- We don't spend as much in our retirement as economic theory predicts we should
- There are strong psychological obstacles to spending more. It's difficult to overcome these.
How much can we afford to spend in retirement? The answer could be more than you think, because we make errors of judgment in thinking about our wealth.
Time was when the question was simple. We used to retire on an annuity that protected us from the two opposing dangers with financial planning – either that we would outlive our wealth or that our wealth would outlive us. With the demise of annuities and final salary pensions, however, we are thrown back onto a rule of thumb – the one which says we can withdraw 4 per cent of our wealth each year without eating into our capital over time.
The trouble is that this is only the roughest of rules. We don’t know what future long-term returns will be. They are prone to radical uncertainty. Which means we don’t really know how much we can spend.
We do, though, have a cushion against such uncertainty. It’s that we don’t need to maintain our wealth as the 4 per cent rule implies. We can run it down. Economic theory says this is what we should do: the life-cycle consumption hypothesis says we save when while we work and dis-save in retirement.
But we don’t do this. For years in most developed countries the retired have not dis-saved anything like as much as the hypothesis predicts. HMRC reports that in 2017-18 (the latest data we have) people left £95.2bn in their wills – an average of over £300,000 for everyone leaving an estate.
Of course, some of this is because people wanted to leave a bequest or because they died unexpectedly.
And of course, we have good reasons for being cautious about our spending. The abject failure of our political class means we don’t know how much, if anything, we’ll need to spend on social care. And we don’t know how long we’ll live – although our spending should fall when we are very old because (for example) things like holidays or days out are less pleasant if our mobility is restricted.
These, however, are not the whole story. Even when we should run down our savings, we face big psychological barriers to doing so.
One is that you can’t teach old dogs new tricks. We spend decades saving and it’s hard to break the habit. I get a sense of triumph when my bank statement tells me I’ve saved a decent amount. It will feel weird when this is no longer the case. Seeing our wealth seep away discomforts us like a dripping tap does.
There’s something else, pointed out by the Nobel laureate Daniel Kahneman and his colleague Amos Tversky 30 years ago. They show that our attitudes are sensitive to reference points. Our current level of wealth, or something near it, is one such reference point. Which is why the loss of (say) £100 gives us more pain that the gain of £100 gives pleasure.
Hence our reluctance to dis-save. Doing so forces our wealth below our reference point and so unsettles us. And the prospect of dis-saving for years means our wealth falls a long way below such points.
This is related to another quirk discovered by Kahneman – the endowment effect. He gave some students a commemorative mug and others nothing and then asked them all what they thought the mugs were worth. Those who had been given a mug named a much higher price than those who’d been given nothing. Which shows that we over value what we have simply because of mere possession and so are loath to part with it.
In this sense, our reluctance to dis-save is a close cousin to another bad investment habit, our tendency to hold onto losing stocks. The price we pay for a share is a natural reference point and it hurts us to sell below that point and book a loss. So we don’t do so, so exposing ourselves to the wrong sort of momentum. This is reinforced by the endowment effect and wishful thinking: we over-value the stock and over-estimate its chances of rising merely because we own it.
If all this is bad there’s worse, as MIT’s Dan Ariely has discovered. He asked some American students to write down the last two digits of their social security number and then to write how much they were willing to pay for a cordless keyboard. Those who had written high numbers offered higher prices than those who had written low ones. This shows that even irrelevant and random things can function as reference points and so distort our behaviour.
The same might be true of our money. Some of us are working too long or spending too little to maintain our wealth simply because it has become a reference point, even if we have more money than we need and if it has been boosted by the good luck of recent high returns.
In this way, instead of us managing our wealth our wealth manages us. As one well-known philosopher said, man “is governed by the products of his own hand.”