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Try mental accounting to make your retirement dreams come true

Senior man pensive
Lee Edwards | Getty Images

You might not know what it's called, but odds are high you do it – you craft systems that enable you to make countless decisions about money without breaking into a sweat.

Or at least so writes Diane Garnick, the chief income strategist at TIAA and the author of a just-published white paper, Income Insights: Mental Accounting in Retirement.

According to her paper, this system – more formally referred to as mental accounting in the world of behavioral finance – "is an economic concept that suggests people code, categorize and evaluate activities based on a variety of subjective criteria, ignoring that funds are transferable."

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Others share that point of view. "Mental accounting is essentially the household equivalent of financial accounting, but it is often done without conscious thought," says Richard Thaler, a professor at the University of Chicago Booth School of Business and author of Misbehaving: The Making of Behavioral Economics. "A primary insight is that people treat various mental 'buckets' of money as non-fungible, meaning that there are implicit rules against taking money from one account – the children's college savings account – and spending it on something else, like a new TV.

And this system, according to Garnick's paper, holds the possibility of delivering tremendous benefits. "With the right architecture, it can save us precious time, economize our thinking and increase our self-control," wrote Garnick, who is also a board member at CFA Institute Research Foundation.

How so? Well, to understand 'how so' requires a bit of background. Prior to retirement, people routinely allocate some portion of their money to many buckets, and often over commit ourselves -- 25% to housing, 25% to food, 25% to loans, and of course, another 50% to entertainment. "We don't necessarily make the best decisions, but if we make a mistake we have time on our side," Garnick wrote.

In an email, Garnick noted that mental accounting enables people to immediately discover which retirement goals they will be able to achieve. "This framework enables a 30-year-old to quickly see if they are saving enough to enjoy hobbies in retirement or if they will be just scraping by, " she wrote. "The insight offered by mental accounting can be powerful since it gives people time to adjust their savings to meet their needs."

Mental accounting in retirement

But come retirement, your mental accounting requires a change in mindset, wrote Garnick. Among other things, you no longer have time on your side should you make a mistake with your money.

So, rather than allocate some funds to many buckets all at once, Garnick proposes fully funding one bucket before moving on to the next. "This framework offers transparency into the age-old question of how much guaranteed lifetime income each household needs while simultaneously offering savers insight into which goals they are on track to meet," she wrote.

For instance, instead of allocating 25% to housing, allocate a portion of your retirement income to funding necessities (housing, transportation, personal items, entertainment and taxes), then fund health care expenses, then emergencies, then fun or what some call discretionary, and lastly bequest.

And this change in mindset won't be easy. "I think the most difficult aspect of mental accounting and retirement savings is when households switch over from saving up for retirement to spending down," says Thaler. "This requires an entirely new mindset. Most of our lives we live on a budget: Spend less then you earn, and put some aside for later. Then they are confronted with the much more difficult task of taking a pile of money and making it last over an uncertain lifetime. Hard!"

Would a budget be better than mental accounting?

On the surface, it might seem a budget would be better than mental accounting. But that's not necessarily the case. "While creating a detailed budget is ideal, many of us don't invest the time necessary to start one, let alone maintain it with all of life's unexpected expenses," wrote Garnick. "Mental accounting provides a framework that enables people to make decisions at the margin without placing their economic future at risk."

The four-box approach

To be fair, mental accounting resembles what some call the four-box strategy whereby you use guaranteed sources of income (such as Social Security, a traditional defined benefit plan, a guaranteed lifetime income annuity) to fund essential expenses, including recurring health care expenses, and risky assets (your retirement accounts) to fund discretionary expenses and bequests.

And that approach has merit too. "When it comes to retirement there are two kinds of people in the world," wrote Garnick. Those with old-fashioned pension plans and those in the YOYO generation, which stands for 'you're on your own.'"

And both kinds of people, Garnick said, can be well served by securing guaranteed income that covers their necessities. This includes social security, a pension if you have one, and guaranteed lifetime income for the YOYO generation.

As for matching risky assets with discretionary expenses an expert said it's a good strategy too. "If (investors) treat retirement accounts as long-term investments that should remain untouched, they are more likely to reach their financial objectives," said Victor Ricciardi, a finance professor at Goucher College and co-editor Investor Behavior: The Psychology of Financial Planning and Investing.

Robert Powell is editor of Retirement Weekly, contributes regularly to USA TODAY, The Wall Street Journal, TheStreet and MarketWatch. Got questions about money? Email Bob at rpowell@allthingsretirement.com.