Why a 401k Fiduciary Must Convince Retirement Investors to Avoid Thinking in Lump Sum Terms
One day, while walking down the street, you meet a man who you’d swear looks exactly like Bill Gates. You know Bill Gates? Microsoft founder. Richest man in the world. Likes to give money away. That’s the one.
Funny thing, though. It turns out this fellow not only looks like Bill Gates, but he is Bill Gates. After you realize you’ve been staring at him a little bit longer than politeness would dictate, you meekly wave “hello” to him. He waves back and then – Surprise! – he begins to speak to you.
“Excuse me,” he says, “but would you like some money?”
You stop dead in your tracks. Is this serious? Is there a trick? It is Bill Gates after all and you know he likes to share his wealth. Still awestruck by the fact you’re in a conversation with a celebrity, all you can spurt out is a tentative, “Sure.”
Bill smiles at you. “Great!” he says. “You’re an average person, right?”
“Well, yeah,” you answer.
A bit more excited, Bill giggles to himself and says, “I’m going to give you a choice between two amounts of money. If you pick the larger sum, you get to keep it?”
“And if I guess wrong?” you ask suspiciously.
“Nothing,” assures Bill. “You just walk on your merry way as if this conversation never happened. So, are you ready?”
“OK,” you say.
Bill shakes his head a little bit too enthusiastically, as if he’s channeling his inner Joe Pesci. “OK, OK, so here’s your choice. When you retire at age 68, I can either give you $100,000 in a lump sum right there on the spot, or,” he pauses, “I can give you $500 a month for the rest of your life. Which one is larger?”
If you’re like most people, you’d choose the hundred grand right on the spot. If you’re like most people, then, you’d be wrong. A lump sum of $100,000 is not larger than $500 a month for the rest of your life.
For those few of you out there who picked the monthly payment, you might find yourselves smiling smugly. Well, there’s bad news for you. You’re wrong, too.
You see, according to standard actuarial tables (using a 3% interest rate assumption), a lump sum of $100,000 at age 65 exactly equals receiving $500 per month for the rest of your life. At least that’s what researchers say who studied this, (Goldstein, Daniel G. and Hershfield, Hal E. and Benartzi, Shlomo, “The Illusion of Wealth and Its Reversal,” January 28, 2014). Simply stated, they showed that if you describe the same monetary value in two different ways, you’ll get two different (and opposite) reactions from the typical person. For example, these researchers have determined, for the average person retiring at age 68, there is no mathematical difference between receiving a single lump sum payment of $100,000 and a payment of $500 per month for life. Despite their financial equivalence, the average person would see the $100,000 as the more adequate of the two.
The paper focuses on reframing this “Illusion of Wealth” from the point of view that people need to see numbers presented in a way they can better understand. Without a sophisticated financial calculator, it’s hard for the professional, let alone the average person, to know when a lump sum is adequate to fund retirement. By looking at a monthly payout figure, people can more easily determine if it can cover their monthly expenses. This is why, when presented with a choice between larger number (e.g., receiving a lump sum of $1.6 million or $10,217 a month for the rest of your life – again, mathematically equivalent amounts), people tended to pick the monthly payment instead of the lump sum. Why did they switch they’re choice? The researchers believe it’s because people see the larger monthly sums as more likely to cover their monthly expense.
The trouble is, many expenses (like property taxes, insurance premiums, etc.) are annual expenses, not monthly expenses. That means you don’t pay for the same amount of expenses every month. Unless you’re very, very, good at keeping track of your cash flow. It’s a whole lot easier to think in terms of the annual income needed to cover annual expenses. There’s an industry “rule” regarding this. It’s a little controversial, but it’s what really drives everything. You can read about it in “80% Salary Replacement Rule: Origins and Exceptions for 401k Retirement Savers to Consider,” (FiduciaryNews.com, December 10, 2013).
Interested in learning more about issues facing today’s 401k investors and how professionals advise them? Check out Mr. Carosa’s upcoming book Hey! What’s My Number?, available later this summer.
Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.