Retirement Income Decumulation: Helping At-Risk Middle Americans Optimize Their Retirement Decisions NEFE Think Tank White Paper © 2009, National Endowment for Financial Education. All Rights Reserved. February 20, 2009
In December 2007, The National Endowment for Financial Education (NEFE) hosted a Think Tank on Retirement Income Decumulation: Critical Choices and Critical Decisions. The interactive event brought together 20 leading national authorities from various fields representing associations, financial planning professionals, academic institutions, think tanks, financial services industries, regulatory associations, and the federal government to explore issues surrounding how middle- and moderate-income income Americans manage and spend down assets during their retirement years. The think tank resulted in a set of consumer messages and decumulation.org, a Web site that helps retirees become better informed about their retirement decision-making.
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Table of Contents Who is At-Risk Middle America? ............................................................................................... 3 Debt and Spending Pressures .................................................................................................. 4 Insecurity About the Future ..................................................................................................... 4 Angst About Discussing and Dealing with Financial Concerns ............................................. 5 Lack of Realistic Preparation to Manage Retirement Income Decumulation ......................... 5 Preparing for the Think Tank ...................................................................................................... 5 The Retirement Income Decumulation Think Tank ................................................................... 7 Addressing the Critical Decision Zones .................................................................................... 11 10 Critical Messages for Influencers ..................................................................................... 11 10 Truths At-Risk Middle America Must Believe ................................................................ 12 10 Critical Messages for Individuals Approaching or In Retirement.................................... 14 Guidelines Within Each Decision Zone .................................................................................... 15 Work ...................................................................................................................................... 15 Social Security ....................................................................................................................... 15 The House .............................................................................................................................. 16 Insurance Products................................................................................................................. 16 Defined Benefit Pensions ...................................................................................................... 17 Defined Contribution Plans ................................................................................................... 17 Debt ....................................................................................................................................... 18 Fraud ...................................................................................................................................... 18 Where We Go from Here .......................................................................................................... 19 Guidelines During Times of Economic Hardship ................................................................. 21 About NEFE .............................................................................................................................. 22 Appendix ................................................................................................................................... 23 Overview ............................................................................................................................... 23 1. Work .................................................................................................................................. 23 2. Social Security ................................................................................................................... 26 3. The House .......................................................................................................................... 28 4. Insurance Products............................................................................................................. 31 5. Defined Benefit Pensions .................................................................................................. 32 6. Financial Assets ................................................................................................................. 34 References ................................................................................................................................. 37
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In December 2007, the National Endowment for Financial Education® (NEFE®) hosted the Retirement Income Decumulation Think Tank, a strategic gathering representing a diverse group of retirement experts and thought leaders. The event required more than a year of preparation, including a preliminary round table, advance interviews with all participants, and the completion of a comprehensive research survey of academic literature conducted by the Center for Retirement Research at Boston College. In 2005, observations by NEFE leaders inspired the idea of holding a retirement-based think tank event: Though strategies abound on how to accumulate retirement assets, less attention is given to formulating strategies for decumulating retirement income. Yet, for millions of Americans of modest means about to enter retirement financially unprepared, strategies for decumulating their limited assets receive the least attention of all. In consideration of the incomplete and fragmented body of knowledge on retirement decumulation, NEFE began planning an event that would relate to its mission: helping individual Americans acquire the knowledge and skills necessary to take control of their financial destiny. NEFE operates on the belief that financially informed individuals are better able to take control of their circumstances, improve their quality of life, and ensure a stable future for themselves and their families. NEFE fulfills this mission by providing practical, reliable, and unbiased financial education to members of the public; accomplishing research in the field of financial education; and creating demand for financial education. A special emphasis is placed on underserved audiences who face challenges that are not being addressed by other organizations. One of NEFE‘s four action areas is ―innovative thinking.‖ The goal of this action area is to inspire creative ideas and new perspectives on personal finance, to communicate them broadly, and to assist in their actualization as appropriate. NEFE collaborates with other organizations to bring focus and attention to financial issues affecting at-risk audiences. By convening many great and creative minds to sort through the issues that often impede Americans in making sound retirement decisions, NEFE took the first step in achieving this goal as it applies to the specific topic of retirement income decumulation. NEFE most often hosts think tanks and symposia on topics that are generally difficult and/or have not received adequate consideration to the broad, underserved audience that NEFE looks to assist. In the case of retirement income decumulation, the households that are most-often overlooked are those that are not on public assistance, but earn less than the mass affluent and are unlikely to pay for professional advice. NEFE refers to this group as ―At-Risk Middle America.‖
Who is At-Risk Middle America? At-Risk Middle America is a diverse population stretching across all cultural and socioeconomic categories, with annualized incomes generally between $30,000 and $100,000. There are tens of millions of At-Risk Middle American households within the middle class, perhaps as many as half of all households in the United States. Many of them are about to enter or have entered NEFE Think Tank White Paper: Retirement Income Decumulation
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retirement with low savings levels. And with retirement now lasting on average well over 20 years, At-Risk Middle American households have neither the financial resources, preparation, support systems, nor protections to carry them through the rest of their lives. Many have been so focused on accumulating money that they haven‘t even begun to think about how they‘ll draw down, or decumulate, their assets. Left unchecked, this situation will result in many millions of formerly middle-class Americans struggling to live for decades primarily on their Social Security checks. In this context, being at-risk means that these consumers do not typically seek the advice and guidance of a qualified financial planner. This audience believes that financial planning is either not needed or is an unaffordable luxury. Furthermore, At-Risk Middle Americans are largely overlooked when it comes to retirement issues—they are not on public assistance, but they make less than the mass affluent. Many have limited assets, and most have undersaved. This makes them especially vulnerable—even one bad financial decision, wrong choice, or unforeseen event such as a serious illness or major home repair could have devastating effects. What further defines these Americans as a national at-risk priority are four complex social, financial, and behavioral characteristics that together represent a serious threat to their retirement years.
