Abstract
We portray the valuation of retirement savings in terms of a mental time travel journey in which a proposed contribution to a pension plan is projected forward to the plan member’s retirement date and this projected value is then discounted back to today, thereby giving a present or personal value. We set this within a broader framework of pension planning, which seeks to smooth consumption over the lifecycle. We explain how two psychological biases—exponential growth bias and present bias—can lead to a difference between the initial value of a pension contribution and its present value, such a difference reflecting an asymmetry between projection and discounting, and how such a difference might lead to inadequate retirement savings and hence to a lower than desired standard of living in retirement. We consider how the two biases might be mitigated.
Highlights
One of the key issues in household finance is the funding of the retirement of the household’s members
We regard the asymmetric personal valuation of retirement savings as a key explanation for pension inadequacy in retirement10—as we show
A recent survey in the UK found that, of savers aged 35–54, 50% said they could not afford to contribute more to their pensions, 40% felt overwhelmed11, while only 20% felt on track with retirement planning (Invesco et al 2021)
Summary
One of the key issues in household finance is the funding of the retirement of the household’s members. To illustrate the LCM in a world without uncertainty and a zero-interest rate, consider a 25-year-old male who will work for 40 years and be retired for 10 years He earns $25,000 each year whilst in work so his total human capital or wealth (the present value of his lifetime income) will be $1,000,000.2 This will be consumed over his 50 years of remaining life. Since he values smooth consumption over his lifecycle, he can spend $20,000 a year and die with all his assets exhausted. We can think of retirement savings planning as a mental time travel exercise in which income, consumption and savings are projected forward and current and future needs are balanced one against the other
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