For small employers, and especially solo practitioners, taking matters into their own hands can be a daunting task. In addition to the markets’ unpredictability, planning and investing for retirement is also fraught with human emotions that can quickly capsize our expectations and dreams of living a comfortable retirement.

Browse through any article about saving for retirement or listen in on discussions taking place in Washington, D.C., today and you’ll likely hear questions like these: Why do nearly a quarter of people with access to voluntary retirement plans choose not to invest in them? Why do people who do invest do so in such small amounts? Why do so many people seemingly ignore the potential benefits of time and compounding?

Many of the answers are emotional, not logical. The investment community is realizing what advertisers have known since the dawn of advertising—that emotion drives action (and sometimes inaction). Understanding how emotions and psychology affect investment decisions lies in a relatively new field of study called behavioral finance, which combines psychology and finance economics. Let’s shed light on some of the more common human behaviors—born out of emotion—that impact our ability to save for retirement.

Hyperbolic Discounting

Hyperbolic discounting is a fancy name for a very human tendency. It’s the tendency to give in to the “now,” potentially at the expense of the “later.” To have that piece of cake tonight and plan to diet tomorrow, or to indulge in a little luxury today, say the proverbial $5 latte instead of putting the savings in the piggy bank. The perceived “pain” of an immediate sacrifice exerts a stronger pull than the perceived “benefit” of a conceptual, long-term gain.

When planning for retirement, even individuals with the best intentions, who know they need to save, will often give in to the “now” at the expense of a greater benefit “later:”

• I’ll start saving when I get a raise.
• A few days or weeks, or even months, won’t make much difference.
• I’ll sign up when I have time.
• I can’t afford it right now.
• I’m too busy right now.

This effect is potentially damaging to our long-term well-being when these “immediate indulgences” add up over time. For example, a three-times-per-week $5 latte habit can cost more than $100,000 over time, versus investing that $15 per week in a tax-deferred employer retirement plan (figure 1). Giving in to the “now” limits our ability to fully benefit from the power of interest compounding.

Loss Aversion

Simply put, “loss aversion” is the “fear of loss.” And fear is one of the most powerful emotions humans know—hard-wired into our brains and DNA. Fear is a primal emotion. It’s the instinct that alerted our earliest ancestors to the possibility of danger and gave them impetus to avoid that danger. The fear of losing something today is more powerful than our anticipation of potentially gaining something we don’t have already. It’s why many investors “sell low” because they don’t want to lose more, and “buy high” because they don’t want to lose out. It’s also why many choose not to invest at all. Studies show that the pain individuals feel when they lose cash is twice as strong as the joy they feel when they gain an item of equal value (figure 2). This fear can prevent individuals from thinking along rational lines:

• Well, at least there’s an employer match, I’d get that.
• If I don’t save, I lose any possibility of any gain at all.
• Saving now increases my chances of having a more successful retirement.

Yet for many, fear—especially of investment loss—can be so powerful that it sabotages the very actions that could help prevent this feared doomsday scenario from becoming a reality.

Familiarity Bias

Fear of loss can magnify the effect of familiarity bias. What’s familiar can seem comfortable and safe. Our past experience is a powerful navigational system for our future actions, whether or not that experience is logical. The unknown is uncharted—and intimidating—territory. In his article “Avoid the Investing Trap of Familiarity” in the November 22, 2010, issue of the New York Times, Carl Richards wrote

Real people like things that they’re familiar with. We often pick the same thing from the menu (even if it wasn’t great) and we like to invest in the familiar as well. This preference for the familiar, often referred to as the “familiarity bias,” leads us to the faulty assumption that just because we’re familiar with something, it must be safe.

For example, if you’ve tried the chicken Marsala on a menu, and it was excellent, do you want to risk your meal on an untried chef’s special and risk losing that safe experience? For individuals who fear loss, an investment in the “known” can appear to be the safer—even safest—choice. According to John Nofsinger in the June 25, 2008, issue of Psychology Today, underestimating investment risk can result in skewed diversification:

• Inferior asset allocation.
• Too much allocation to one or few stocks.
• Preferences for local stocks or industries.
• Preferences for cultural proximity.
• Preferences for professional proximity (e.g., a doctor investing in medical stocks).