Debt and Spending Pressures Financial planners are well aware that fewer than 20 percent of America‘s middle class even have adequate emergency savings (defined as three month‘s worth of income)1. Even worse, families are acquiring significantly more than 100 percent more debt than their disposable incomes, often driven by their desire to maintain a comfortable lifestyle and live in neighborhoods with better schools for their children2. Over the years, this has contributed to a strong tendency in our society to incur debt in order to emulate the higher economic classes. The results have been staggering: Middle Americans accounted for 92 percent of 2006 bankruptcies and are reeling from severe financial setbacks brought on in large part by the subprime mortgage loan fallout.3
Insecurity About the Future Even before the current financial crisis and resulting recession, some 70 percent of Middle Americans lived paycheck to paycheck.4 Job security has disintegrated, and millions of at-risk households face the grim prospect of losing or seeing severe cost increases in their health insurance. Families worry about the demise of traditional pension plans, and have watched helplessly as the value of their retirement savings and their homes—the primary nest egg for AtRisk Middle Americans—sank to new lows. And in light of growing federal deficits, families also worry about the future reliability of Social Security.
1
Middle Class in Turmoil Study, Center for American Progress (2006).
2
Middle Class in Turmoil Study, Center for American Progress (2006).
3
Middle Class Barely Treads Water Study, Harvard University Study quoted in USA Today (2007).
4
Getting Paid in America Survey, American Payroll Association (2007).
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Angst About Discussing and Dealing with Financial Concerns Money is the number one stress factor for Middle Americans, yet it also is a seriously taboo subject. At-Risk Middle Americans are extremely hesitant to directly address issues of money and envy, debt, and overspending. Some social scientists are hopeful that the financial crisis is finally forcing a change in attitudes toward money and, consequently, habits around it. Current money attitudes and habits, however, are deeply internalized. In fact, a large majority of Middle Americans say they seldom or never disagree with their own spouse about money, indicating that there‘s not a lot of talking about finances going on in the first place.5
Lack of Realistic Preparation to Manage Retirement Income Decumulation Almost half of Middle Americans have ―extreme difficulty‖ understanding most financial information, and more than half think retirement planning is harder than raising kids.6 So where do they go for advice? Not to professional financial planners, not to the financial services industry, and not to the media—they rely on relatives, friends, and coworkers. The lack of professional direction shows up in many unrealistic expectations. For example, although only about 12 percent of retirees have jobs, more than 75 percent of Middle Americans approaching retirement are confident that they‘ll make money after they retire.7 Financially, mentally, and culturally, At-Risk Middle Americans are largely unprepared to fund its third stage of life. Nor do they benefit from adequate financial education, public policies, and services to promote behavioral change that will assist this audience in achieving self-sufficiency. Without a collaborative financial literacy and social change effort that combines the best thinking of nonprofit organizations, financial planners, business, government, employers, and mass media, At-Risk Middle Americans‘ uneducated choices and bad decisions regarding their retirement years pose a serious threat to not only their financial future, but that of their children and their communities.
