Investor behaviour and lump sum bias

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Australian superannuation funds face a number of barriers in providing an adequate and sustainable level of retirement income for their members. This article looks at one such barrier, an investor behaviour known as ‘lump sum’ bias.

What is lump sum bias?

Public superannuation funds accumulate capital for people to retire on. But most people find it difficult to calculate how much retirement income their capital can reliably produce from year to year. They tend to over-estimate the amount of annual income it can reliably produce.

Anecdotes about such behaviour are common place. Retirement expert, Don Ezra, suggests that if you ask an intelligent, but non-mathematical, person how much yearly income a lump sum of $100,000 could reliably generate for the rest of their lives, their usual response would be in the range of $10,000 to $20,000. Most experts would put the correct figure at around $5,000 per annum, perhaps even less.

Lump sum bias is where people place a higher value on a lump sum than the actuarially fair and sustainable income stream it could produce.

In rational economic theory, a person should choose the payment outcome that has the highest discounted value. Behaviourally, however, people have a bias towards a lump sum payment. There are a number of factors that explain why people exhibit such bias, including:

  • wealth illusion – one simply looks bigger than the other
  • affect heuristic – people make a rapid, intuitive judgment because it feels like a good amount
  • simple temporal discounting – people generally prefer dollars today over dollars tomorrow
  • preference for certainty – people perceive the future as uncertain, and by taking a lump sum payment today, they eliminate a degree of uncertainty, even if they potentially sacrifice some ultimately higher value
  • opportunity cost – people believe that having a single large sum might enable them to create or exploit an otherwise unavailable opportunity
  • utility of money – people expect the utility of money to decrease as they age and that they will have fewer and less attractive opportunities to enjoy the money.

Evidence of lump sum bias

United States academic Dan Goldstein conducted an experiment where participants were asked to rate their satisfaction with either a $100,000 lump sum or monthly payments of $300, $500 or $900 for life. For a 65-year-old, such a lump sum is roughly equivalent to $500 a month for life.

Respondents had clear preference for the lump sum, even compared to the much more actuarially valuable $900 monthly payments. In fact, Goldstein calculated that the ‘indifference point’ (ie where people would take either) between monthly payments and a $100,000 lump sum was $1,065 a month, nearly twice what it should have been.

Australian financial research firm Investment Trends conducted a similar survey in Australia. They asked people 40 years of age and over how much minimum guaranteed annual income they would need for the rest of their life, in return for a $100,000 investment. Figure 1 outlines the results. The average response was $8,200 per annum, with $10,000 per annum being the most selected option. This is well above the actuarially fair amount of approximately $5,000 per annum.

Figure 1 Lifetime annual income required for a $100k lump sumAM PS Chart1 120914

Summary

When it comes to developing an income plan for retirement, lump sum bias can negatively impact the planning process. People who are unable to determine an equivalent income stream from a lump sum might not be saving enough. In particular, people with smaller amounts of retirement savings feel that a lump sum is more adequate for retirement than an equivalent income stream.

Most super fund members get their periodic statement with their latest account balance on it. If they also received a projection of their annual income in retirement in today’s dollars (while highlighting the likelihood of a range of outcomes deviating from the average) it would help prevent them from falling short of retirement adequacy by over-estimating the value of their lump sums.

 

Aaron Minney is Head of Retirement Income Research and Phil Sainsbury is a Research Analyst at Challenger Limited.

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3 Responses to Investor behaviour and lump sum bias

  1. David M September 12, 2014 at 10:49 AM #

    Well written article, have known and seen this in action but wasn’t aware it had a label. I think some form of additional reporting about the possible income stream is a good idea; this might encourage people to help grow their superannuation.

  2. Warren Bird September 12, 2014 at 10:37 AM #

    To me, the answer to the poll question that is related to this article is: “it depends on the credit rating of the institution promising me the income.”

    What I mean is this. If faced with a choice between a $100,000 lump sum or $4,000 a year from the Government, I’d take the income stream. But if the promise of $4,000 a year was from a BBB rated financial institution with no clear investment process, I’d take the lump sum and invest it in a portfolio of my own choosing.

    If the BBB rated institution offered my $7,000 a year I might think about it. Even then, if this was all I had saved up, I’d be worried about the concentration risk and would prefer a more diversified source of income.

    So I’m curious whether any of the research took this into account? What was the actual nature of the income promise that people were asked to compare with the lump sum? Clearly if people like me responded, it would bias up the break-even income level!

    • Stuart Barton September 17, 2014 at 12:31 PM #

      Ceteris paribus would be the answer, wouldn’t it? The research is expressly solving for one variable, so doesn’t take into account the issuer’s creditworthiness, nor the actual or self-perceived skill level of the respondent. A separate experiment would be required to test for sensitivity around the perceived creditworthiness of the income stream issuer, Even so I am not sure that the theoretically risk-free Government is an appropriate foil, as not even Australia’s A-rated life companies/annuity providers will have higher perceived creditworthiness.

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