The other day, I took my little one to play in a nearby garden. Kids being naturally curious, he bombarded me with questions about the trees, plants, flowers, and the variety of flora we encountered. As we wandered among the blooms, his questions sparked a chain of thought in my mind.
Reflecting on his inquiries, I was reminded of our own financial garden. Just like the garden we explored, our finances too can be likened to a patchwork of different elements. In this metaphorical financial garden, one corner is dedicated solely to nurturing fruit trees, representing our retirement savings.
In contrast, other sections of the garden may host flowers, vegetables, or herbs, symbolising your everyday expenses, discretionary spending, or short-term savings goals. While these areas are essential for your immediate needs and pleasures, they remain separate from the retirement orchard, as trees take longer to mature.
As we continued our walk, I was thinking about how mental accounting creates a boundary around our retirement savings, ensuring they remain untouched until they’re ready to yield a bountiful harvest in the future. But let’s understand how:
In the labyrinth of financial decision-making, human psychology often takes the lead, steering our choices and actions. One such phenomenon that profoundly influences our financial behaviour is mental accounting. Coined by economist Richard Thaler, mental accounting refers to the subconscious categorization of money into different mental “buckets” based on various criteria like the source of income, intended use, or time frame for spending.
While mental accounting can sometimes lead to irrational financial decisions, its strategic application, particularly in retirement planning, can significantly boost saving and investing behaviours.
When it comes to retirement planning, the concept of having a separate basket labelled for retirement funds, distinct from everyday expenses or discretionary spending- creates a mental boundary, acts like a cognitive cue that signals the mind that these funds are designated for a specific purpose, reducing the temptation to use these funds for immediate needs, clearly and safely bypassing the cognitive biases such as present bias (tendency to prioritise immediate gratification over long-term rewards) and status quo bias (preference for maintaining current investment allocations), serving as a powerful nudging mechanism.
Once funds are allocated to the retirement basket, individuals tend to exhibit a reluctance to deviate from their designated purpose. This psychological “lock-in” effect arises from the mental accounting principle of loss aversion, where the pain of losing something (in this case, retirement savings) outweighs the pleasure of gaining, probing individuals to be less inclined to dip into their retirement funds for non-essential expenditures, thereby fortifying their commitment to long-term saving and investing.
People are more motivated with positivity than negativity, and another exciting benefit of mental accounting is – to influence individuals’ perceptions of retirement saving and investing positively, which I call as positive framing, highlighting the benefits of compound interest and tax advantages associated with retirement accounts etc., enhances the attractiveness of allocating funds to their retirement basket.
This is not all, one of the most important benefits of a dedicated savings for retirement is – it brings behavioural financial discipline, that fosters a sense of accountability and monitoring specifically tailored to retirement savings goals. Just as businesses maintain separate financial records for different departments, individuals intuitively track the performance and growth of their retirement funds distinct from other financial accounts.
This heightened vigilance encourages regular contributions, diligent monitoring of investment performance, and adjustments to the retirement portfolio in line with evolving financial objectives and market conditions.
While talking about financial discipline, I believe, employing mental accounting principles, financial institutions and employers often offer automatic saving and investing mechanisms specifically designed for funding retirement.
Through SIPs, EPF contributions, NPS deductions, and retirement mutual funds, we can seamlessly allocate funds for the future, empowering ourselves to resist impulsive spending and maintain financial discipline, so as to reinforce our retirement nest egg.
Coming back to where we started from – similar to how we must care for the fruit trees separately, watering them diligently and shielding them from harm, we allocate a portion of our earnings exclusively for retirement. We understand that plucking fruits from the trees prematurely would hinder their growth and compromise the bounty they could yield in the future, something similar happens to retirement savings as well.
So, as we navigate the complex landscape of personal finance, let us embrace the strategic deployment of mental accounting to secure our financial future and unlock the gates to a prosperous retirement.
Sagneet Kaur is SVP, Behavioural Finance & Consumer Insights, PGIM India Mutual Fund.