Preparing for the Think Tank The first step in planning the think tank was to seek the guidance and expertise of national retirement experts. On September 7, 2006, in Washington, D.C., NEFE held an eight-person roundtable on the topic of Retirement Income Choices and Decisions. During this meeting, the eight retirement experts identified the decisions that Americans in the target range of $30,000 to $100,000 annual household income would face in retirement. This group of experts believed it was necessary to learn what research tells us, especially with regard to potential rules of thumb on making retirement decisions. The roundtable participants also wanted to address messaging and dissemination strategies that would be valuable, and decided that the upcoming think tank should focus its efforts on issues surrounding decumulation, which is less well known and understood than accumulation. 5
What Americans Pay For—and How Study, Pew Research Center (2007).
6
Consumers Say Financial Services Should Be Easier Survey, ING Financial Planning and Investing Study (2006).
7
Working After Retirement: The Gap Between Expectations and Reality Study, Pew Research Center (2006).
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To directly address what research already tells us regarding guiding principles in retirement decision making, NEFE commissioned an academic literature survey. The Center for Retirement Research at Boston College conducted a review of relevant academic literature that revealed what is known and what is not known about issues surrounding retirement income decumulation. The review incorporated findings from economic research, behavioral finance, and survey data and spanned six ―decision zones‖—Work, Social Security, Housing, Insurance Products, Defined Benefit Pensions Plans, and Financial Assets (such as Defined Contribution Plans). These decision zones—defined as the most critical areas of decision-making for retirees— anchored the Think Tank on Retirement Income Decumulation and its preparatory work. Later, NEFE added two more zones dealing with income reducers: Debt and Fraud. The eight decision zones provided a holistic way to completely address retirement income decumulation. The aim of the think tank quickly became this: to explore the decisions that retirees must make, the sequencing of those decisions, what consequences these decisions bear on their financial future and standard of living, and how to prompt behavioral change in retirees to improve their financial well-being throughout retirement. Because NEFE wanted the research and findings to have as much impact as possible, especially since many retirees in the target audience are unlikely to pay for or use professional advice, a tangible think tank outcome emerged in the form of messages and practical guidelines. Many decisions that are made by retirees have irreversible consequences that alter their financial wellbeing. Therefore, we found it necessary to develop messages that help demystify retirement income decumulation and help retirees make better choices into their retirement. Retirement income decumulation is a complex issue with many variables, and it requires some risk analysis. The goal of the think tank was never to identify or advance a particular retirement nest egg size or withdrawal number. Rather, the purpose of the think tank was to take a step back and take a look at the big picture. NEFE identified a need to develop and advance the best general advice, rules of thumb, principles, and messages that will put into context a proper awareness, insight, and action involving the subject of retirement income decumulation. In other words, by holding the think tank, NEFE wanted to create and gain consensus on a set of messages that Americans need to consider long before determining their own nest egg number or withdrawal rate. These messages are anchored to specific decisions that individuals need to consider in a sequential manner over time. They will help people orient and organize their thinking so that they can approach this series of decisions with the mindset that they have the power and capacity to positively affect their financial well-being by making sound retirement decisions. Shortly after commissioning the Center for Retirement Research at Boston College to complete the literature survey, NEFE hired a strategic communications firm to guide the messaging effort. Using the research as a guide, they crafted pre-messages and templates, provided a structure to help facilitate breakout groups, and vetted and refined messages as they were interactively developed with the insight and collective knowledge of all think tank participants. NEFE Think Tank White Paper: Retirement Income Decumulation
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To achieve diversity of thought and the richness of experience, NEFE invited a high-level group of national leaders to provide a unique cross section of expertise in professional positions relevant to each decision zone. Attendees included experts from national financial education associations and foundations, academic institutions, financial services professionals, insurance and securities industries, and the federal government.
The Retirement Income Decumulation Think Tank The event, titled Retirement Income Decumulation: Critical Choices and Critical Decisions, was held December 10–12, 2007, in Wellesley, Massachusetts, and generated considerable discussion regarding the best approach to influence better retirement decumulation decisions. Participants agreed on one priority that must be addressed immediately: significantly widen consumer-centric retirement planning and management services for lower- to middle-income households while simultaneously creating new products and services to meet the unique needs of those who are most likely to spend down their limited resources too quickly. This challenge will not be easy. A senior financial services executive pointed out to think tank participants that his company had tried offering hundreds of pages of free online education and planning information to Middle America. He said that consumers mostly ignored them, despite the company‘s highly regarded brand name and considerable promotion efforts. The challenge of improving retirement decisions has become considerably more complicated given how the global financial crisis may be affecting the psyche and motivations of At-Risk American households. With fearful media stories and policy makers proposing options such as eliminating penalties for early withdrawals from retirement accounts, At-Risk Middle Americans are not just predisposed to make bad decisions—they may perceive that they‘re being urged to do so. At-Risk Middle Americans‘ need for a comprehensive understanding of the realities of retirement and the decisions a successful retirement requires has never been greater. But the storm in which retirement guidelines are shouted defies being heard, for the storm is more violent and destructive than ever. Designed as an actionable event, NEFE‘s think tank marked the first step in a long road toward a nationwide collaboration among financial experts, academia, civic leadership, service and product providers, government representatives, mass media, and consumers to create a new awareness about the retirement decumulation challenge and to encourage positive behaviors by those most at risk.
