A failure to appreciate compound interest leads to two serious retirement-planning pitfalls
Everyone’s heard the old adage “youth is wasted on the young,” and it may ring painfully true for financial advisors taking on millennial clients. The decision to put off building their nest egg is common as young investors expect to earn a living until they’re 65 — an assumption that was more than likely shared by older Canadians who retired earlier than they planned to.
Part of this lack of preparation could be due to a bias against long-term planning: in a broad study of millennials published last year, the Ontario Securities Commission found that many delayed a decision to start investing due to a desire to savour their freedom first. But while many may think time’s on their side, they may also be blinded by a common mathematical error.
“[E]xponential-growth bias is the tendency to neglect the effects of compound interest,” said Shlomo Benartzi, a professor and co-head of the behavioural decision-making group at UCLA Anderson School of Management, in a column for The Wall Street Journal. “Research shows that this bias matters: Households with a stronger bias tend to save less and borrow more.”
In an effort to understand why people make such mistakes, behavioural economists have come up with tests to assess the degree to which individuals suffer from exponential-growth bias. In one study, researchers from New York University and the University of California, San Diego asked participants to consider a hypothetical situation involving two people saving for retirement in 40 years.
“Alan deposits $100 every month into his retirement account. Bill waits 20 years before depositing money into his account,” Benartzi wrote, citing the experimental question. “Both accounts earn 10% interest every year, compounded annually.”
When asked how much Bill would need to put in his account every month to catch up with Alan when they both retire, Benartzi said, the majority of participants assumed the answer was $200; in fact, the correct answer is $773. The results indicate that people tend to underestimate how difficult making up for lost time is.
Other research suggests that the bias impacts people’s debt attitudes and behaviour. Citing work by researchers from University of California-Davis and Dartmouth College, Benartzi said that exponential-growth bias increases households’ short-term debt-to-income ratio from 23% to 54%. “[T]he bias leads people to underestimate the long-term cost of debt,” he explained. “Because people with the bias don’t understand how interest accumulates, they are more likely to take on expensive loans.”
As serious as the problems are, Benartzi said, they can be minimized or eliminated with relatively simple interventions. One approach is to do the math for them, he said, as studies have found that people can’t solve questions involving compound growth even if they had old-fashioned calculators on hand. “This suggests that, instead of just telling people their interest rate, we should tell them how much they could expect to have or owe in the future based on that rate,” he said.
Citing his own work with others from Microsoft Research and the University of California, Los Angeles, he said exposing people to their projected monthly income in retirement (as opposed to a lump sum) can boost their savings rate, at least when the lump sum is modest.
“This suggests that individuals understand dollar amounts better than interest rates, and that everyday dollar amounts are best of all,” he said.