Blogs | November 16, 2012

How inattention can cost you €11,000 (or more)

Are you thinking of starting a pension plan but haven’t got round to it yet? It can pay to be attentive.

With Christmas coming, you might not want to make any financial commitments, so why not wait until the new year? But then in January you’ll be paying for Christmas, so you’ll want to wait. But then you’ll be planning a holiday, then thinking about changing your car. Before you know it, a year will have passed and you still won’t have gotten round to starting that pension.

You know you’ve got to prepare for old age, but there’s always a good reason not to do so now. Such an attitude reflects a common problem – that we have limited attention and can get easily distracted even from big things.

The gorilla in the room
The most famous example of this is that people who watch folk playing basketball often fail to spot a gorilla walking among them. Such lack of attention can be fatal; airline pilots focusing on landing a plane can fail to spot another plane on the runway. The obvious solution to the danger of getting distracted is to start your pension plan now, while it’s in your mind.

Yes, it’s very tedious. But you only have to do it once. It is, however, not just to overcome limited attention that there’s a case for acting now rather than later. There’s also a narrow financial reason to do so.

Listen to Albert Einstein
You might think that, with returns on savings so low, there’s little harm in postponing saving. You’re wrong. In fact, here’s a way in which you can double your money. Let’s do some sums.

Assume you save €1,000 a year with a return of three percent a year – which isn’t too optimistic an expectation of the return on a bundle of cash and shares. After 30 years of saving, you’ll have €47,575. But after 25 years, you’ll have just €36,459. An extra five years of saving will make you €11,116. That’s a return of more than 100% on the extra €5000. This is because the €1,000 you save today will enjoy 30 years’ worth of compound interest, which will grow it to €2,427. As Albert Einstein reportedly said, the most powerful force in the universe is compound interest.

Plan an easier journey
It’s not just maths that tells us to save now. So too does one of the oldest stories in western civilisation. Homer describes how the sirens would lure sailors to their death with their beautiful singing. To avoid this fate, Odysseus ordered his men to tie him to the mast of his ship, to stop him sailing towards them. This is an early example of a commitment device.

Odysseus sacrificed some freedom in order to avoid making disastrous choices. Such behaviour is common. We commit to expensive gym membership to get fit; we have a rule of not drinking before six o’clock to limit our alcohol intake; we avoid thinking about politics to stop us getting angry.

Regular saving by direct debit serves the same function. In theory, we could save money without such commitment, by freely choosing to do so. But in practice we won’t; we’ll always see a guitar or pair of shoes that we must have, and so end up with no money at the end of the month. A firm commitment to save, then, is a way of ensuring that we get into good habits.

And the thing about habits is that, eventually, you don’t notice them. It’s like stopping taking sugar in your tea. At first, your tea will taste horrible. But within a few days, you’ll be used to the taste and you’ll have a painless way of losing weight.

The “commitment paradox”
And herein lies a paradox. You might think such a commitment reduces your flexibility. But in fact it might increase it. If you suffer a loss of income, adjust by reducing how much you save can be a lot less painful than cutting your spending or getting into debt. So, if you’re putting off that decision to start a pension, do it now. But you probably won’t.

BiasGoal settingProcrastination

Chris Dillow
Chris Dillow

Investors Chronicle writer and economist