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Think tank participants acknowledged the critical outcomes that such a public awareness and social behavioral change campaign must create: Vastly increase the number of At-Risk Middle American households that are prepared to successfully finance their retirement years Avoid a looming national crisis created by millions of Americans who are likely to spend virtually all of their retirement assets with many years of life ahead Acknowledge At-Risk Middle America as a distinct population whose lack of preparation to finance its retirement poses a serious risk to the nation‘s economic and social wellbeing Enhance the understanding of At-Risk Middle Americans to facilitate effective retirement solutions involving government, employers, the financial services industry, educators, mass media, social services, advocacy organizations, and other institutions At the center of this initiative is the set of messages and practical guidelines that was inspired by the think tank, and shaped through dialog, conference calls, and several revision phases with think tank participants.
In the real-time graphic recording from the Retirement Income Decumulation Think Tank, graphic recorder Kriss Wittmann captured discussion about the Center for Retirement Research at Boston College’s Literature Survey Report on Retirement Decisions.
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Break-out groups worked on creating preliminary messages and practical guidelines for each of the decision zones.
Break-out discussions identified critical decisions that have to be made in each decision zone.
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Think tank participants brainstormed consumer messages and dissemination techniques during a session at the Retirement Income Decumulation Think Tank.
On the final day of the think tank, participants deliberate how to change the financial behavior and retirement decision-making of At-Risk Middle America by packaging decision zone messages.
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Addressing the Critical Decision Zones NEFE‘s think tank started building the foundation for an integrated and multifaceted retirement decumulation initiative—which is as important to our nation‘s well-being as convincing millions of Americans to stop smoking and buckle their seat belts. Working toward this common goal, NEFE‘s think tank participants laid out 10 critical messages to encourage bold, forward-thinking action by our nation‘s government, business, and civic leadership.
10 Critical Messages for Influencers 1. We need to realize that America faces a national crisis brought on by some 50 million AtRisk Middle American households, many of which have neither the assets, preparation, support systems, nor protections to finance retirement years. 2. As a nation, we must rethink and reposition the entire notion of retirement, deemphasizing early retirement as a symbol of financial success while simultaneously encouraging people to work longer for their own benefit. 3. Retirement decumulation planning and practice must be made a priority consideration equal to the nation‘s societal emphasis on asset accumulation, education, personal health, and nutrition. 4. Motivating At-Risk Middle Americans to work longer, take Social Security later, and reduce their borrowing as they age are vital components in improving their retirement years and in avoiding a national crisis. 5. Responding to the retirement decumulation crisis requires a research-based behavior change campaign, similar to how the nation changed public attitudes and habits toward smoking. 6. Improving At-Risk Middle Americans‘ financial behaviors requires building societal and peer influences that reinforce the importance of being prepared to finance one‘s retirement. 7. The nation‘s retirement financial infrastructure must be revised and improved to make it harder for Americans to make harmful decisions, and easier to participate in programs that automatically help them save and spend their retirement funds wisely. 8. Employers must become more active in supporting later retirement, and in providing financial literacy and planning assistance to their employees and retirees. 9. Government must consider policies specifically to improve financial literacy, create consumer-centric advice resources, design and regulate suitable consumer financial products, and promote better consumer decision making, especially regarding Social Security retirement benefits.
