«David F. Babbel Fellow, Wharton Financial Institutions Center Professor of Insurance and Finance The Wharton School, University of Pennsylvania ...»
Wharton Financial Institutions Center
Policy Brief: Personal Finance
Investing your Lump Sum at Retirement
David F. Babbel
Fellow, Wharton Financial Institutions Center
Professor of Insurance and Finance
The Wharton School, University of Pennsylvania
Craig B. Merrill
Fellow, Wharton Financial Institutions Center
Professor of Finance and Insurance
The Marriott School of Management, Brigham Young University
First Draft: June 10, 2006
This Draft: August 14, 2007 This essay is based, in part, on a study by the same authors entitled “Rational Decumulation,” Wharton Financial Institutions Center Working Paper #06-14, May 2007. That study was co-sponsored by the Wharton Financial Institutions Center and New York Life Insurance Company. The usual disclaimer applies. http://fic.wharton.upenn.edu/fic/papers/06/p0614.htm Introduction Imagine sitting down on the day of your retirement to plan your financial future. You know what your annual expenses have been and you want to maintain your current standard of living. So, you consult a th recent mortality table and find that if you’ve made it to your 65 birthday, you can expect to live to 85 years old. You perform a little calculation and find that, together with your Social Security monthly payments, you have just enough savings to maintain your current standard of living and spend all of your savings and future expected earnings by the time you die at the age of 85. But, what if you live longer?
Will you be reduced to eking out an existence on Social Security alone? Where will the additional money come from? What if future investment returns are not what you anticipated at the start of your retirement?
These questions are increasingly urgent in America today, as forces are combining to make planning for outliving your resources more important than it has been in the past. Old rules of thumb for spending your assets in retirement, called decumulation, need to be reconsidered.
The Perfect Storm Retirees must take strategic action in the deployment of their accumulated savings and funds as they begin retirement. Five forces are converging upon Americans in what some have called the Perfect Storm – others the Tsunami Wave – that is about to engulf us from all sides. The best we can do is to organize our own finances in such a way that we can provide for ourselves, because there isn’t anything we can do
to stop these converging forces. These five forces are:
1) The decreasing levels and importance of Social Security benefits. Relative to the benefits provided to our parents, people currently in their working years will receive a much lower return on their Social Security contributions. As can be seen in the chart below, the implicit rate of return on contributions was far higher for earlier beneficiaries. [Source: Social Security Administration.]
See, for example, Philip J. Scro fani, “Perfect Storms and Ticking Time Bombs.” Sage Advice, October 2005.
The adverse effect of this lower rate of return especially impacts the higher contributors, as shown below. This chart shows that people who had the lowest earnings levels are projected to receive a rate of return on their contributions of 2.8%, seven times higher than 0.4% returns that are projected for those whose earnings were taxed at the maximum levels. However, the rates of return for both groups are very low. [Source: Social Security Administration.]
2) The demise of defined benefit (DB) pensions. Over the past 15 years, there has been only one new pension program of any size initiated in the U.S. The number of pension plans in the U.S. peaked at 175,000 in 1983, and has since declined to less than 25,000. While much of the reduction was due to the elimination of small and medium plans, some of the largest pension programs have also been discontinued, closed to new membership, or frozen to all employees. About 30% of the remaining pension programs plan to do close within the coming two years. Many of those that still remain are insolvent or otherwise underfunded, and the government’s Pension Benefit Guarantee Corporation (PBGC) is reeling under a load it cannot sustain. During the same time period, 401(k) defined contribution (DC) plans increased from around 17,000 to over 450,000. When all defined contribution type plans are included, there are over 650,000 today. While the reasons for the substitution of DC for DB plans are complex and cannot be covered here, suffice it to say that there is a dynamic change going on in response to various economic factors and government initiatives that will change the way we cope with retirement income needs.
Over time, the problem is bound to get worse.
The economic implications for the average individual are significant. Under a traditional pension program, the retiree receives a set monthly income for as long as he or she lives. Under a defined contribution program, such as a 401(k) or 403(b) program, the amount of income you collect after retirement and how long you continue to receive it is anyone’s guess. There are no guarantees. In effect, the risk of retirement has been shifted away from the employer and the PBGC that insures the pension benefits, and placed upon the shoulders of the employee. Put another way, the financial risk of retirement has been transferred from those best able to bear it to those less knowledgeable and least able to bear it. In the past, annuitization (discussed below) was less important, as pensions were combined with Social SecuThe industry-supported Employee Bene fit Research Institute and Mercer Human Resources Consulting study was reported in an article by Peter G. Gosselin entitled “More employers doing away with pensions, stud y finds.” Los Angeles Times, July 11, 2007.
rity and handled most of our retirement needs. But today, as pension benefits are gradually (and at times, suddenly) eliminated, and as Social Security benefits stagnate, and are sometimes reduced through delayed eligibility and taxation, annuitization becomes a much more important retirement strategy.
3) The aging of the baby boom generation. Beginning last year, the first members of the largest generation in American history turned 60, leaving their jobs and entering the retirement force. The “boomers,” as this generation is commonly known (born from 1946 to 1964), will continue to exit the workforce for at least another twenty years. Currently constituting over 27% of the U.S. population and 47% of all households, they will become dependent upon Social Security, retirement plans, and any accumulated assets.