“In part, this explains why so many people invest so heavily in the companies they work for” (Kate McCaffery, walletpop.com, April 27, 2010).

Information and Change Overload

Another potential contributing factor to individuals’ attraction to what they know and find familiar lies in the tremendous amount of information they are confronted with each and every day in a world that’s characterized by rapid social, economic, and technological change.

Ironically, the very carrier for the exponential growth of information individuals are exposed to—the Internet—may be the most effective way of sifting, sorting, and managing that information. The explosion of available information means it’s easier than ever to explore and manage information about what we care about. Used properly, technological tools can help individuals sort the informational wheat from the chaff and help each individual to choose and focus on what’s most relevant. How can this play out in individuals’ savings and investment actions (or non-actions)? Consider the barrage of articles and advertisements from financial services companies. Consider the length and language of the average investment prospectus. Consider the interruption of a retirement plan enrollment meeting—20 minutes or so packed with unfamiliar information—to a workday. It’s no wonder that individual consumers often feel confused, deeply stressed, and overwhelmed by the investment world. These emotions and reactions can lead to inaction, shutting down, and a refusal to take the steps necessary to make sense of it all.

Choice and Control

To be able to choose is desirable. “We have a biological need for choice and control,” writes Professor Sheena Iyengar (The Art of Choosing, 2010). However, there is another paradox in that the very choice and control we desire can, especially when there’s an abundance of it, be paralyzing and stress inducing.

Retirement and investing paradoxes continue with the notions of choice and control. Both are highly regarded features of employer-sponsored defined contribution retirement plans. When asked to indicate how important key features of defined contribution plans are, investors (in an online ING customer survey) showed marked preference to those aspects that give them convenience, choice, and control (figure 3). Yet while clearly valuing choice and control, consumers resoundingly say that they want help and direction with respect to retirement investment. Eighty-nine percent want regular communication from their employers about how to allocate their retirement savings (Shedding Light on Retirement . . . in Today’s World for Today’s Consumers, ING North America Insurance Corporation, 2011).

Self-Comparison

Humans are social beings. We exist in tandem with our peers, however we define them, and one of the most fundamental ways we value ourselves and our accomplishments is in relation to our environment and how we perceive other people in it. The standards by which we establish our own sense of self-worth based on this comparison can take many forms. The opinions of others can help us analyze our own options—the number of stars a product received from others who already bought it—and often influence and guide purchase decisions.

We define ourselves by how we “measure up” within the various universes in which we place ourselves. It’s good to be considered first-string, first-chair, first-anything. “First” and “best” are often synonymous. Anything less is, well, less, and somehow lacking. Yet in any universe, how many “firsts” can there be? The concept is, by nature, exclusive of the majority. Most individuals want to define themselves in favorable terms. As Iyengar notes, it is supremely human to think that we are unique:

1. People are more alike than they think.
2. What people believe about themselves, or what they would like to believe, doesn’t vary much from person to person.
3. Each person is convinced that he or she is unique.

The label “ordinary” has become practically pejorative when it’s used to measure activity and performance. Who wants to be “ordinary” or “average” on any level? And yet even “average,” as generally defined, means firmly in the middle, with half above and half below. This desire to avoid being ordinary can color our own perceptions with “optimism bias”—also called the “Lake Wobegon effect,” named for the fictional town created by the radio host Garrison Keillor, where “all of the women are strong, all the men are good-looking, and all the children are above average.” Research in popular culture bears out the power of this bias, in both personal and professional contexts (“How to Fight your Optimism Bias,” www.trizle.com):

• 80 percent of drivers think they are above-average drivers.
• 94 percent of professors believe their work is above average.
• 99 percent of students believe they’re above average in getting along with others.
• Most Americans believe they’ll earn above-average income in the future.
• The majority of CEOs think their companies will thrive more than their average industry competitors.