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10. The financial services industry must create a market for and provide consumer-centric retirement planning and management services to At-Risk Middle American households while simultaneously creating financial products to meet their unique needs. Just as our nation‘s leadership must help facilitate a societal shift in how Americans perceive and prepare for retirement, At-Risk Middle Americans must acknowledge and believe certain truths before messages can be heard or acted upon. The following 10 truths define the current realities of retirement and lay a foundation for behavioral change:
10 Truths At-Risk Middle America Must Believe 1. Many working-class and middle-class American households are at risk of catastrophic personal financial crisis because they have not adequately planned for how to pay themselves in their retirement years. 2. It is the responsibility of every American to know his or her financial situation and know the answers to these questions: How am I going to use my house, Social Security, pension, and any savings to pay myself during my retirement years? 3. Even though it may seem like a luxury, getting objective retirement advice from a qualified financial planner is important and needs to be considered. 4. Americans are living longer, which means you need a plan to pay yourself during your retirement. Understand that retirement could last several decades. 5. If you are able to, working until you are between 66 and 70 will significantly improve your ability to pay for a quality retirement life. 6. Taking Social Security payments too early means receiving less money each month than you would receive if you waited for even a few years. This could subsequently result in you not having enough to pay yourself through all of your retirement years. 7. Your retirement spending plan is not complete until you know how you will pay for medical and long-term care needs. 8. Putting at least part of your retirement savings into an annuity that will give you a regular monthly payment for the rest of your life creates a dependable source of income. 9. To maintain a predictable cash flow in your retirement years, pay off your consumer and credit card debt before you retire, and don‘t borrow money during retirement unless you know precisely how you‘ll pay it back. 10. Spending your 401(k) savings before you retire has a negative impact on your ability to pay for your retirement.
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At-Risk Middle Americans‘ acceptance of these realities is the first milestone in manifesting the sought-after behavior change on how to first finance retirement and then decumulate assets. To help At-Risk Middle Americans maneuver this behavior change, think tank participants crafted specific universal retirement decumulation guidelines within each of the eight decision zones: Work Social Security The house Insurance products Defined benefit pensions Defined contribution plans Debt Fraud The process of defining these decision zones and the most important consumer guidelines to be considered within each one began well before NEFE‘s think tank event. Participants in the roundtable gathering identified several of the areas in which Americans make critical—and often irrevocable—decisions about initiating and paying for their retirement. Then, when NEFE followed up the roundtable by asking the Center for Retirement Research at Boston College to conduct a review of available academic literature, the center was also asked to articulate the most commonly proposed consumer guidelines within the decisions zones. In preparing for the think tank, NEFE expanded the research to also include an assessment of guidelines most often quoted by news and personal finance media. In research presentations and breakout work groups, NEFE‘s think tank experts dissected, debated, and defended countless considerations and specifics regarding which guidelines are the most important to be communicated to At-Risk Middle Americans. NEFE‘s team then consolidated and summarized the group‘s general consensus as a strategic message document, which was circulated to all think tank experts for even more discussion, revisions, and additions. After several months, NEFE‘s considerable facilitation efforts produced a single, easy-tounderstand set of the most important guidelines for all Middle American consumers—at-risk and not—to follow in preparing and paying for their retirement. Following are the critical messages that NEFE hopes the leadership community will help communicate as NEFE engages business, government, and consumer organizations in a collective effort to avert a potentially catastrophic retirement crisis. The first set outlines 10 overarching practical pointers, which are the most basic decumulation rules.
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10 Critical Messages for Individuals Approaching or In Retirement 1. It is up to you to educate yourself and have a realistic plan to pay for your retirement years. 2. Start your planning with the realistic assumption that you must spend dramatically less once you retire. Costs probably will be higher and your disposable income likely will decrease due to inflation. 3. For best results, think in terms of saving for and creating a monthly ―retirement paycheck‖ for yourself. 4. Get advice from a qualified financial planner on how best to use your retirement assets, including your pension, 401(k), and the value of your home. 5. Working longer and delaying Social Security up to age 70 will dramatically improve your quality of life by giving you the ―Retirement Triple Play‖: You will receive a much larger overall monthly benefit, and all Social Security retirement benefits are adjusted for inflation You will keep adding to your retirement nest egg instead of depleting it too quickly You may keep your health-care benefits longer 6. Aim to work until you‘re at least 66, but save and plan your spending as if you were going to retire at 60. 7. You do not know whether your retirement will last less than 10 years or more than 40 years. To be prepared for reaching advanced age, continue saving and making wise investments even during your retirement. 8. Have a plan for health-care coverage and out-of-pocket medical and health-care expenses. 9. If at all possible, pay off your mortgage and otherwise reduce your housing costs before retiring. Likewise, don‘t retire if you still have credit card and other consumer debt. 10. Never forget that your retirement money is being targeted by sophisticated con artists, Internet fraud, and financial scams. Make no decisions too quickly, and never without double-checking the facts. Live by the rule that if it sounds too good to be true, it almost always is.
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Guidelines Within Each Decision Zone In addition, messages were developed specifically for each decision zone. Guidelines for the eight critical decision zones follow:
Work If you are healthy, don‘t stop working until you prove you can afford to. Aim to work at least until your full retirement age (66 to 67). It produces many benefits, including: o Prolonging any health-care coverage you have o Building your retirement assets o Increasing your ability to reduce your debt If you are considering phased retirement, know what impact scaling back will have on your retirement income, health-care coverage, job security, and other life situations. Part-time work is a good way to supplement your retirement income.
