Your Brain is a Discounting Mechanism

• “Discounting” is the term psychologists have coined for the natural tendencies to overemphasize immediate gratification and to minimize the importance of future needs.

• Discounting can prove to be a major obstacle to saving for retirement.

• Discounting can be overcome by focusing on the tax benefits and future rewards that can come from retirement savings.

“You cannot escape the responsibility of tomorrow by evading it today.” 

– Abraham Lincoln

In last week’s post I explained the near magical powers of tax-free compounding.  And yet, the U.S. Government Accountability Office estimates almost half of Americans who are 55 or older have failed to capitalize on this granddaddy of all tax breaks by contributing to tax-favored retirement accounts such as a 401(k), an IRA, or the Roth version of either.  This begs the question: Why do so few of us take advantage of this extremely potent tax break?  Behavioral economists think they know the answer.

Psychologists have identified a variety of human behaviors or tendencies (referred to “cognitive biases”) that are not rational in their own right, but rather have become a part of our human nature as we’ve evolved.  Behavioral economists have concluded that these built-in biases can lead to poor financial decision-making.

One such bias is “hyperbolic discounting”.  That is, the natural tendency to over-emphasize instant gratification or an immediate hardship, and to discount a forthcoming benefit or future cost.  Moreover, the longer the time delay, the greater the discount.  Wikipedia explains it this way:

“For example, in an early study subjects said they would be indifferent between receiving $15 immediately or $30 after 3 months, $60 after 1 year, or $100 after 3 years.  These indifferences reflect annual discount rates that declined from 277% to 139% to 63% as delays got longer.  This contrasts with exponential discounting, in which valuation falls by a constant factor per unit delay and the discount rate stays the same.”

Hyperbolic discounting also explains why impulsive purchases tend to make us happier than contributions to a retirement account, notwithstanding the much greater future reward.  This aspect of discounting was discussed by a father and his daughter in the novel “Where’d you go Bernadette” by Maria Semple.

Dad: “Have you ever heard that the brain is a discounting mechanism?”

Daughter: “No.”

Dad: “Let’s say you get a present and open it and it’s a fabulous diamond necklace.  Initially, you’re delirious with happiness, jumping up and down, you’re so excited.  The next day, the necklace still makes you happy, but less so.  After a year, you see the necklace and you think, Oh, that old thing.  …You know why your brain does that?”

Daughter: “Nuh-uh.”

Dad: “It’s for survival.  You need to be prepared for novel experiences because they often signal danger.  If you live in a jungle full of fragrant flowers, you have to stop being so overwhelmed by the lovely smell because otherwise you couldn’t smell a predator.  That’s why your brain is considered a discounting mechanism.  It’s literally a matter of survival.”

Evolution has hard-wired our cognitive biases into our brains and so simply recognizing them isn’t always enough to ensure you won’t fall victim to them.  For example, I will occasionally give in to the guilty pleasure of ordering a dessert after a nice meal, even though I may no longer be hungry.  I know, but choose to ignore when I am ordering a slice of key lime pie, that (i) the immediate pleasure the treat will bring will be short lived, and (ii) pales in comparison to the long, hard workout that will be needed the following day to burn off the unwanted calories.

Fortunately, there are things you can do to prevent your cognitive biases from keeping you from a financially secure retirement.  A few examples:

• Focus on the tax savings you are not paying. Use a calculator such as this or this to see just how much a small, consistent contribution to a qualified retirement account can grow to by the time you retire.

• Avoid impulse shopping.  Instead, if you are able to just say no to an expensive watch and buy a Seiko instead, then reward yourself with a less expensive luxury, and deposit the rest of your savings in your retirement account.  

• Think frequently about the happier retirement you’ll enjoy tomorrow if you save for retirement now.  Picture yourself relaxing at the beach, margarita in hand with a reggae band playing in the background.  The more vivid the dream, the more apt you are to build the nest egg you need to turn your goal into reality.