Overcoming over-confidence in financial planning

Arguably the greatest investor of his generation, Warren Buffet, put it pretty simply: “Diversification is a protection against ignorance.” Mr Buffet was talking about investing to build up wealth. And he should know. According to Forbes magazine, Mr Buffet is worth almost $110 billion and is the sixth richest American.

The same tenet applies to investing in the retirement phase of life. In fact, protecting against the downside is even more important as people get older and have fewer years to make up for any downturns in share markets.

Tapping into diverse sources of retirement income is key to balancing risk and return. Every type of income has its benefits and understanding them, and when they’re applicable, allows you to achieve a better income in retirement.

There are some lessons we can all learn from recent findings in the field of psychology. David Dunning is a psychology professor at the University of Michigan and has spent most of his professional life studying flaws in human thinking. He also has a penchant for catchy titles for his academic work. Check out his TED talk titled “Why incompetent people think they’re amazing”.

Along with American social psychologist Justin Kruger, Professor Dunning worked out that there’s a cognitive bias in society whereby people with low ability in a set of circumstances tend to overestimate what they can achieve. For example, novice chess players often believe they can beat people who have been playing the game for years. More than 80 per cent of Americans think they are above average drivers, when that’s mathematically impossible. Or have you ever tried to fix a leaky tap and ended up calling the plumber?

The Dunning-Kruger effect was first discussed in 1999 in the aptly titled paper, “Unskilled and Unaware of It: How Difficulties in Recognizing One’s Own Incompetence Lead to Inflated Self-Assessments.”

It isn’t about ego. Everyone is captured by it because we aren’t all experts at everything. The effect isn’t linear. Those with least expertise are most likely to over-estimate their ability, according to Professors Dunning and Kruger. And it’s a catch-22 situation. Our brains hide blind spots from us. It means we often feel more confident about taking on a task than we should. We are unaware of our over-confidence.

The Dunning-Kruger effect hits all aspects of life, including investing. Thinking you know more than you do can be a dangerous bias when saving for retirement. So, too, thinking you know enough about creating a comprehensive retirement income plan.

So how do people overcome the Dunning-Kruger effect when planning for retirement? Engaging a financial planning professional is almost always the best option. But there are considerations ahead of meeting with a financial planner that people should think about. The acquisition of knowledge reduces the likelihood of your retirement income plan being caught up in the Dunning-Kruger effect.

There are two basic steps to put together a comprehensive retirement income plan that need to be understood.

The first is to create an income safety net to cover basic living costs. That means ensuring you have enough income to get by day to day, for however long you live. On its own, the Age Pension might not be enough to provide this level of support. That’s where combining the Age Pension with a lifetime annuity can create regular income to fully cover essential costs.

The second step is to have money you can access at any time. Once the basics are covered, it’s great to have enough to go out to dinner, treat the grandkids or go on holidays. An account-based pension is a common way to do this, as is investing in shares or property directly. This is income that isn’t guaranteed. It might one day run out or fall dramatically, as opposed to the first category, in which income is paid for the rest of your life.

These two steps illustrate how diversification can be the basis of a successful retirement income plan.

Back to Messrs Buffett, Dunning and Kruger. Warren Buffet’s full quote was: “Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.”

But as Professors Dunning and Kruger have shown, most people overestimate their ability, and don’t really know what they’re doing.

So putting the greatest investor of his generation with two of the finest psychologists of the 21st century together, what’s the single lesson for retirement incomes?


Name: Maree
Age: 67
Status: Single
Assets: Homeowner, $450,000 in superannuation, $20,000 in personal assets and $50,000 in cash.

Maree spoke to a financial adviser about a comprehensive retirement income plan. She opened an account-based pension with 70 per cent ($315,000) of her super, which for the time being at least, funds all the extras she enjoys: heading to the movies, meeting friends for dinner, heading off on holidays. She has some money in the bank. Maree also purchased a $135,000 lifetime annuity from Challenger, funded from 30 per cent of her super. It provides guaranteed income payments, linked to inflation, for the rest of her life. Just as importantly, it helps provide peace of mind because Maree knows she will never have to fully depend on the Age Pension.