Social Security Deciding when to begin taking Social Security benefits is one of the key decisions that determines if you will have enough money for your retirement years. If you are near retirement age, it is not wise to make decisions about how you should pay for retirement based on fear that the U.S. Government can‘t afford Social Security payments. The earlier you take your Social Security benefits, the less monthly income you will receive during your retirement years. If at all possible, do not begin taking Social Security until you are at least your full retirement age (66 to 67). If you take Social Security benefits at age 62, your benefit will be approximately 25 to 30 percent less (depending on your age) than if you had waited until your full retirement age. Claiming Social Security at age 70 produces a monthly payment that is at least 75 percent higher than if you started taking benefits at 62. If you wait to receive benefits until after your full retirement age, your monthly benefit continues to increase until you reach age 70. If you delay receiving benefits until age 70, you‘ll get 32 percent more monthly benefit than you would at full retirement age (66 to 67).
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The House A house may be your biggest asset, but be careful about viewing the value of your house as if it were your retirement plan. Housing prices fluctuate. You need other forms of savings. If at all possible, plan to pay off your mortgage before you retire. Reverse mortgages may be useful in some situations, but make sure to thoroughly investigate all charges, fees, and other options. The amount you will be able to borrow is usually based on a number of factors including age, equity in your house, and the prevailing interest rate. Plan so that you do not need to use home equity. However, if it‘s necessary, the way you use your home equity to help pay for your retirement years should not be an emotional decision, but one based on research and your personal needs. As in all complex financial matters, get advice from a qualified financial planner about your best options.
Insurance Products Use your employer-provided health-care coverage as long as possible. Then, after age 65, purchase Medicare Parts B and D. Part B covers most doctor, hospital, and related expenses. Part D provides a prescription drug benefit. Understand that Medicare is not a free pass; in fact, it may only pay about half of your health-care expenses. Still plan to save for out-of-pocket expenses and premiums, some say as much as $225,000. Examine long-term health-care insurance options carefully to make the right choice for you. It is wise to get unbiased professional advice about all of your options. Insurance companies sell many forms of annuities (financial products that provide a guaranteed monthly income for your lifetime). Study them carefully. It may be a good idea to have some portion of your savings in an immediate fixed annuity, but they come with different costs, benefits, and provisions. Study and compare these products carefully. If you buy an annuity, get one at a reasonable cost that is adjusted for inflation. Don‘t purchase insurance or investment products unless you understand how they work. Most retired Americans do not need life insurance, except perhaps to cover burial expenses.
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Defined Benefit Pensions Your employer pension is an annuity that gives you a steady ―paycheck‖ for your retirement. Be sure you understand the terms of accepting early retirement incentives and lump-sum payouts in lieu of the annuity. If you take a lump-sum pension payment from your employer, you are likely to be tempted to spend it more rapidly than you should. Instead, invest it carefully. To protect yourself from inflation, save some of your pension benefits to ensure you have enough money for your advanced elderly years.
Defined Contribution Plans In most cases, you should not ―cash out‖ your retirement 401(k) savings to receive a lump sum before age 59½. This always will cost you money, and there are far better ways to pay yourself through all of your retirement years, including using a rollover or keeping money in your company plan. Always consider how much risk you can tolerate in making your investments. Even at retirement, most people still need to invest to create diversified assets that may need to last for decades. This will also help you weather market turmoil. Consider investing part of your retirement savings in a fixed annuity that gives you a steady ―paycheck‖ for your entire retirement. Be aware that in general, annuities can be complex financial products. Get good advice about how to best invest your assets to fit your personal situation. When you retire, have a portion of your assets still invested in stock funds to capture growth opportunities and protect against inflation. The amount you withdraw for living expenses is critical. Don‘t withdraw too much. Aim to have enough money for at least 30 years of retirement. Don‘t withdraw more than 4 percent of your savings in the first year. To calculate withdrawal amounts every subsequent year, multiply the percent you withdrew the first year by 1.03. In an economic downturn, consider using a lower withdrawal rate. As a precaution, set aside at least a year‘s worth of living expenses to protect against having to sell investments at low values to raise cash.