In a 2009 ING online survey of 1,197 respondents, 44.5 percent of respondents said they were healthier than average and another 25.5 percent described their health as “excellent.” Meanwhile, 27.2 percent described their health as “average,” and only 2.9 percent in total described their health as “worse than average” or “very bad.”

Can these findings from psychology be applied to individuals’ investment behavior, potentially helping them to achieve better retirement outcomes? If people don’t like to think of themselves as average, what happens when someone shows them that they are average, or even below average, with respect to their retirement savings? This “social comparison” experiment is making its way into a number of industries, including the financial sector (see ING’s peer comparison tool, www.ingcompareme.com).

Understanding the many, varied, and often-interconnected biases, behaviors, and impulses that can drive investment behavior (or inaction) is a first step in helping individuals achieve more secure retirement outcomes. Deconstructing some behavioral finance insights can help us construct potential solutions.

Automatic defined contribution plan features—enrollment and contribution increase—can turn the tables on several identified obstacles to retirement investing:

• The consumer retains “control,” but exercising that control becomes the choice of whether to remain in the plan or to take active steps to leave it—also called “negative election.”
• Hyperbolic discounting may be overcome if the individual does not have to make a conscious decision to “sacrifice” a portion of pay to the plan.
• The potentially overwhelming information and actions required to join an employer-sponsored plan are eliminated.
• Procrastination and inertia may keep the individual from negatively electing out of the plan.

Information design and choice architecture can help individuals navigate the complex information that often accompanies financial products. Often there’s no choice in the amount or complexity of information that must be conveyed to investors and potential investors. Complex regulations often demand delivery of certain types and vehicles of information.

• Information layering and design can help to highlight key points and messages.
• Information and choices can be summarized using easily understandable and accessible language that overlays more technical communications.
• Choice architecture—how choices are presented—can play a role in helping individuals act and make decisions. “Either-or,” linear decision-making presentations can help simplify the complex.

Asset-allocated investment options can also play a role—offering individuals the flexibility to participate or not . . . and to change their minds, but removing the burdens of information and choice overload:

• Target date funds can offer a simple, goal-based solution for potentially confused investors overwhelmed by choice.
• Asset allocation funds can offer diversification to investors who may not want to make day-to-day decisions, and consequently removing tendencies to invest in the “familiar.”
• Managed accounts can offer highly personalized strategies with automatic adjustments based on personal circumstances:

Tools and engagement devices can help enable positive saving action:

• Simple risk assessment tools can help individuals who don’t want to give up investment control sort through their many options.
• Calculators can help self-directed individuals personalize their own strategies while visualizing the future benefits of starting early and contributing more.
• The use of games—a growing trend known as gamification—can increase engagement and build financial literacy by exposing consumer to fundamental investment concepts and terms through game play.

Just the Beginning

Human behavior is infinitely complex, even when the analysis is confined to financial matters. The concepts presented here represent only the very beginning to map the mind-sets of individuals planning for retirement.

As you look to improve your retirement picture, keep in mind that while your strategy will continue to be influenced by the market’s ups and down, the way you deal with change—emotionally—may be as important as anything else in helping you work toward a better and more secure retirement.

The ABA Retirement Funds, an affiliate of the ABA, is dedicated to helping lawyers with their retirement by providing fully bundled retirement solutions for law firms of all sizes. Established in 1963, the organization has nearly 3,800 plans, 37,000 participants, and more than $4 billion in assets in the ABA Retirement Funds Program (www.abaretirement.com).

This article is an adaptation of the ING Retirement Research Institute’s white paper entitled “Mapping the Mindset of the Retirement Consumer, Exploring the Interconnected Emotional Pathways That Affect Investing” (ing.us/rri/ing-studies/mapping-the-mindset).

ING Institutional Plan Services LLC, the Program’s Recordkeeper on behalf of ING Life Insurance and Annuity Company (ING), provides record keeping, communication, administration, and marketing services for the ABA Retirement Funds Program.