Finpsych for Feds: Present Bias

Most of us like to think that when it comes to money, we are rational decision-makers. We gather information, compare our options, consider the consequences, and make the choice that best advances our financial interests. In practice, however, decades of research in psychology and economics have demonstrated that human decision-making is considerably more complicated. We routinely rely on mental shortcuts, emotional reactions, habits, and assumptions that can influence our choices without our being fully aware of them.

This is the grounding concept for FinPsych for Feds, my new four-part series exploring how the science of human behavior can help us better understand the financial decisions we make. This series sits at the intersection of psychology, economics, and financial planning, a field commonly known as behavioral finance, or, more recently, financial psychology.

Traditional economic theory has often modeled people as rational decision-makers who evaluate all available information and consistently choose the option that maximizes their financial well-being. Real people, as behavioral economists have demonstrated, are considerably messier. We make decisions based on incomplete information, emotion, habit, social influence, and mental shortcuts.

These tendencies are not necessarily flaws! Many of them developed because they are useful ways for human beings to make decisions in a complicated world. The problem is that a mental shortcut that works reasonably well in everyday life can produce poor results when applied to investing, retirement planning, or other complex financial decisions.

Daniel Kahneman and Amos Tversky were among the most influential researchers in establishing this framework. Their work on judgment under uncertainty and what became known as prospect theory demonstrated that people do not always evaluate financial choices according to the assumptions of traditional economic models. We respond differently to gains and losses, place disproportionate value on immediate outcomes, and can be heavily influenced by seemingly irrelevant reference points.

Richard Thaler subsequently helped bring many of these ideas into economics and finance, including through his work on mental accounting, a topic we’ll be talking about in great detail next week. Collectively, Thaler’s research has given financial professionals a more realistic understanding of how people actually behave with money.

This perspective is particularly useful for civilian federal employees and retirees. A federal career involves an unusual number of financial decisions whose consequences are delayed. Contributions to the TSP may compound for decades before being used. A FERS annuity is built over the course of your career and generally becomes the cornerstone of income planning in retirement. Social Security decisions can affect income for the remainder of your life. Decisions about FEHB, survivor benefits, life insurance, and retirement timing can likewise have consequences that may not become apparent for decades into the future.

In other words, federal employees are frequently asked to make decisions today for the benefit of a future version of themselves.

Naturally, that brings us to the first behavioral concept in the series: present bias.

Why Today Often Wins

Present bias is the tendency to place disproportionate weight on immediate rewards and costs relative to those that occur in the future. Economists have studied the broader concept of temporal discounting, which describes the tendency to value a benefit less when it is delayed. Present bias refers to the particularly strong preference many people display for immediate gratification when compared with future rewards.

Consider a federal employee deciding whether to increase a TSP contribution. Increasing the contribution might mean giving up several hundred dollars of current spending power each month in exchange for a potentially much larger financial benefit decades from now. The arithmetic is relatively straightforward. The psychology is not.

The reduction in take-home pay is immediate and certain. The eventual benefit depends on time, investment returns, inflation, taxes, spending needs, and longevity. Our brains naturally tend to give greater psychological weight to what is happening now than to what may happen many years from now.

This helps explain why financial procrastination is so common. “I’ll increase my savings next year” sounds like a relatively harmless decision, particularly when today’s expenses feel pressing. But next year brings its own expenses and competing priorities. A promotion, a home repair, a child’s education, a vacation, or simply an increase in the cost of living can provide a new reason to postpone the decision.

Present bias can also affect how we think about retirement itself. Working an additional year provides an immediate and familiar reward: another year’s salary, another year of contributions, and potentially additional retirement benefits. Retiring, by contrast, requires giving up a current paycheck in exchange for something less tangible but infinitely more precious: time.

The psychological difficulty of that trade-off should not be underestimated. A person can be financially ready for retirement and still experience the decision as a loss because the immediate income is so salient. On the other hand, someone who is financially capable of working longer may choose to retire because the value of additional time has become more important than the value of another year’s salary.

Neither choice is inherently correct. What matters is recognizing the psychological forces influencing the decision.

Planning Around Our Biases

The practical lesson of behavioral finance is not that we need to become perfectly rational human beings. We can’t! A better approach is to build financial systems that take our predictable tendencies into account.

Automation is one of the simplest examples. When TSP contributions occur automatically through payroll, the decision to save does not have to be reconsidered every pay period. The future gets funded before the present has an opportunity to spend the money.

Gradual increases can work in much the same way. Rather than waiting for the mythical point at which there is suddenly “plenty” of money available to save, an employee can increase contributions incrementally as income rises. The psychological adjustment to a modest increase can be much easier than consciously deciding to sacrifice a large amount of current spending. For more information on how you can implement this strategy for yourself in your TSP, check out STWS founder Dan Sipe’s “January Jump: The Easy Way to Boost Your TSP Savings” article.

Looking Ahead

Present bias is only one way our psychology can influence financial decisions. It helps explain why the needs of today can sometimes overshadow the needs of tomorrow, even when we know our future selves will benefit from making a different choice.

But our relationship with money is shaped by more than just timing. We also have a tendency to assign different meanings or intentions to certain pools of money. We may think of some money as “retirement money,” some as “emergency money,” and some as “fun money,” even though all of it is part of the same overarching financial picture.

But that’s a topic for another time… 

Join us next week for Part 2 of FinPsych for Feds, as we explore the mental accounting bias and the surprising ways the mental “buckets” we create for our money can influence our financial decisions.

**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. **