Would you rather have a million dollars, or $5,000 a month in retirement? How you answer that question will tell you whether you suffer an “illusion of poverty” or an “illusion of wealth.”
These days, investors can easily track how the daily ups and downs of the market affect their wealth. Even investors with multiple investment accounts spread across different firms can calculate changes in their net worth in real time, thanks to websites and apps that do the work for them. One could assume that having all of this information makes people more financially savvy about saving for retirement. But new research suggests that the opposite may be true.
That’s in part because many of the digital tools used to track net worth present information in a way that leads some investors to develop mistaken beliefs about how much money they actually have for retirement. To understand how, consider a phenomenon known as the illusion of wealth and the illusion of poverty.
To see which illusion you might suffer from, assume you have $1 million for retirement. How adequate does this amount seem on a seven-point scale, with one being “totally inadequate” and seven being “totally adequate”?
$1,000,000 or $5,000 Monthly?
Instead of highlighting only total wealth, financial websites and apps should help people focus on their projected monthly income, too.
Next, assume you have $5,000 to spend every month during your retirement. How adequate does this amount seem on that same seven-point scale?
The first thing to note is that these two amounts are roughly equivalent based on current annuity pricing. (A rule of thumb is that monthly annuity payments are about 1/200th of the corresponding lump sum, assuming they begin at age 65.) And yet people often have sharply different feelings about the two financial descriptions.
Most tools give savers the total amount saved – the $1 million. The problem is that depending on how you answered the above question, you will view that $1 million differently. Some people feel that $1 million is a much more adequate amount than $5,000 a month. These people tend to suffer from the illusion of wealth. Because they get a false sense of security from seemingly large amounts of money, such as those that appear when they check their accounts, they behave as if the $1 million is more than $5,000 in monthly income.
This can lead some people to undersave for retirement. One million dollars might seem like a lot, but it isn’t nearly enough for those expecting to have, say, $8,000 a month to spend over a 20- to 30-year retirement.
Yet, other people feel that $5,000 a month is more adequate than a $1 million lump sum. They suffer from the illusion of poverty.
Because they might be inclined to think about wealth in terms of monthly income as opposed to a large sum, they incorrectly assume that the $1 million they see on the screen equates to less than $5,000 a month. Instead of living the lifestyle they can afford, they worry they’re running out of money and skip trips and scrimp on prescriptions.
Ironically, the illusion of poverty becomes more prevalent as the amounts of money get bigger. This is likely due to a “ceiling effect”: A million dollars is a lot of money, but so is $2 million, and so is $4 million. In short, people become desensitized to large sums; all of those extra millions lose their meaning.
In contrast, differences in monthly income still feel “real” to them as wealth increases. This is because we’re used to thinking of expenses in terms of monthly amounts, whether it’s a car lease or health insurance or a mortgage payment. So for some people, getting $20,000 a month might seem like a lot of money, even when having the roughly equivalent lump sum of $4 million might not.
And this brings us back to the display of financial information in the digital age. Unfortunately, the vast majority of websites and apps tend to reinforce both of these illusions by displaying our net worth and savings in terms of lump sums, not projected monthly income. The danger is that those who suffer an illusion of wealth may think they have more than they actually have, and risk overspending, while those who suffer an illusion of poverty may think they have less, and underspend.
There is an easy fi x for these illusions. Instead of highlighting only total wealth, financial websites and apps should help people focus on their projected monthly income, too. It’s this amount that puts our wealth in perspective, helping us understand the meaning of these large sums.
Instead of focusing our attention on small daily fluctuations in overall wealth – such changes rarely matter anyway – we encourage you to think about how savings will impact your lifestyle in retirement.
Will you have to cut back? Or can you still afford the life you want?