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Selling to the brain:Understanding the mechanics of decision-making
NameTitleLegg Mason
INVESTMENT PRODUCTS: NOT FDIC INSURED • NO BANK GUARANTEE • MAY LOSE VALUE
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
1For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
About Michael Mauboussin
• Chief Investment Strategist, Legg Mason Capital Management
• Author- Think Twice: Harnessing the Power of
Counterintuition
- More Than You Know: Finding Financial Wisdom in Unconventional Places
• Co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns
• Adjunct professor of finance at Columbia Business School since 1993 and is on the faculty of the Heilbrunn Center for Graham and Dodd Investing
2For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Today’s Agenda
• Understanding the Decision-Making Framework
• The Mechanics of Decision-Making
- Hyperbolic Discounting
- Defaults
- Choice Architecture
• Action Steps
3For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Understanding the Decision-Making Framework
4For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Hyperbolic Discounting
5For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Hyperbolic Discountingthe tendency for people to prefer smaller payoffs now over larger payoffs later
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Exponential Discounting: Time-consistent model –assumes a constant discount rate, with valuations falling by a constant factor per unit delay
Hyperbolic Discounting: Time-inconsistent model –assumes a varying discount rate, with valuations falling rapidly for small delay periods, but slowly for longer delay periods
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
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Constant rate of decline Rapid rate of decline in short run
Slow rate of decline
in long run
Hyperbolic DiscountingExponential Discounting
Hyperbolic Discounting The perception of delayed rewards
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
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Today Tomorrow
+
One yearOne year and one day
+
Source: Shane Frederick; George Loewenstein; Ted O'Donoghue, “Time Discounting and Time Preference: A Critical Review,” Journal of Economic Literature, Volume 40, No. 2. (June, 2002), 351-401.
Time discounting and time preference: 10% tomorrow vs. 10% in the future
“We want to be good in the future but are looking for the instant gratification today.”
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
9
Choose among 24 movie videos:• Some are low brow: e.g., The Hangover • Some are high brow: e.g., Schindler’s List
“Tonight, I want to have fun . . . next week I want things that are good for me.”
Source: Reed, Lowenstein, and Kalyanaraman, “Mixing Virtue and Vice: Combining the immediacy effect and the diversification heuristic, Journal of Behavioral Decision Making, 12, 257-273, November 1998, Published 1999.
Choosing for tonight Choosing for Next Wednesday Choosing for Second Wednesday
High brow
High brow High browLow brow Low brow
Mixing virtue and vice
Low browLow browLow brow
High browHigh browHigh brow
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70%To eat today
To eat next week74%
Source: Read, D. and van Leeuwen, B., “Predicting Hunger: The effects of appetite and delay on choice,” Organizational behavior and human decision processes, 76, 189-205, 1998.
The healthy-unhealthy choice
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
U.S. Military Severance Packages
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OfficersEnlisted
Annuity worth $83KLump Sum $46K
Lump sumAnnuity
Lump sum
Annuity worth $40K
Lump Sum $22K
Source: John T. Warner and Saul Pleeter, “The Personal Discount Rate: Evidence from military downsizing programs,” The American Economic Review, 91 (1), 33-53, March 2001.
Lump sum
Lump sumAnnuity
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Annuity
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0.0
-0.05
0.05
ChooseSmaller
ImmediateReward
ChooseLarger
DelayedReward
EmotionalSystem
Frontalsystem
Bra
in A
ctiv
ity
Source: Samuel M. McClure, David I. Laibson, George Loewenstein, and Jonathan D. Cohen, “Separate Neural Systems Value Immediate and Delayed Monetary Rewards,” Science, Volume 306, October 15, 2004, 503-507.
Brain Activity: Frontal vs. Emotional Systems
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Hyperbolic Discounting & RetirementEffective dates of savings increases generally occur in the future
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8.9% 9.4%
6.0%5.4% 5.8%
6.4% 6.2% 5.9%7.2%
6.5% 6.7%
15.7%
10.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
1 2 3 4 5 6 7 8 9 10 11 12 13+
*Source: Choice Architecture and Retirement Savings Plans, by Shlomo Benartzi, Ehud Peleg, Richard H. Thaler.
