With the shift from defined benefit plans to defined contribution plans, the onus is increasingly on individuals to make complex decisions that will shape their future financial security. Yet many struggle to make sensible choices, often making long-term decisions based on very short-term market trends. Studies show that one way financial advisors can help clients make better decisions is though using the right framing — that is, by putting appropriate investments in an appealing light. For those in or near retirement, that may mean focusing on future income needs, rather than investment returns.
Consider the “70% rule” that advises people to plan on spending about 70% of their current income during their retirement. For most people, this rule of thumb is intuitively appealing, which could explain why it has become so popular among financial planners.
Now let’s use slightly different lenses and reframe the 70% rule as the 30% rule. That is, rather than focusing on the 70% of expenditures someone would sustain through retirement, let’s consider the 30% of expenditures that should be eliminated. Most people find the 30% rule unpalatable, even though the 70% and 30% rules are mathematically identical.
The comparison of the 70% and 30% rules highlights how seemingly small changes to the lenses or “frames” we use can have a huge impact on our decisions. In the case of financial decision-making, University of Illinois Professor Jeffrey Brown (Brown et al 2008) investigated the role of framing in choosing lifetime income solutions. They asked more than 1,300 individuals older than 50 to make a choice between:
1. A life annuity paying $650 each month until death, or
2. A traditional savings account of $100,000 bearing 4% interest.
The two choices were designed to have the same actuarial value in order to ensure an apples-to-apples comparison.
Half the people in the study were presented with the two options in a “consumption” frame, where the annuity was described as providing monthly income of $650 for life. Of those viewing the consumption frame, 70% preferred the annuity. The other half were presented with the choices in an “investment frame,” where the annuity was described as an investment with a $650 return for life. Only 21% of those who viewed the choices in an “investment” frame selected the annuity. While the economic characteristics of the choice sets were essentially the same, the framing of the alternatives in terms of either monthly income or investment return had a dramatic effect on the outcomes.
These results can be explained by the fact that lifetime income solutions are perceived to be safe when framed as a consumption plan because they guarantee lifetime income. However, the same solutions are perceived to be quite risky when framed as an investment plan because the policy owner runs the risk of dying early and relinquishing wealth to the insurer.
Clearly, the context in which retirement income solutions are presented has a dramatic effect on their attractiveness. If we agree that the underlying purpose of retirement plans is to provide income at retirement, it is more appropriate to frame those plans in terms of monthly income, not investment return.