Try mental ‘buckets’ to boost retirement plan
Mental accounting might help a saver see future shortfalls
And this system, according to Garnick’s paper, holds the possibility of delivering tremendous benefits. “With the right architecture, it can save us precious time, economize our thinking and increase our self-control,” wrote Garnick, a board member at CFA Institute Research Foundation.
How so? Well, to understand requires a bit of background. Prior to retirement, people routinely allocate some portion of their money to many buckets and often over-commit ourselves — 25% to housing, 25% to food, 25% to loans and, of course, an additional 50% to entertainment.
“We don’t necessarily make the best decisions, but if we make a mistake we have time on our side,” Garnick wrote. Come retirement, your mental accounting requires a change in mind-set, Garnick wrote. Among other things, you no longer have time on your side should you make a mistake with your money.
So, rather than allocate some funds to many buckets all at once, Garnick proposes fully funding one bucket before moving on to the next. “This framework offers transparency into the age-old question of how much guaranteed lifetime income each household needs while simultaneously offering savers insight into which goals they are on track to meet.”
Instead of allocating 25% to housing, allocate a portion of your retirement income to funding necessities (housing, transportation, personal items, entertainment and taxes), then fund health care expenses, then emergencies, then fun (or discretionary) and, lastly, bequests.
And this change in mind-set won’t be easy.
“I think the most difficult aspect of mental accounting and retirement savings is when households switch over from saving up for retirement to spending down,” Thaler says. “Most of our lives we live on a budget: Spend less than you earn, and put some aside for later. Then they are confronted with the much more difficult task of taking a pile of money and making it last over an uncertain lifetime. Hard!” On the surface, it might seem a budget would be better than mental accounting. But that’s not necessarily the case.
“While creating a detailed budget is ideal, many of us don’t invest the time necessary to start one, let alone maintain it with all of life’s unexpected expenses,” Garnick wrote. “Mental accounting provides a framework that enables people to make decisions at the margin without placing their economic future at risk.” To be fair, mental accounting resembles what some call the fourbox strategy, whereby you use guaranteed sources of income (such as Social Security, a traditional defined benefit plan, a guaranteed lifetime income annuity) to fund essential expenses, including recurring health care expenses, and risky assets (your retirement accounts) to fund discretionary costs and bequests.
And that approach has merit too. “When it comes to retirement there are two kinds of people in the world,” Garnick wrote. “Those with old-fashioned pension plans and those in the YOYO generation, which stands for ‘you’re on your own.’ ”
And both kinds of people, Garnick said, can be well served by securing guaranteed income that covers their necessities.
As for matching risky assets with discretionary expenses, one expert said it’s a good strategy too. “If (investors) treat retirement accounts as long-term investments that should remain untouched, they are more likely to reach their financial objectives,” said Victor Ricciardi, a finance professor at Goucher College and co-editor