So in year one, Maree’s income is as follows:

  • $5907 from her Challenger lifetime annuity
  • $28,367 from her account-based pension
  • $9326 from the Age Pension
  • $1400 from bank interest.

Maree’s income streams, combined with the interest she earns from the money in the bank, provide her with $45,000 a year. And if her account-based pension runs out, she will have guaranteed income from her Challenger lifetime annuity and the Age Pension for life.

Securing your retirement income
As we’ve seen, things can change quickly and unexpectedly. Getting your retirement income sorted can help support a positive outlook in retirement. A Challenger lifetime annuity gives you a guaranteed monthly income, no matter how long you live, or how share markets perform.

Find out more about Challenger lifetime annuities here or use the Challenger Retire with confidence tool to discover how a comprehensive retirement income plan can support a positive outlook in retirement.

Disclaimer: The calculations above are from Challenger’s Retirement Illustrator tool as at 24 March 2021 (accessible to financial advisers only). Unless otherwise stated, the Illustrator does not take into account the short-term measures announced as part of the Commonwealth government’s economic plan in response to COVID-19 (as outlined in the Coronavirus Economic Response Package Omnibus Bill 2020) including payments to support households, early release of superannuation and temporary reductions in the superannuation minimum drawdown rates. Depending on an investor’s situation and user inputs, this may impact illustrations provided in the Illustrator.

The Retirement Illustrator also contains the following assumptions:

Government Age Pension: The government Age Pension amounts illustrated are based on current law including the new deeming rates of 0.25 per cent and 2.25 per cent. For the purpose of rates and threshold indexation CPI and AWOTE are assumed to be the same. Any future changes to legislation will alter the Age Pension amounts projected. It is important to note that the government Age Pension amounts projected are illustrations only and are not a guarantee that a person will be entitled to the government Age Pension. Eligibility for government Age Pension entitlements will vary depending on personal circumstances, including the future value of investments and changes to marital status. To check eligibility for the government Age Pension, go to servicesaustralia.gov.au.

Continuance of life: The Illustrator assumes the life/lives being illustrated do not die before the end of the illustration period. Where death occurs before the end of the illustration period the results will be different.

Taxation: The Illustrator does not calculate any tax payable on the projected regular retirement income or capital gains. Generally, once a person turns age 60 and retires, any income received from superannuation investments is tax free. However, other investments not purchased with money rolled over within the superannuation system may be subject to tax. Where the annuity is purchased with non-superannuation money, tax may be payable on any lump sum withdrawal amount.

Amounts are shown in today’s dollars: Results are shown in ‘today’s dollars’. This means illustrations take into account the impact of inflation between the time of the illustration and the future date, in order to show all figures in today’s purchasing power.

Assumed rates of return: The Illustrator assumes account-based pension growth assets return 6.50 per cent p.a. and defensive assets, 2.40 per cent p.a. before management fees of 0.80 per cent and 0.40 per cent respectively. In addition, platform fees are assumed to be 0.40 per cent and cash deposits return 2.80 per cent p.a. Lifetime annuities is assumed to form part of defensive assets and to maintain an overall asset allocation of 50/50 growth/defensive (including the allocation to the defensive lifetime annuity), the asset allocation of the account-based pensions has been set accordingly.

The information in this article is provided by Challenger Life Company Limited ABN 44 072 486 938, AFSL 234670 (Challenger Life), general only and has been prepared without taking into account any person’s objectives, financial situation or needs. Because of that, each person should, before acting on any such information, consider its appropriateness, having regard to their objectives, financial situation and needs. Each person should obtain and consider the Product Disclosure Statement (PDS) before making a decision about whether to acquire or continue to hold the relevant product. A copy of the PDS can be obtained from your financial adviser, our Investor Services team on 13 35 66, or at www.challenger.com.au All references to guaranteed payments from Challenger refer to the payments Challenger Life promises to pay under the relevant policy documents. Neither the Challenger group of companies nor any company within the Challenger group guarantees the performance of Challenger Life’s obligations or assumes any obligations in respect of products issued, or guarantees given, by Challenger Life.

Written by Challenger Group