased annually

• Participant accounts automatically invested in diversified portfolios

• Offer an “opt out” for DIYs

Consider an Automatic Plan

• 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.

• 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.

Plan design drives participant decision-making, often in unanticipated ways.

What Can Plan Sponsors Do?

• Plan sponsors and providers have the ability to alter participant behavior by choosing different default structures.

• 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.

• One solution to this dilemma is to reconfigure default decisions around the needs of reluctant savers.

Plan design drives participant decision-making, often in unanticipated ways.

What Can Plan Sponsors Do?

The Automatic Plan – Rethinking the Defaults

Decision Typical Default Automatic Default

Participation Join – if you like You’re enrolled

Investments Default option is a fixed or money market

Default option is a balanced fund, suited to your age

Retirement Here’s a lump sum Here’s help balancing the benefits of lump sum with an annuity with guaranteed payments

Target Demographic

Active decision-makers and planners

Reluctant savers and avoiders

Source: The Vanguard Group, 2004

How Does the Automatic Plan Impact Providers?

The typical default plan participant education and communications are targeted towards joining the plan and choosing investment options.

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.

Pros and Cons

• Advantages of the automatic plan include higher participation rates and better investment diversification.

• A disadvantage of the automatic plan is that participants tend to remain at the default contribution levels rather than increasing.

Inertia and Procrastination

When faced with a complex or difficult decision, individuals often employ two simple heuristics

1. Keep things as they are (inertia), or

2. Put the decision off until tomorrow (procrastination).

Participant Choice in Distributions

57

2022

11

Lump SumDistribution

Deferral ofDistribution

Regular GuaranteedPayments (Annuity)

Installment Payments

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

Conclusions

• In the typical default plan, not all employees are active, self-motivated decision makers.

• Most are unsure of their savings and investment decisions. Decisions often change based on how questions are framed and their plan’s default option.

• They allow inertia and procrastination to rule their financial lives.

Behavioral finance offers a range of insights into how individuals make financial decisions.

• The autopilot plan helps employers enhance retirement readiness, especially with reluctant savers and avoiders.

• Removes the active decision making process for most employees, allows freedom for the active decision makers.

• Uses inertia to guide participants to a better retirement plan.

ConclusionsBehavioral finance offers a range of insights into how individuals make financial decisions.

Questions

?