Published: Feb 15, 2014 6:00 a.m. ET


How to avoid bad spending decisions based on fear and cognitive decline


Retirement columnist


Well it’s possible that your fears combined with natural cognitive decline might lead to bad investment and spending decisions, according to Michael Finke, co-author of a just-published study. Read Cognitive Ability and Post-Retirement Asset Decumulation.

According to the study, retirees, and especially those with low cognitive ability, become increasingly and perhaps unnecessarily conservative with their money as they age.

First, retirees tend not to withdraw much if any money from their retirement accounts in their older years. “There is evidence that retirees are decumulating their assets very slowly or not at all,” wrote the authors of the paper, Chris Browning, Sandra Huston, and Finke, all of whom are professors at Texas Tech University.

And that flies in the face of economic theories about life-cycle savings and investing. According to life-cycle theory, one would expect older Americans to drawdown their money in way that “that maximizes expected utility.”

But that’s not what happened in the study. Instead, those with low cognitive ability had what the researchers called negative decumulation — they didn’t take out any money from their retirement accounts during the period studied. “Those whose cognitive abilities were slipping were…exhibiting a defense mechanism to avoid making mistakes — they were actually spending less,” said Finke.

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Besides not withdrawing any money from their nest eggs, retirees are also shifting, perhaps irrationally, their money away from stocks to bonds as they age. According to Finke, the research suggests that we tend to get too careful and avoid risks as we get older and start experiencing a cognitive decline.

“Our studies show that there is a tendency to be too conservative with one’s portfolio and to avoid spending down assets,” he said, noting that “fear tied in with natural cognitive decline might lead to bad investment and spending decisions.”

Risk avoidance increases with age

What accounts for this behavior? “As we get older, we tend to avoid risks,” said Finke. “In addition to experimental evidence that risk tolerance declines in old age, we know that people also lose volume and processing ability in their prefrontal cortex.”

And when we start making mistakes, Finke said it’s natural to avoid taking risks as a coping mechanism.

“There is also evidence that we use the prefrontal cortex to moderate the emotional centers of our brains — for example the part of the brain tasked with error correction is in the limbic, or more emotion driven part of the brain,” Finke said. “If we begin losing our ability to tamp down emotional responses to a loss, we may be more inclined to abandon a risky behavior such as owning stock.”

And that is exactly what Finke and his co-authors found in their study. “Investors who experienced a larger incremental decline in cognitive ability between 2008 and 2010 were far more likely to shift their portfolio away from stocks and toward safer assets,” said Finke.

And that sort of shift could be dangerous to your wealth. In fact, Finke said research that examined the relationship between cognitive decline and change in wealth found “strong evidence that those with the biggest cognitive decline saw the largest decline in wealth.”

Hard to make withdrawal decisions

Finke, Browning, and Huston also noted in their research that various life-cycle factors and cognitive ability are affecting whether and how older Americans withdraw their money from their retirement accounts.

To be fair, the researchers noted, that “decumulating in a manner that maximizes expected utility is a complex process that requires the estimation and input of multiple factors when analyzing consumption alternatives.”

Indeed, you have to consider such things as your life expectancy, your health, and your investment returns when trying to determine the optimal amount to withdraw from your nest egg. And given all that, the researchers said the decumulation decisions of retirees may be impacted by their cognitive ability.

Of course, there do seem — at least on paper — plenty of good reasons why older Americans might not be taking out as much as they should from their retirement accounts. For one, they really don’t know how long they’ll need their money to last. But that, the researchers wrote, just suggests that some older Americans seemingly don’t have “the ability to estimate the likelihood of uncertainties and incorporate them into a complex decision framework.”

Why does it matter?

Why all the fuss about this? Well, according to the researchers, “cognitive ability is relevant to financial decisions and that the presence or absence of cognitive ability is important when considering choices in combination across multiple time periods.”

What’s especially noteworthy, for example, is how those with higher cognitive ability manage their retirement assets. According to the study, those with higher levels of cognitive ability were decumulating at a significantly higher rate than those with lower levels of cognitive ability. And in a related paper, Browning found that, all else equal, those who had higher cognitive ability scores were actually decumulating their assets in a manner consistent with life-cycle theory. Read Did Cognitive Ability Affect the Stock Reallocation Decisions of Older Investors During the Great Recession? and Cognitive Status, Self-Control, & Asset Decumulation: Evidence from the HRS.

Prepare for cognitive decline

So what might you do or not do given the findings from all this research?

Well, for starters, it might be worth getting a sense of your cognitive ability. In their study, for instance, the researchers looked at fluid cognitive function. Fluid ability, the researchers wrote, is important when solving complex unstructured problems. To test fluid ability, the researchers evaluated working memory and numeracy (See the quiz below).

Two, no matter whether your cognitive ability is high or low, it might be prudent to acknowledge that you might — unnecessarily — avoid risk as you age.

Three, consider planning for any cognitive decline now. According to Finke, the notion that your financial decision making will decline as you age is similar to the decline that happens in driving. The big difference is that when drivers are given objective evidence of declining skills, they change behavior, according to Finke. And that’s not necessarily the case with financial decision making.

Four, prepare your finances now for when you’re older and perhaps less keen of mind. For instance, Finke suggests that you consider buying — as part of taking care of your older self — the type of investments that rebalance automatically, such as a balanced mutual fund. Consider, too, working with an adviser you can trust. And, consider annuitizing your wealth in old age. All those actions, said Finke, should help you avoid spending and investing mistakes in your older years.

And last but not least, Finke advised that you “quit checking your brokerage account all the time.”

Numeracy test

To determine your numeracy, answer the following questions. For each correct response, you get one point. If you score 2 or higher, you are considered to have high numeracy.


Question 2: If five people all have the winning numbers in the lottery and the prize is two million dollars, how much will each of them get?

Question 3: Let’s say you have $200 in a savings account. The account earns 10% interest a year. How much would you have in the account at the end of two years?

Word memory test

Take 60 seconds to look at this list of words. Then immediately try to recall as many words from the list as possible. For each word correctly recalled, you get one point. Wait five minutes and try to recall as many words from the list as possible. For each word correctly recall, you get one point. Add up the scores from the immediate and delayed test. If you scored 12 or above you have high cognitive ability. Of note, the average score of both the immediate and delayed recall test is roughly 5.5 for those age 60; 4.5 for those age 75; and 3.5 for those age 85.

Here are the words: Clock, Bank, Army, Apple, Rock, Worm, Sword, Cat, Desk and Baby.

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