Participants’ Choices of the Delay Between Signing Up for the Program and the Effective Date of the Savings Increase
• 8.9% prefer the saving increase to be implemented within the same month they sign up
• 91.9% prefer to postpone
• 15.7% prefer that the first increase take place exactly one year after signing up
• 10% would like to wait longer than a year
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Hyperbolic Discounting & RetirementMost investors wait until the end of the year to increase contributions
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*Source: Choice Architecture and Retirement Savings Plans, by Shlomo Benartzi, Ehud Peleg, Richard H. Thaler.
Participants’ Choices of the Month of Saving Increase
• January is the overwhelming favorite, with 37.3% respondents electing to have their contribution increase take effect at the beginning of the year
• Contribution increase elections dramatically decrease in the second half of the year
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
The cost of procrastination
Source: Legg Mason. This illustration assumes a $200 monthly contribution that earns interest at 8%. This chart is for illustrative purposes only and does not represent an actual investment or the performance of any specific investment. Actual investments may include fees, charges and other expenses that would affect an investment’s return.
Beginning age Account Balance at age 65 Years lost by waiting Lost earnings
25 $702,856 0 0
30 $461,835 5 $241,021
35 $300,059 10 $402,797
40 $191,473 15 $511,383
45 $118,589 20 $584,267
50 $69,669 25 $633,187
55 $36,833 30 $666,023
60 $14,793 35 $688,063
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Lesson Learned
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There is a natural tendency to postpone the “right” decision• Provoke action by showing the high cost of procrastination
• Appeal to emotions by taking a role in helping others envision their retirement
• Encourage retirement savings plan participation
–Escalator programs
–Corporate matches
–Profit-sharing
“As predicted by hyperbolic discounting, the rewards provided by buying something today often outweigh the discounted pleasure of future payments.”–Joe Redden, Marketing Professor and founder of BehaviorLab.org
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Defaults
17For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Defaults:presenting a choice that is selected automatically unless an alternative is specified
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Source: Based on data from Eric J. Johnson and Daniel Goldstein, “Do Defaults Save Lives?” Science 302 (November 21, 2003), 1338-1339.
Do defaults save lives? Organ donation rates
Effe
ctiv
e co
nsen
t per
cent
age
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Auto insurance and default options
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New Jersey
Pennsylvania
Default choice
Limited right to sue
Full right to sue
Limited right to sue
Full right to sue
Full right to sue
Limited right to
sue
State Preference
Source: Eric J. Johnson, Mary Steffel, and Daniel G. Goldstein, “Making Better Decisions: From Measuring to Constructing Preferences,” Health Psychology, 2005, Volume 24, No. 4 (Suppl.), S17-S22.
Full right to sue
Full right to sue
Limited right to sue
Limited right to
sue
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Defaults & Retirement
• Defaults exert tremendous influence on realized savings outcomes at every stage of the savings lifecycle:
– Savings plan participation
– Contributions
– Asset Allocation
– Rollovers
– Decumulation
• Defaults are not neutral – they can either facilitate or hinder better savings outcomes
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Source: The Importance of Default Options for Retirement Savings Outcomes: Evidence from the United States, by John Beshears, James J. Choi, David Laibson, Brigitte C. Madrian, National Bureau of Economic Research, January 2006.
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Savings Plan Participation
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Source: The Importance of Default Options for Retirement Savings Outcomes: Evidence from the United States, by John Beshears, James J. Choi, David Laibson, Brigitte C. Madrian, National Bureau of Economic Research, January 2006.
• Under automatic enrollment, participation jumps to approximately 95% of employees once it takes effect and increases only slightly thereafter• At low levels of tenure, the difference in participation rates under the standard enrollment and automatic enrollment scenarios is substantial – 35 percentage points at three months of tenure
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Contributions
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Source: The Importance of Default Options for Retirement Savings Outcomes: Evidence from the United States, by John Beshears, James J. Choi, David Laibson, Brigitte C. Madrian, National Bureau of Economic Research, January 2006.
