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How Anchoring Hurts 401k Retirement Savers

How Anchoring Hurts 401k Retirement Savers
December 12
01:41 2017

In the September 1974 issue of Science, Amos Tversky and Daniel Kahneman published a ground-breaking paper in the nascent field of behavioral finance. “Judgment under Uncertainty: Heuristics and Biases” outlined three different mental shortcuts (i.e., “heuristics”) that often enable cognitive biases resulting in sub-optimal decisions: “Representativeness,” “Availability,” and “Anchoring.”

“Representativeness” is a form of hasty generalization caused when we judge one thing based on how similar it is to another thing. For example, if 401k savers see the market going up (or down), they assume their retirement assets will also go up (or down) simply because both contain equity investments. In effect, “representativeness” causes people to “pre-judge” something merely due to its similarity (or lack thereof) to something else. If you can see how this can quickly go bad, then you understand the essential problem with this particular bias.

“Availability” creates an ad hoc conclusion based on one’s awareness of a certain item. Retirement savers are more likely to believe they’re better off with investments they are familiar with rather than investments they aren’t familiar with. In addition, they are further influenced by the frequency of news stories about specific investments or classes of investments. If all they see in the news tells of how Bitcoin values are skyrocketing, they’re likely to believe Bitcoin is a good investment (despite the fact that Bitcoin is quite speculative). If all they see in the news is how the new tax plan will hurt people, they’re likely to believe the tax plan is going to cost them money (despite the fact it will actually reduce their taxes). Now you know why advertising can be an effective means to influence consumer behavior.

Finally, “anchoring” refers to our uncanny ability to select arbitrary points of reference without any regard for objective reality. The subsequent “adjustment” we make from this random starting point leaves us satisfied, even if the end result is not necessarily rational. Investors will often look at what the market is doing and compare their own returns to that. If the market is up 10% and they are up 5%, they’re not happy, even though they’re making money. If the market is down 10% and they’re only down 5%, they’re happy, even though they’re losing money. This is perhaps the greatest reason why people miss their goals – they’re anchored to (and therefore aiming at) the wrong target.

Of these three cognitive biases, anchoring presents the greatest relevance to 401k fiduciaries. Laraine McKinnon, Founder and CEO of LMC17, a strategic-consulting firm in Silicon Valley, calls anchoring “one of the most pervasive behavioral themes in the 401k for participants and plan sponsors alike. In my extensive experience working strategically with Fortune 500 401k plans, I’ve seen anchoring as a problem that stalls important changes that would clearly benefit the participant.”

In his 1989 paper, “Choice Based on Reasons: The Case of Attraction and Compromise Effects,” (Journal of Consumer Research, 16 (September), 158-174), Itamar Simonson coined the term “The Compromise Effect.” Simonson maintains people tend to compromise when presented with multiple options. For example, when given a choice between an expensive alternative and an inexpensive alternative, they will usually compromise down to the cheaper choice. On the other hand, when offered three possibilities, they’re more likely to shun the most expensive and least expensive and instead opt for the middle ground.

This is how framing works in everyday decision making. “Anchoring is a framing technique for buying decisions that determines three points of the pricing plane: the lowest point, highest point, and middle point,” says Margaret J. King, Ph.D, Director at The Center for Cultural Studies & Analysis, a think tank that studies human behavior located in Philadelphia, Pennsylvania. “As long as buying is grounded by this frame, most of us can feel confident we are making a rational decision on big-ticket to little-ticket calls: from college tuition to toasters. Consumer Reports has noted that their ratings do this by creating the middle ground where most (of their readers) do their purchasing. The irony is that there is really no way of proving an anchoring point without looking at a larger system (budget, middle-market, or luxury systems) to put the three-point system into perspective. That’s what salesmen do – restructure the buyer expectation by corralling data within one of these levels. To change perspective, you have to compare prices outside those 3 points: for example, contrasting the premiums paid out for long-term care to the costs of home care plus the opportunity costs to the family.”

We see the harmful results of Simonson’s “two-choice” scenario plenty of times within the 401k universe. “The most common example – applicable to thousands of plans – is the default savings rate of 3%. This is a common default rate, but is in fact, an insufficient savings level,” says McKinnon. “When fiduciary committees meet to discuss raising the default savings rate, perhaps from 3% to 6%, members will balk at doubling the rate and express concern that there will be participant backlash.”

Before explaining anchoring to individuals less inclined to consider it, it’s a good idea to relate it to more common situations. “The anchoring dynamic can be found in everyday behavior,” says Todd S. Lowenstein, Head of Research at HighMark Capital Management in Montecito, California. “You shop for an appliance and use the price of the first model you see as a reference point for all subsequent choices, or maybe you refuse to pay more than a certain dollar amount for a certain item. Anchoring is even more common when dealing with concepts of greater complexity such as investing. Setting a reference point provides a level of comfort and security, even if it may actually cause harm in the long term.”

Lowenstein offers this example: “Many 401k plan administrators will tell you that when participants are provided with a total of four different investment options, there is a strong tendency toward allocations that are split close to one-fourth of the total contributions in each option. In other words, even allocations occur due to anchoring on the finite universe of choices. However, clearly one’s own unique goals and risk tolerance should be the more dominant factor in optimizing these choices rather than a simple equal allocation. We also see many investors anchor on the last downturn and extrapolate that outcome as to how the next downturn will unfold in duration and magnitude like the past.”

Anchoring your perceptions with what’s happened in the market over the last few quarters can lead to devastating results for the retirement saver. “In the world of 401k plans, all too often I see anchoring in a bad way,” says Richard Rausser, Senior Vice President at Pentegra in White Plains, New York. “The classic example is the ‘set it’ and ‘forget it’ mentality that many participants use in a manner that might hurt them. Before the advent of auto enrollment and target date funds, many participants ‘picked’ a salary deferral rate and ‘picked’ one or more investment funds without much strategic thought. While things tended to go well for a while, at some point many participants experienced a rude awaking during a market decline. In many cases the trauma of the market event caused another poor strategic move which resulted in some participants taking big losses by selling their investments to ‘protect’ themselves from more downside losses. The end result was that they typically sold low and later on bought back the same investments at higher prices. This is the exact opposite of what a disciplined investor should do, which is to buy low and sell high.”

With the introduction of the concept of anchoring, Tversky and Kahneman opened the door to a new way of thinking about and addressing the financial decision-making process. For more than four decades, subsequent research has expanded upon their idea. Yet, plan sponsors and participants continue to remain uninformed about the dangers of anchoring. “Anchoring is a critical part of the larger body of the behavior finance domain that plays an increasingly important role in markets and sound investing,” says Lowenstein. “It matters because investors are predictably irrational, cultivating mindfulness around this discipline helps to minimize unforced errors and capture opportunity.”

It’s up to the plan fiduciary to determine how to best help retirement savers navigate around the obstacle of anchoring. First, though, perhaps it’s best if they acclimate themselves to the many instances in which anchoring rears its ugly head in the world of retirement saving.

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  • 3 Practical Suggestions to Get Around the Obstacle of Anchoring? – Human behavior being what it is, it’s nearly impossible to avoid anchoring. Still, there are proven ways to avoid its most harmful consequences.
  • Anchoring Jiu-Jitsu: 3 Techniques that Use Anchoring to Promote Good Retirement Saving Decisions – In retirement planning, there can never be any guarantees. That’s why it’s critical that these tools are used continually and consistently. A magician never gives the audience’s eyes a chance to wander.

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary SolutionsHey! What’s My Number? How to Improve the Odds You Will Retire in Comfort and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on Twitter, Facebook, and LinkedIn.

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.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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