Behavioral Finance

With the second installment in his multi-part series on retirement-related behavioral issues, François Gadenne challenges us to think differently about how we will manage different sources of income when we’re retired.

Must We Learn to Budget In-Flows Differently in Retirement? So you think that a retiree’s Personal Income Statement looks like the one they had during their employment days? Typically, an employee’s major source of income comes from their Human Capital in the form of wages. Lest we forget, getting old is quite literally earned. Yet, where do your in-flows come from when you are retired?

During Employment Years

As an employee, we are used to seeing one major and often single source of in-flows in our Personal Income Statement: Employment income in the form of W-2 wages arising from the steady growth of our Human Capital.

The self-employed will see Human Capital in-flows in the form of 1099 Income. They may also see in-flows from Business Investments in the form of rental income, royalty income, etc.

Most of us will not see much income from our Social Capital during our employment years. While we may see the occasional gift or inheritance, Social Security and Defined Benefit Pensions only begin to pay monthly income after retirement. On the other hand, those of us with medical and/or disability conditions may see income from matching social or insurance programs.

During our employment years, we are also in the Accumulation phase with regards to our Financial Capital. During the Accumulation phase, we convert what we save from our Human Capital in-flows into Financial Capital. If we invest this Financial Capital well enough and do not lose it, it may even grow it at a compound rate that makes up for inflation and taxes.

Most of us do not see in-flows from Financial Capital on our Personal Income Statement during our employment years. Most of such savings are in tax-deferred investment vehicles, 401(k)s, IRAs, etc. and the investment vehicles are geared for Total Return and Capital Gains instead of monthly income generation.

During Retirement Years

This in-flows state of affairs changes during retirement. A retiree’s sources of income become more diverse and may include in-flows from Human Capital (part-time work, self-employment, income from hobbies, etc.), Business Investments (rental income, royalties, etc.), Social Capital (Social Security, Defined Benefit Plans, etc.) as well as Financial Capital.

To Summarize:

Income from Human Capital
o W2 Wages
o 1099 Income

Income from Business Investments
o Rental Income
o Royalties

Income from Social Capital
o Social Security
o Health and Disability
o DB Plans
o Children
o Church and Community Support
o Gifts

Income from Financial Capital
o Investment Income
o Annuity Income

Recent data from a recent CRS Report for Congress – November 7, 2005, Table 1, page CRS-4, Topics in Aging: Income and Poverty Among Older Americans in 2004, Debra Whitman and Patrick Purcell suggests that the median, annual in-flows into the Personal Income Statement of current retirees (age 65 and above) are as follows:

Income from Human Capital

o Wages: $15,000

Income from Social Capital
o Private DB: $6,720
o Public DB: $15,600
o Social Security: $10,399

Income from Financial Capital
o Annual Income: $952

These numbers are counter-intuitive for most of us in the Financial Industry. In particular, two questions come to mind:

• Is the median annual income from Financial Capital really this small?
Medians and averages can easily be misleading. Clearly market segmentation matters greatly and answers to this questions will vary depending upon your target market.

• Will the Baby Boomers display the same pattern since this data speaks to the prior generation?
It is very likely that they will not display the same pattern. Consensus suggests that they may not benefit to the same amount of Social Capital as the prior generation and there is evidence to suggest that much of the existing Financial Capital may be concentrated with the Baby Boomers. While time will tell, we are all making business decisions that answer this question one way or the other.

Independently of our answers, we can observe that this Personal Income Statement format is often not used in the Accumulation-focused advisory process. Looking at the difference between the Employee’s and the Retiree’s Personal Income Statement, we can understand why this is the case. However, we probably all agree at this point that it should be used in the Retirement Income planning process.

RIIA’s Education Committee is currently developing the Body of Knowledge, Curriculum and Learning Objectives for RIIA’ Retirement Income Expert (RIE) designation which will include the concept of the Retiree’s Personal Income Statement. If you have an opinion on this topic, let us know.

©Copyright 2007 David A. Macchia. All rights reserved.

During the first half of May François Gadenne stepped into my blogger role and contributed ten wonderful essays that offered a vision for future of retirement as well as RIIA’s role in helping to define that future. I’ve asked François to continue to contribute to this blog as his great insight benefits all who visit here. Today he presents the first in a multi-part series that asks, “What must we learn in order to retire?“

Human Nature was forged in an environment that is not the environment we currently live in. Today we live in abundance when human nature was forged in scarcity. We live in a world where food can be preserved and stored in great quantity. We evolved in a world where the currency of the day, food, lost its value quickly as it spoiled.

The good news is that in addition to evolving slowly, humans are also fast learners. Learning improves adaptation when the environment moves faster than can be accommodated by the slow speed of evolution through natural selection. Learning is an effort to make sense of the realities of the past and of the possibilities of the future as they can be understood in the present.

Learning is what we do when we drive a new car. There are lessons that each one of us must learn and re-learn individually when we drive a new car. For instance, where and how large are the blind spots with this new car? It we learn where the blind spots are fast enough and systematically enough, we may have fewer accidents.

Since the financial environment changes, each generation will learn and remember different lessons. Some lessons may work well for a while and clearly become less valuable at other points in time. Might there be lessons that we need to learn or re-learn in order to retire?

For starters, we may want to learn about our Behavioral Finance blind-spots:

• We have limited self-control. We suffer from over-confidence and we over-react. Life is a succession of over-shooting and under-shooting the ideal behaviors.
• Not only do we lack self-control, we can be manipulated in ways that we do not perceive. We are subject to Framing Errors such as Contextual Norms, Mental Accounts, Statistical Errors, etc.
• We are also subject to Aversions such as Regret and Loss.

The good news is that forewarned is forearmed. Learning about Behavioral Finance can give us enough self-knowledge to be aware of some of our financial blind spots. We learn about blind spots quickly, one way or another, when driving a new car. When is the last time that your financial blind spots caused you to make a bad decision? Are you learning fast enough?

Each new generation must learn and re-learn some of the lessons of the past as well as some new lessons. The next few posts will explore what such lessons may be for those of us who plan to retire.

To be continued…

©Copyright 2007 David A. Macchia. All rights reserved.