FinPsych for Feds: Mental Accounting

In Part 1 of FinPsych for Feds, we explored present bias and why the immediate can feel more important than the future.  For federal employees, that can be especially consequential when today’s spending competes with benefits that may not arrive for decades.

But our relationship with money isn’t shaped only by when we expect to use it, how we categorize our money can also impact our financial perspectives. We routinely think of certain dollars as “retirement money,” “emergency money,” or “fun money,” even though they’re all part of the same household balance sheet.

That’s the cognitive bias we’re examining in this week’s installment: mental accounting. As we’ll see, the mental buckets we create can help us build better financial habits, but they can also cause us to make decisions that don’t make sense when we step back and look at the bigger picture.

One of the central ideas in behavioral finance is that people do not always treat money as economically interchangeable. In theory, a dollar is a dollar regardless of where it came from or where it is held. In practice, we frequently assign money to psychological categories and then make different decisions depending on which category it occupies. This bias is known as mental accounting.

The concept was developed and popularized by economist Richard Thaler, whose work helped demonstrate that people’s financial decisions often depart from the assumptions of traditional economic theory. Mental accounting describes the process by which individuals mentally organize, categorize, and evaluate financial resources. We create separate “accounts” in our minds for different purposes, even when the money is technically part of the same portfolio.

The Buckets We Create in Our Heads

Consider the difference between $1,000 in a checking account and $1,000 received unexpectedly as a tax refund. Economically, there is no meaningful distinction between the two dollars. Psychologically, though, there can be a significant one. The checking account money may be viewed as ordinary household income, while the refund may be labeled “vacation money,” “fun money,” or “found money.” And the label we assign to those dollars can heavily influence how readily we spend them.

Mental accounting is not inherently problematic. In fact, it can be extremely useful. A household that establishes an emergency fund and mentally designates it for unexpected expenses may be much less likely to spend that money on discretionary purchases. Similarly, creating a separate savings account for property taxes, a future automobile, or a vacation can make financial goals easier to manage. The psychological separation provides a behavioral structure that can reinforce good habits.

The problem occurs when our mental categories become more important than our underlying goals.

Federal employees and retirees have numerous opportunities to engage in mental accounting because their financial lives often consist of several distinct sources and uses of money. A FERS retiree may receive a monthly annuity, Social Security, TSP distributions, and income from taxable investments. A current employee may have a salary, TSP assets, an emergency fund, a pension benefit that is accruing in the background, and other investment accounts. Over time, each pool of money can acquire its own psychological identity.

An employee might say, “My TSP is for retirement, so I don’t consider it part of my financial resources.” There is some wisdom in this statement. Retirement assets should generally be preserved for their intended purpose, and treating them as long-term resources can help prevent unnecessary withdrawals. At the same time, the statement can become problematic if it causes someone to make poor decisions elsewhere on the balance sheet.

When the Mental Buckets Help…and When They Don’t

Imagine a household with substantial cash savings earning very little interest while simultaneously carrying high-interest consumer debt. If the savings are mentally designated as “house money” and therefore untouchable, the household may continue paying expensive interest because the psychological label prevents the money from being considered available for debt reduction.

The dollars are technically totally accessible… but the mind has made them defunct.

Retirement introduces another layer of complexity. Many retirees mentally divide their income into “spending money” and “retirement money.” A pension may feel like income that is intended to be spent, while a TSP balance can feel like a nest egg that must be protected at all costs. That distinction could cause retirees to underuse assets they have accumulated specifically to support their retirement.

This is where financial psychology can challenge a common assumption: the purpose of financial planning is not necessarily to maximize the amount of money left in every account. Instead, we want to allocate financial resources in a way that supports an individual or family’s goals, subject to reasonable constraints around risk, taxes, longevity, and financial security, of course.

A retiree who has sufficient resources to travel, pursue hobbies, support family, or otherwise enjoy retirement may be defeating part of the purpose of saving if an emotionally “untouchable” investment account prevents them from spending any of it.

The reverse problem can occur as well. A pension may be psychologically classified as “free money” because it arrives automatically each month. That can make it easier to spend the entire amount without considering irregular expenses, inflation, taxes, or the possibility that investment assets will eventually need to supplement the pension. The fact that an income stream is reliable does not mean it is unlimited.

Auditing Your Mental Accounting Bias

A useful exercise to keep mental accounting in check is to identify the mental “accounts” you have created and ask yourself what purpose each one serves. Perhaps your emergency fund is “untouchable,” your TSP is “retirement only,” your checking account is “spending money,” and an inheritance is “for the children.”

None of those labels is necessarily wrong. The more important question is whether each label helps you execute your financial plan or whether it prevents you from considering the full range of available choices.

This distinction is particularly important for federal employees because retirement planning should ultimately be conducted at the level of the household’s entire financial system. Your FERS annuity, Social Security benefits, TSP, IRAs, taxable investments, cash reserves, insurance, and other assets do not operate independently. They interact. A decision that looks sensible within one mental account may look quite different when the entire portfolio is considered.

Again, mental account is not necessarily bad, but it is inevitable. We organize money into categories because doing so makes a complicated world easier or us to understand. The hope is that being aware of this proclivity will help us use it to help aid us in our financial planning goals, rather than allowing it to dictate our behavior without examination.

Give your money a purpose, but periodically step back and look at the whole picture. Your dollars may have different jobs, but they are ultimately working toward one financial wellbeing.

We’ve now examined two ways our psychology can influence financial decisions: present bias affects how we weigh today against tomorrow, while mental accounting affects how we think about the money we have.

Next, we’ll look at what happens when the thing we’re thinking about isn’t a potential reward, but a potential loss.

Join us next week for Part 3 of FinPsych for Feds, as we explore loss aversion and why the fear of losing can sometimes be more powerful than the desire for gain.

**Written by Katelyn Murray, CFP®, ChFEBC®, FBS®, CFT-1™, ECA. The information has been obtained from sources considered reliable but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Katelyn Murray and not necessarily those of RJFS or Raymond James. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy suggested. Every investor’s situation is unique and you should consider your investment goals, risk tolerance, and time horizon before making any investment or financial decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. **