Researchers from “The Illusion of Wealth and Its Reversal” simply
stated that if you describe the same monetary value in two different ways,
you’ll get two different (and opposite) reactions from the typical person. For
example, for the average person retiring at age 68, there is no mathematical
difference between receiving a single lump sum payment of $100,000 and a
payment of $500 per month for life. Despite their financial equivalence, the
average person would see the $100,000 as the more adequate of the two.
The research focuses on reframing this “Illusion of Wealth”
from the point of view that people need to see numbers presented in a way they
can better understand. Without a sophisticated financial calculator, it’s hard
for the professional, let alone the average person, to know when a lump sum is
adequate to fund retirement.
By looking at a monthly payout figure, people can more
easily determine if it can cover their monthly expenses. This is why, when
presented with a choice between larger number (e.g., receiving a lump sum of
$1.6 million or $10,217 a month for the rest of your life – again, mathematically
equivalent amounts), people tended to pick the monthly payment instead of the
lump sum. Why did they switch their choice? The researchers believe it’s
because people see the larger monthly sums as more likely to cover their
monthly expense.
The trouble is that many expenses, like property taxes,
insurance premiums, etc., are annual expenses, not monthly expenses. That means
you don’t pay for the same amount of expenses every month. Unless you’re good
at keeping track of your cash flow. It’s a whole lot easier to think in terms
of the annual income needed to cover annual expenses. There’s an industry
“rule” regarding this. It’s a little controversial, but it’s what really drives
everything.
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