Which Illusion Do You Suffer From: Wealth or Poverty?

Do you suffer from an illusion of wealth or an illusion of poverty?

Think quickly, would you rather have a $1 million retirement nest egg or $5,000 in monthly income to spend during retirement?  Your answer could tell you whether you possess an ‘illusion of poverty’ or an ‘illusion of wealth’ according to recent research published in the Journal of Marketing Research.  In their paper, “The Illusion of Wealth and Its Reversal,” Drs. Shlomo Bernartzi and Hal Hershfield  of UCLA, and Dr. Goldstein of Microsoft Research examine the responses of study participants to this question to determine biases towards particular financial decisions that people make.

You may be asking yourself, “Why would I be forced to choose between a $1 million lump sum and a $5,000 monthly income?”  The answer to that question is that under current economic and financial conditions, these two numbers are roughly equivalent.  In other words, under current annuity pricing models it takes roughly one million dollars to buy an annuity with $5,000 monthly payments for life assuming the payments begin at age 65.

Let us go back to our first question, “would you rather have a one million dollar retirement nest egg or $5,000 in monthly income during retirement?”  If you answered that you preferred the $1 million sum, you view the one million dollar lump sum as being much more adequate than the $5,000 monthly income, even though they are financially equivalent.  The research presented in the paper would indicate that you might suffer from an illusion of wealth, because you may have a false sense of security from a perceived large amount of money.  An individual suffering from the illusion of wealth might believe that a million dollar nest egg is sufficient for any retirement income goal, and have a false sense of reality about his or her retirement prospects.

On the other hand, those of us who would prefer a $5,000 a month income to a one million dollar lump sum may suffer from the illusion of poverty because they are apt to view wealth in terms of monthly income versus a lump sum.  These individuals are unlikely to understand or see that $1 million equates to a monthly income of $5,000 a month, and would likely worry excessively over running out of money later in life and tend towards frugality when it comes to non-essential lifestyle items like vacations, gifts, or higher-end furnishings or vehicles.  The research further indicates that the illusion of poverty became more prevalent with larger sums of money.  People suffering from the illusion of poverty have difficulty distinguishing among large sums of money insomuch that the difference between a $1 million and $5 million lump sum is indistinguishable to them in terms of the income that either sum provides.

Most of us are likely to be biased one way or the other towards the illusion of wealth or the illusion of poverty:  that is just human nature.  There is a relatively simple way to overcome this, however.  Instead of thinking only in terms of the lump sum of money or the monthly income, we should consider the perspective of the entire financial picture.  Instead of focusing solely on one element of the financial picture, we need to look at the monthly income that a lump sum produces, or vice versa.

To learn more about how your behavioral biases impact your financial decisions, be sure to attend Bollin Wealth Management’s Retirement University™ series session on Behavioral Finance.  The free informational seminar takes place on Tuesday, October 24, 2017 at 6:30 PM at the offices of Bollin Wealth Management.  Space is limited, so RSVP today!

Sources:  “The Illusion of Wealth and Its Reversal,” Wall Street Journal