Bounded Rationality

Shefrin (2002) identifies some main themes in behavioural finance and economics that suggest people will not make decisions strictly on rational analyses (bounded rationality and cognitive biases) and the way a problem or decision is presented to the decision-maker will affect their action (decision framing). Mullainathan and Thaler (2000, p. 9) suggest that:

…this standard life-cycle model of savings abstracts from both bounded rationality and bounded willpower, yet saving for retirement is both a difficult cognitive problem and a difficult self-control problem.

Mullainathan and Thaler (2000, p. 1) explain that “bounded rationality reflects the limited cognitive abilities that constrain human problem solving”. While bounded willpower, otherwise termed bounded self-control, refers to the concept that while individuals may possess the appropriate intentions, they may lack the control or willpower to instigate the changes required in their behaviour. Mitchell and Utkus (2003) suggest that superficially the retirement saving problem is possibly an ideal illustration of Simon’s (1957) concept of bounded rationality. Simon (1957) (in Tiessen & Waterhouse 1983, p. 258) defined bounded rationality in the following way:

The capacity of the human mind for formulating and solving complex problems is very small compared with the size of the problems whose solution is required for objectively rational behaviour in the real world.

Furthermore, Mitchell and Utkus (2003, p. 3) argue that:

…being good at retirement saving requires accurate estimates of uncertain future processes including lifetime earnings, asset returns, tax rates, family and health status, and longevity. In order to solve this problem, the human brain as a calculating machine would need to have the capacity to solve much decades-long time value of money problems, with massive uncertainties as to stochastic cash flows and their timing.

Mullainathan and Thaler (2000, p. 1) concur that, “since saving for retirement requires both complex calculations and willpower, behavioural factors are essential elements of any complete descriptive theory”.

3.3.1.1 Implication of Financial Literacy for Retirement Saving

A lack of financial literacy is said to have important consequences when it comes to planning and saving for retirement (Lusardi & Mitchell 2006). Fox, Bartholomae and Lee (2005, p. 195) state that “financial literacy denotes one’s understanding and knowledge of financial concepts and is crucial to effective consumer financial decision making”. Hilgert, Hogart and Beverly (2003) demonstrated a strong link between financial knowledge and financial behaviour. Hogarth and Hilgert (2002) identified married couples, non-minority groups, the middle-aged, the more highly educated, and those on higher incomes as more financially knowledgeable. Lusardi and Mitchell (2006) identified older Americans as more financially illiterate and women, minorities (disadvantaged), and those without a college degree were at risk of displaying low financial knowledge. They also found that financial knowledge and planning are inter-related. They suggest that individuals with more financial knowledge are more likely to plan and those who do plan are more likely to rely on formal planning processes.

The 2008 ANZ survey of adult financial literacy in Australia (ANZ 2008) found that Australian adults are generally financially literate. However, it was found that certain groups face particular challenges when it comes to money management and financial

products. These groups were identified as: the young (18-24 years); females; people with a low level of education (year 10 and below); and those living in highest socio- economic disadvantaged areas. Literacy scores were significantly higher for people aged between 35-39 years, males, people with a university degree, people living in the least socio-economic disadvantaged areas, upper white collar workers, and those with annual household incomes of at least $150,000 per annum. When it came to superannuation matters the ANZ survey (ANZ 2008) reported that a significant proportion of people failed to read their superannuation statements and that people had a low level of awareness of some advantages and risks of superannuation. Thirty- one percent of those who read their annual superannuation statements found them difficult to understand. The survey found that 25 percent of superannuation fund members suggested that they did not receive or did not read their superannuation statements.

An earlier literacy study of working Australians conducted by Mercer (2006) found that Australians knew little about their own superannuation funds. It was also found that 40 percent of working Australians did not know if their funds are largely invested either in aggressive or conservative strategies. Mercer (2006) identified that working Australians admit to having a poor knowledge of retirement issues, and when given a short quiz on superannuation and retirement issues nearly two in three answered only half (or less) of all questions correctly. Worthington (2008) suggests that Australians’ knowledge of superannuation is good in some areas and poor in others. He identifies a poor level of knowledge when it comes to reading and understanding superannuation statements, retirement planning, and knowledge of employer contributions. Worthington (2008, p. 367) warns that “_{the lack of retirement planning is more}

problematic, and could potentially cause the most severe adverse outcomes for fund members”.

Beal and Delpachitra (2004), through a mailed survey, also found low knowledge of superannuation matters by Australians. The survey required respondents to answer a number of questions relating to superannuation. In line with a Commonwealth Brief Guide, they considered the technical questions as ‘not difficult’ and assessed basic knowledge to determine the very well informed. The survey was not administered randomly, but to a target population in two suburbs of Brisbane (Australia). The

chosen suburbs had a relatively higher educated and income socio-demographic group. Beal and Delpachitra (2004) thought that if this group exhibited low level knowledge then the results could be generalised to the population. Only 21.7 percent of respondents achieved an overall pass mark (50 percent) when answering the questions. However, 36.1 percent indicated that they were at least ‘quite well informed’ on superannuation matters. The authors put this down to over-confidence about self-knowledge. The authors recommended that the government spend more money on educating the community on superannuation.

Evidence from the US indicates that households with greater financial sophistication are more likely to invest in risky asset markets which tend to produce higher long- term investment growth, and to invest more efficiently (Calvert, Campbell & Sodini 2007). Furthermore, Lusardi and Mitchell (2007a) using Rand American Life Panel (ALP) data established that those individuals displaying greater financial literacy were more likely to plan for retirement. They also found that older, better educated, and male respondents are more likely to be planners, as they exhibit higher levels of financial knowledge. Lusardi and Mitchell (2008) used two sets of data (2004 and 1992) from the United States Health and Retirement Study and found that those respondents who reported that they planned for retirement accumulated higher levels of wealth. They identified a strong correlation between planning and financial literacy and a strong association between planning and wealth. They also found that low educated, low income and Black and Hispanic households were at risk of not preparing adequately for their retirement. Therefore, the issue that a number of individuals will lack the required knowledge to structure their retirement plan adequately cannot be ignored. Behavioural finance theory describes several other individual behavioural constraints that will also limit an individual’s capacity to save for retirement. A discussion of these issues follows.