• Under the 3%default scenario, 28% of participants opted for the default
• Under the 6% default scenario, 49% of participants opted for the default
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
The Default Impact: A Tale of Two Investors
Source: Legg Mason. This illustration assumes an annual contribution of 3% ($2,250) and 6% ($4,500) on gross annual income of $75,000 that earns interest at 6% annually. This chart is for illustrative purposes only and does not represent an actual investment or the performance of any specific investment. Actual investments may include fees, charges and other expenses that would affect an investment’s return.
3% annual contribution ($2,250) vs. 6% annual contribution ($4,500) based on gross income of $75,000
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Lesson Learned
A high percentage of people go with defaultsü Increase retirement plan participation via automatic enrollment
ü Consider setting a pre-specified contribution rate with a pre-specified asset allocation
ü Set default contribution rates at higher levels to encourage increased contributions
ü Encourage maximizing of contributions as a way to reach retirement savings goals
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“When you have to make a choice and don't make it, that is in itself a choice.”
–William James, American Psychologist and Professor
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Choice Architecture
25For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Predictably Irrational: Subscription Selection
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16%
0%
84%
68%
32%
Students selecting option
Source: Dan Ariely, Predictably Irrational: The hidden forces that shape our decisions (New York: HarperCollins, 2010), 3-5.
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Choice Architecture:the conscious decision to arrange items to achieve a desired outcome
27For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
A Trip to the Supermarket
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Order in Product Customization Decisions
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Source: Jonathan Levav, Mark Heitmann, Andreas Herrmann, Sheena S. Iyengar, “Order in Product Customization Decisions: Evidence from Field Experiments,” Journal of Political Economy, 2010, Volume 118, Number 2, 274-299.
Car Accessories
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Choice + Retirement = Major Challenge
• The central challenge in saving for retirement is striking the right balance between portfolio risk and longevity risk.
• Most people focus exclusively on portfolio risk, rather than longevity risk
• As a result, many people put themselves at a disadvantage by being too conservative in their asset allocation
• Investors have to consider all variables- How much they save- How the markets behave- What age they want to retire at- How much they plan on spending in
retirement- How long they will live in retirement
Simulation results of a more conservative retirement portfolio
with 40 years of savings
Source: Legg Mason Global Asset Allocation, LLC, as of December 2010. Past performance is not guarantee of future results.
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Lesson Learned
How you present an option affects how people choose• Provide perspective on what it means to invest for retirement
– Help strike the balance between portfolio risk and longevity risk
• Give close consideration to retirement plan design features– Carefully consider investment fund menu
– Pay attention to the number of funds in the investment menu
– Think about how risk-based and retirement/target date funds are presented on the investment menu
• Review investment election form design
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“Choice architecture is particularly important in domains such as retirement savings where most of the decision-makers are unsophisticated.”– “Choice Architecture and Retirement Saving Plans,” By Shlomo Benartzi, Ehud Peleg, Richard Thaler
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
Key Takeaways
• Finding: Most people have a tendency to postpone making the “right’ decision
- Action: Provoke immediate action by showing the impact of the cost of waiting
• Finding: A high percentage of people go with defaults
- Action: Influence decision-making by setting default options to influence retirement plan participation and higher contribution rates
• Finding: How you present an option affects how people choose
- Action Step: Strike the balance between portfolio risk and longevity risk; Give careful consideration how your retirement plan is designed; consider every detail
32For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.
33
Life is the sum of all your choices.
–Albert Camus
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All investments involve risks including loss of principal.© 2011 Legg Mason Investor Services, LLC, member FINRA/SIPC. Legg Mason Investor Services, LLC and Legg Mason Capital Management are subsidiaries of Legg Mason, Inc.
FN1111845
INVESTMENT PRODUCTS: NOT FDIC INSURED • NOT BANK GUARANTEE • MAY LOSE VALUE
For broker/dealer and Plan Sponsor use only. Not for use with Plan Sponsors who have less than 100 participants and not for use with any of the participants of such a plan. Not for use with the public.