As baby boomers retire and start spending their nest eggs, they will need new
financial products to make their money last, according to speakers at a recent
Wharton Impact Conference titled “Managing Retirement Payouts: Positioning,
Investing and Spending Assets.” The conference explored emerging patterns in
spending during retirement and debated new ideas to help retirees manage their
finances after leaving the workforce.
According to Olivia S. Mitchell—executive director of Wharton’s Pension
Research Council and director of the Boettner Center for Pensions and Retirement
Research, the conference’s sponsors—a significant amount of research exists on
the adequacy of retirement saving and the transition from traditional pension
plans to today’s do-it-yourself programs. Now, with the baby-boom generation on
the brink of retirement, analysts are becoming concerned about how those savings
will be spent.
The “decumulation” phase
“We decided it was high time to turn our attention to the ‘decumulation’
phase of retirement security,” said Mitchell. “Our focus today is
forward-looking. How do, and how should, people think about managing their money
in retirement?”
Financial service providers, researchers, and regulators “have devoted
substantial attention to the ‘accumulation’ portion of the life cycle—focusing
people on saving more for retirement and diversifying their retirement savings,”
she continued. “What has been sorely missing is a concerted analysis of risk
management during the retirement payout phase.”
One way retirees deal with post-retirement spending is to go back to work.
One-third to half of all workers who partially or fully retire return to some
level of employment, according to Sewin Chan, associate director of public
policy at the Robert F. Wagner Graduate School of Public Service at New York
University. Chan presented a paper she wrote with Ann Huff Stevens, professor of
economics at the University of California, Davis, titled “Is Retirement Being
Remade? Developments in Labor Market Patterns at Older Ages.”
“When we think about retirement, the traditional path goes something like
this: Work. Work. Work. Retire,” Chan said. “But many people also take a more
gradual retirement and reduce the amount they work before making a permanent
exit from the workforce. And then there are people who reverse their retirement
and go back to the labor force once they exit.”
These so-called bridge jobs can last as long as five years, with the median
hours worked by those partially retired being 16 hours a week and 40 weeks a
year, according to Chan. The decision to return to work may also alter
investment patterns in retirement, she suggested: “Someone might be willing to
take on a riskier portfolio in early retirement knowing they can return to the
labor market after a while.”
Less on food, more on entertainment
Despite concerns about the level of retirement saving, Erik Hurst, professor
of economics at the University of Chicago’s Graduate School of Business,
contended that most U.S. workers seem to be saving enough for a secure
retirement. Hurst argued that drops in consumption following retirement do not
prove that retirees have undersaved. Rather, he has found that much of the
decline in spending by retirees is concentrated in work-related categories,
primarily transportation, clothing, and food consumption outside the home. Using
diaries that track food expenditure and nutrition intake, he concluded that
retirees spend more time producing food at home at a lower cost than while
working. At the same time, he noted, entertainment expenditures rise in
retirement. “They’re eating out less, but they’re still going to the golf course
as much.”
Hurst acknowledged that despite his overall findings, there may be a
substantial fraction of retirees who have not saved enough for a comfortable
retirement period. When it comes to spending on food, those in the bottom
quartile of pre-retirement wealth reported declines of more than 30% in
expenditures, while those in higher wealth brackets reported declines ranging
from only 9% to 14%.
Those who leave the workforce unexpectedly, perhaps due to poor health, may
also experience sharper declines in expenditures beyond what might be associated
with the end of their working lives, Hurst added. “The average household seems
to plan well. But there is a segment—perhaps upwards of 25%—that doesn’t plan
well, and these people do experience a decline, maybe as a result of a health
shock. The focus should be on understanding who these households are and what
they’re about.”
Home equity
For many retirees, the biggest chunk of their net worth is tied up in their
homes, and recent dramatic increases in real estate prices have prompted
interest in how retirees might tap that equity to finance retirement.
Housing values rose approximately 40% between 2000 and 2005. Home equity
typically makes up more than 60% of individuals’ net worth, according to Wharton
real estate professor Todd Sinai and finance professor Nicholas Souleles. They
examined how much housing equity might be available for spending during
retirement in a paper titled “Net Worth and Housing Equity in Retirement.”
No matter how much their home has appreciated, Sinai noted, retirees still
need to pay something for housing after they stop working, regardless of whether
they sell the house and cash in on their real estate appreciation.
To gauge how much of that equity would be available for non-housing
consumption in retirement, Sinai and Souleles constructed two models. Using
current reverse mortgage programs before fees, they projected that the median
90-year-old household could spend up to 75% of its housing equity, while a
65-year-old could consume half the equity. According to another model based on
an idealized reverse mortgage offering maximum liquidity, the range was wider.
By age 90, the amount of home equity available for consumption would rise to
84%, or about $94,000, while the median 65-year-old household could only tap 34%
of its housing equity, or about $36,000. The paper notes that 15% of those
households would have no housing equity available.
“We have had a sizeable increase in housing values leading to an increase in
net worth, but not all of that is consumable,” Sinai concluded. “We need to take
that into account: The fraction that is consumable has not changed, although
there is a real change in what is available to seniors as housing values have
gone up.”
Living to 110
Much of the conference research touched on how to avoid outliving one’s
assets in retirement. Mitchell noted that accumulation-type annuity products
have been around a long time, but little attention has been devoted to payout
annuities, which are financial contracts that guarantee a steady income as long
as the retiree lives.