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Debt Do not enter your retirement years with credit card or other consumer debt. If possible, pay off your entire mortgage by retirement. Do not take on new debt prior to or during retirement without a realistic plan to pay it off. Consider the 10 years before retirement as your ―debt-reduction decade.‖
Fraud Older Americans—even those who are experienced with investing and financially literate—are highly targeted by scammers, con artists, misleading advertising, and fraud, so be especially on guard. Recognize that most fraud is committed by people whom the victims know—friends, neighbors, members of social and religious institutions, and people they‘ve done business with before. Never give in to pressure tactics. Make no major money decisions quickly, and never without getting a second or third opinion from people you trust. Investigate every financial decision thoroughly. If you suspect you may be targeted for fraud, immediately contact authorities. Remember that if something sounds too good to be true, it almost always is. Help elder family members and friends to ensure that they are not taken by fraud, suspicious relationships, or other manipulative attempts to get money from them.
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Where We Go from Here No doubt you‘ve noticed the explosion of new product rollouts and marketing aimed at the huge bubble of baby boomers preparing to enter the third—and most complicated—phase of their financial lives. Add to this the unsettling devaluation of assets resulting from the global financial crisis of 2008–2009, and it is easy to see how a growing percentage of retirement-minded middle class Americans may be sufficiently inclined to rethink how they go about planning for and financing their retirement years. We also have seen the federal government, financial planning experts, and news media start to weigh in on the idea that working longer and taking Social Security later will help ensure financial well-being into old age. These are all very positive steps, especially given the current economic situation. But things are far more complicated for At-Risk Middle Americans, the majority of whom make decisions rooted in fear, lack of knowledge, and a growing distrust of financial institutions, exacerbated by the current financial crisis. Whether by design or default, the specifics of how these households will manage to pay themselves a regular ―retirement paycheck‖ will go unanswered unless we work together to reach At-Risk Middle Americans. NEFE is working to reach At-Risk Middle Americans through a consumer Web site called decumulation.org. It is our primary vehicle to disseminate the messages resulting from the think tank. On the home page, one main question is asked: ―What is My Retirement Paycheck?‖ Users are informed right away that decumulation.org is dedicated to helping them optimize their retirement paycheck. The phrase ―retirement paycheck‖ describes the notion of retirement income decumulation in a way that is at once relevant and practical. In the context shown in the following graphic, determining one‘s retirement paycheck involves a holistic approach. That‘s what decumulation.org aims to accomplish: it provides a holistic and comprehensive collection of guidelines, articles, and additional links and resources to help At-Risk Middle Americans become informed, active participants in their retirement decisions.
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Beyond the guidelines for each decision zone (which underwent revisions to be more engaging and Web-friendly for the consumer), users can access short articles that provide more in-depth information about special situations and considerations within each of the eight areas. At the time of the think tank in December 2007, few could have predicted the economic crisis that unfolded in 2008. The current economy has increased the awareness and interest in retirement income decumulation and has provided cause for an additional set of messages.
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Guidelines During Times of Economic Hardship All market declines come to an end; this one will, too. Therefore, exercise patience and self-control. If you are approaching retirement in a severe market downturn, it may be wise to postpone retirement until market conditions improve. If you are in retirement during a severe market downturn, significantly decrease your draw-down rate until market conditions—and your portfolio—improve. During an economic downturn, be especially cautious and conservative in your spending patterns. As a precaution, set aside at least one year‘s worth of living expenses to protect against having to sell investments at low values to raise cash. NEFE‘s think tank challenged the whole notion of retirement. It provided the spark to a national conversation on getting the word out for essential truths that must be believed and decisions that must be made to improve the quality of retirement years for at-risk households—and by extension, all Americans. Working together, we will turn these messages into action that benefits us all.
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About NEFE The National Endowment for Financial Education® (NEFE®) is leading the effort to develop and disseminate principles and essential retirement income decision guidelines for at-risk Americans. NEFE is the only private, nonprofit, noncommercial, nonpartisan national foundation wholly dedicated to improving the financial well-being of all Americans through financial education. It places special emphasis on underserved audiences who face financial challenges not being addressed by others. To best serve these audiences and provide them with the most accessible, meaningful, and up-to-date financial education possible, NEFE collaborates with experienced and knowledgeable leaders of financial institutions; financial planning practices; academia; national, regional, and local foundations and nonprofits; and state and federal governments. NEFE provides funding, logistical support, and personal finance expertise to develop a variety of materials and programs, including the award-winning High School Financial Planning Program® (HSFPP), the CashCourse college program, and the consumer-oriented smartaboutmoney.org Web site. NEFE funds research and awards research-based development grants that advance innovative thinking and contribute to our understanding of financial behavior. NEFE also serves segments of the American public in need of specialized financial information through partnerships with numerous organizations. www.nefe.org www.smartaboutmoney.org www.decumulation.org
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Appendix In preparation of the Retirement Income Decumulation Think Tank, NEFE commissioned the Center for Retirement Research at Boston College to complete an academic literature review that reveals what is known and what is not known about issues surrounding retirement income decumulation. Anthony Webb and Alicia H. Munnell prepared the ―Literature Survey Report on Retirement Decisions.‖ Anthony Webb is a Research Economist with the Center for Retirement Research (CRR) at Boston College. Alicia H. Munnell is the Director of the CRR and the Peter F. Drucker Professor of Management Sciences at Boston College‘s Carroll School of Management. Excerpts from the ―Literature Survey Report on Retirement Decisions,‖ completed in October 2007, follow.