4) The emergence of post boomers. Generations X (born between 1965 and 1979) and Y (born between 1980 and 2001) will be burdened not only with the responsibility of providing for their own future retirement and health needs, but also with supporting the Social Security and Medicare costs of the boomers. The net effect of this is that there will soon be many more people draining funds from the Social Security system, with far fewer people contributing to it.
In 2006, there were 7.2 persons between the ages of 18 and 65 for each person over 65. Within the next 23 years, this ratio is projected to drop to 3.7, according to the Census Bureau.
5) The increasing longevity of the American population. In the table below, we show how the life expectancy for the population at large has increased over the past century. While expected lifetimes are longer in all categories, the life expectancies for people who reach age 65 are the most relevant for our analysis.
An examination of the table shows that since Social Security began monthly payments in 1940, the number of months we can expect to receive benefits for those of us who reach age 65 has increased by roughly 50% for men and women. Coupled with the fact that when Social Security was instituted, the average person did not live to age 65, increased longevity has placed a tremendous burden upon the retirement system. It should be kept in mind when reviewing this table that these are life expectancies for the population at large. For people who reach age 65 in good health, the life expectancies are currently about four years longer than shown, and remember that half of those people will live longer, many much longer.
When considered together with the decreasing yields from bonds and lower returns from stocks in recent years, these forces spell disaster for those who do not take more prudent financial measures to prest pare for what is becoming the major financial risk of the 21 century: living too long.
Sources: Centers for Disease Control and Prevention, National Center for Health Statistics, National Vital Statistics System.
So there you have it. The decreasing rates of return on our Social Security contributions, the accelerating demise of defined benefit pensions, combined with the advent of America’s largest generation in history now approaching retirement, their longer expected lifetimes, and the much smaller relative population of people who are going to be asked to support their unfunded benefits – taken together we have all the necessary ingredients for the perfect storm – with a few extra ingredients thrown in for bad measure!
What is Annuitization?
Lifetime income annuities, sometimes called life annuities, income annuities, single premiu m immediate annuities, or payout annuities, involve large insurers pooling people of similar age and sex, with each person giving to the insurer an amount that will generate suffic ient returns to provide them with a monthly income throughout their expected lifetimes. Those who die before reaching their life expectancy are, in effect, insuring those who live beyond their life expectancy. In essence, it is the opposite of life insurance, where the payments of those who remain living go to cover the benefits paid to the estates of those who die prematurely. In the case of life annuities, the risk of outliving one’s income is pooled among all annuity purchases, providing a kind of insurance against outliving one’s assets.
If, at retirement, people plan their finances to cover their economic needs throughout the remainder of their expected lifetime, which is roughly until age 86, half of them can be expected to fail. This is simply because half will live longer, and many much longer, than their life expectancy.
(See chart below.) However, if they choose a life annuity instead, they will be able to spend at the same rate, but be covered for as long as they live. A life annuity is the only investment vehic le that features this advantage. Trying to replicate this advantage of a secure lifetime income, but without the riskpooling of a life annuity, will cost you from 25% to 40% more money, because you would need to set aside enough money to last throughout your entire possible lifetime, instead of simply enough to last throughout your expected lifetime. Even at this higher cost, you cannot be sure you will achieve a secure lifetime income, because interest rates could change over the next 30-50 years while you are in retirement. (We will discuss this later.) Economists’ Views of Decumulation George Bernard Shaw once quipped, “If you laid all the economists end to end, they still wouldn’t reach a conclusion.” Well, that time-honored adage has changed, at least in one area, because economists have come to agreement from Germany to New Zealand, and from Israel to Canada, that annuitization of a substantial portion of retirement wealth is the best way to go. The list of economists who have discovered this includes some of the most prominent in the world, among whom are Nobel Prize winners.
Studies supporting this conclusion have been conducted at such heralded universities and business schools as MIT, The Wharton School, Berkeley, Chicago, Yale, Harvard, London Business School, Illinois, Hebrew University, and Carnegie Mellon, just to name a few. The value of annuities in retirement seems to be a rare area of consensus among economists.
A recent National Bureau of Economics study, which appeared in the prestigious American Economic Review, demonstrated under much more plausible conditions than had ever been supposed, that full annuitization was optimal for people who had no desire to leave a bequest to their heirs or charitable organizations. It also concluded that for those with bequest motives, substantial annuitization of retirement wealth was still the most prudent way to act.
In another recent study, we re-examined the unique features of annuitization and showed that people who place their retirement wealth in mutual funds of stock, bonds, the money market, or some combination thereof are subjected to greater risk, often higher expenses, and returns that are unlikely to keep pace with annuity returns, especially when risk is taken into account. The recommendations from our study as well as existing academic models are below.
Recommendations Like others before us, we found that substantial annuitization was generally prescribed by a sophisticated model of economic decision-making. The reason we conducted yet another study of this was to incorporate several degrees of greater realism that had not been included in earlier economic models, and to re-examine the annuitization decision in this richer economic context.
The level of annuitization that was considered optimal depended on a number of factors, such as amount of wealth at retirement, level of Social Security benefits accrued, tolerance for risk, desire to leave a bequest, impatience to consume, general level of interest rates, expected return on stock, and stock market risk levels. It also depended on marital status, age, and whether pension income was being earned.
While we cannot present here all of the scenarios that were examined, we can give some general conclusions about what our study showed.