“Now that boomers are reaching the crucial realization that retirement is no
longer a dream but soon a reality, the question arises as to how people will
avoid outliving their assets,” she said. “To this end, an inflation-linked
lifetime income annuity product has a very important place in many boomer
portfolios. The challenge is to get boomers to understand first how long they
may actually survive in retirement, and second, how to protect against living
too long. Only then will it be possible to get boomers to take longevity risk
seriously. Personally, I am planning (and worrying about!) living to 110.”
The value of annuities
Mitchell explored a piece of this so-called annuity puzzle in a paper she
wrote with Jeffrey R. Brown, professor of finance, and Marcus Casey, a PhD
candidate in economics, both from the University of Illinois at
Urbana-Champaign, titled “Who Values the Annuity from Social Security? New
Evidence From the Health and Retirement Study.”
Brown pointed out the disconnect between the value of life annuities and a
lack of interest in buying them. The disconnect will grow increasingly important
as defined-benefit retirement plans that guarantee income for life wane but are
not replaced by the voluntary annuity market, he said. “People ought to find
annuities valuable.” In practice, Social Security is an annuity, “but beyond
that, few people use annuities in retirement.”
Brown cited several explanations for the slow take-up of current annuity
products, including:
- Public perception of high prices
- A desire to pass savings along to heirs
- Consumers’ need for liquidity to hedge against medical expenditure shocks
- Retirees’ tendency to defer thinking about death
- Reliance on Social Security benefits
- The lack of inflation protection in most existing products
“But the puzzle remains,” said Brown. “At the end of the day, this research
still doesn’t explain why retirees are slow to annuitize.”
The authors surveyed respondents in the 2004 Health and Retirement Study, and
asked 1,000 people between the age of 50 and 64 to imagine they were 65 and
receiving $1,000 per month in Social Security benefits. Would they be willing to
lower the benefit by $500 a month in order to receive a one-time $87,000 lump
sum payment? The authors were fascinated to find that almost 60% of the
respondents indicated they would take the lump sum instead of the lifelong
Social Security payout stream. Those surveyed did indicate some price
sensitivity; risk-averse consumers valued the inflation-indexed life annuity at
20% to 50% more than its actuarial value. Yet a 25% price increase would be
enough to induce 11% to favor the lump sum. This survey was conducted before the
2005 debate on the sustainability of the Social Security program, so respondents
were not asked whether they anticipated that future benefits would be
curtailed.
Marketplace battlefield
Sometimes the retirement payout marketplace seems to be a battlefield, with
boomers advised either to fully annuitize or to avoid annuities completely,
according to Mitchell. She added: “Our research and that of others suggest there
may be room for compromise, which will make consumers better off.”
Some of the products that could play this role are deferred and tiered
annuities that pay more in the event of disability and nursing home need,
inflation-linked payout products, and variable annuities giving investors access
to equity even in retirement. Phased withdrawal plans can also benefit from
inflation protection in the form of Treasury inflation-protected securities
(TIPS), Mitchell said.
One new approach for managing retirement financial risk may be the “lockbox”
proposed by William F. Sharpe, cofounder of retirement consulting firm Financial
Engines and an emeritus professor at Stanford University’s Graduate School of
Business, who received the Nobel Prize in Economic Sciences for his work in
developing models to aid investment decisions. Sharpe led the presentation of a
paper titled “Efficient Retirement Financial Strategies,” co-written with Jason
S. Scott, who directs the research and development group at Financial Engines,
and John G. Watson, a fellow at Financial Engines.
Sharpe challenged accepted rules for retirement savings and spending used by
financial planners, such as the “4% rule” which suggests retirees may consume a
real value equal to 4% of initial wealth as long as 50% to 75% of the retiree’s
portfolio is invested in equities. “We started looking at some of the rules of
thumb through financial economists’ eyes, and to be perfectly frank, we didn’t
like much of what we saw,” said Sharpe.
The problem with traditional retirement security strategies is that they are
split into two parts: an investment strategy and a spending policy, he argued.
“These really need to be interlocked and integrated. To the extent they are not,
you can get results that are not as good as your client deserves.”
The “lockbox” strategy
Sharpe’s research team proposes a “lockbox” strategy in which fractions of
initial wealth are allocated to virtual accounts, or lockboxes. The money in
each lockbox is independently invested, and each year the retiree spends only
the contents of that lockbox designated for that year. “The point is that each
lockbox has a strategy which is efficient vis-a-vis its year of maturity.
Therefore, the whole thing is efficient.”
Sharpe said the lockbox concept also protects against age-related problems in
savings and retirement spending. “The lockbox maximizes my expected utility at
my current age vs. 20 years older—or dead. I don’t want to wait until I get
there, because I’ll be drooling and I won’t know what utility it is. It allows
me to think now about the future me and act in loco parentis for my senile and
elderly self.”
Mitchell noted a sense of optimism regarding the development of future
products that will be useful for managing risk in retirement. “Risk management
research has already been driving mutual funds and insurers to cooperate in the
retirement space to better meet retirees’ interest in both capital market access
and minimum guarantees,” she stated. “More deferred products will likely be
interesting in the future—for instance, guaranteed income streams that switch on
at some pre-specified age, such as 75 or 85.”
She pointed out that in Germany and the UK, deferred annuities have been
mandated by the government to protect people against running out of money too
soon.
In her closing remarks at the conference, Mitchell encouraged the researchers
to bend their talents to this area and told them, “The theme that comes through
is that it’s not just ‘either-or’—it’s not just about annuitization or
investment. Instead, there is a much richer set of financial innovations for an
aging world that we must help bring to the global marketplace.”
