What do a diamond, the UN, and preparing for retirement have in common? They are all examples of when rational thought has been hijacked by a process known as anchoring. The field of Behavioral Finance has chronicled the power of anchoring since the 1970s. Anchoring leads otherwise reasonable people to make irrational decisions that can result in their financial detriment. The danger is best explained by the situations described below.

Diamonds

The conventional wisdom has people spending two months’ pay for an engagement ring. If a potential newlywed makes $50,000 a year, by the two months’ pay rule, the ring should cost $8,300! For anyone living paycheck to paycheck (most of us), this is an unreasonable if not irrational amount to spend on an engagement ring. This mental shortcut anchors the decision-making of potential newlyweds into spending much more than they might be able to afford, especially when research shows most Americans have less than $1,000 in savings.

Two months’ pay for a ring has no basis in responsible financial behavior; in fact, it was part of an ad campaign by the De Beers mining company to increase diamond sales.

The United Nations

Behavioral economists Daniel Kahneman and Amos Tversky were the first to illustrate the power of anchoring in decision-making. In 1974, experiment subjects were asked to estimate the percentage of African countries represented in the United Nations in relation to a number spun on a wheel. When participants spun a 10, the median estimate was 25 percent; when they spun a 65, the estimate went to 45 percent. This example demonstrates that people determine a value based on a preconceived baseline and then adjust away from it by anchoring on the original amount.

Retirement Plans

Anchoring can also undermine your retirement savings when it comes to choosing how much to save. Many employer defined contribution plans have set up auto enrollment, but anchored the default rate too low at 3 percent. Regardless of the default savings rate, plan participants anchor to it in overwhelming numbers. With or without auto enrollment, other anchors include saving the minimum, the maximum, as much as the match, or what coworkers do.

None of these shortcuts in decision-making inform how much someone would need to save to reach a financial goal in retirement. The decision errors are understandable. Estimating retirement savings is a complex task, and easily pushes beyond the limits of nearly all savers’ expertise.

Anchoring occurs when, one way or another, we have a preconceived starting point when trying to calculate how to move forward. This could be that a diamond ring ought to be worth two months’ salary. Or it could be that 3 percent of every paycheck is a good place to begin saving for retirement. And, unfortunately, even if we have been warned about anchoring, it still happens.

The best guard against anchoring is an awareness of when we step outside the limits of rational decision-making. Outside those limits we are most vulnerable to anchors that are sinking our retirement accounts.

For defined benefit plan participants decisions are streamlined, and stay within reasonable boundaries of knowledge. The shift to defined contribution plans over the years has added complexity without a corresponding increase in expertise from plan participants, leaving everyone vulnerable to insufficient savings in retirement.

PERA’s Defined Contribution Plan and voluntary 401(k) and 457 plans include advice tools (at no additional cost) which help inform how much to save to reach a certain goal and what funds to consider given a participant’s risk tolerance and investment time horizon. Advice tools go a long way toward restructuring decision-making from irrational and reflexive back to rational and deliberate – and can help eliminate the problems associated with anchoring.