Overview Background. The retirement landscape is shifting so that baby boomers and younger generations will face more decisions than previous generations about how to manage their assets in retirement. Poor choices can have serious consequences for a household‘s standard of living. Low-income households could be deprived of necessities, while higher income households could see their lifestyle fall far short of expectations. Shortfalls could also shift burdens to other family members or to the government. Goal. This report will help a group of experts derive rules of thumb, based on a review of the relevant academic literature, that will do more good than harm. It will incorporate findings from economic research, behavioral finance, and survey data.
1. Work The Facts Age of Retirement. Labor force participation rates among older men declined dramatically during the twentieth century. The gainful employment rate fell from 78.0 percent among men aged 65 plus in 1880, to 43.5 percent in 1940, while the labor force participation rate fell from 41.8 percent in 1940 to 16.3 percent in 1990. Figure 1 shows both male and female labor force participation rates over the last half century. Although the introduction of Social Security and the development of employer pensions contributed to the decline in the participation rate of males, the decline predated these developments and was a response to industrialization and rising living standards. In contrast, labor force participation rates increased among older women during the above period, reflecting the more general increase in female labor force participation.
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19 50 19 55 19 60 19 65 19 70 19 75 19 80 19 85 19 90 19 9 20 5 00 20 05
90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
Men 6 5+ Men 55-6 4
Wom en 6 5+ Wom en 55-6 4
Figure 1. Labor Force Participation Rates by Age and Sex, 1950-2006 (Annual) Source: U.S. Census Bureau, Current Population Survey, 1950-2006
Figure 1 shows that labor force participation among older men flattened out in the 1980s and early 1990s and has since shown signs of increasing. Participation rates among women aged 5564 continued to increase, with a brief hiatus in the 1970s and early 1980s. Phased Retirement. Although a majority of older workers express a desire to gradually reduce their hours as they age, the actual incidence of phased retirement is very low, and usually involves a change of employer.8 Phased retirement results in a reduction in earnings, and for many workers will necessitate a change of employer unless in-service distributions are permitted. The Pension Protection Act of 2006 changed federal tax law permitting, but not requiring, employers to modify their defined benefit pension plan provisions so that a worker who has reached age 62 can receive such distributions. Employers with defined contribution plans were already permitted to allow active employees to take withdrawals, subject to the tax penalty applicable to withdrawals taken earlier than age 59½, although it would appear that only about half of plans permit such distributions even by those older than that age. Buy Outs. Buy-out offers are employer-provided incentives to take early retirement. They may take the form of lump sums, increases in pension benefits, and health insurance. Academic Literature Age of Retirement. There is a substantial literature that considers why the age of retirement now appears to be increasing. Explanations include relaxations in the Social Security earnings test,9 a desire to retain health insurance coverage during a period of increasing medical costs,10 the 8
Hutchens (2007).
9
Friedberg (2000); and Friedberg and Webb (2006).
10
Gruber and Madrian (1994).
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displacement of defined benefit pension plans (whose design has been shown to encourage early retirement), by 401(k) and other defined contribution plans that lack these age-related retirement incentives,11 and some increase in the use of part-time and bridge jobs on the path to full retirement.12 The inadequacy of household financial preparedness for retirement is well documented. Where feasible, working longer is a powerful antidote to inadequate saving. Research shows that simply continuing to work from age 63 to 65 can reduce the number of households with inadequate retirement incomes by ten percentage points.13 However, research also shows that a substantial minority of households experience involuntary withdrawal from the labor market, usually as a result of layoff or ill health. These households are not only unable to work during what would otherwise be their prime saving years, but also have to make their savings stretch over a longer than anticipated retirement, resulting in sometimes substantial declines in consumption at retirement.14 Phased Retirement. Phased retirement appears to be a concept that works better in theory than in practice. Research shows that both workers and their employers may suffer fixed costs of labor force participation that make part time work unattractive.15 Variations in fixed costs of labor force participation may explain why phased retirement often involves a change of employer and/or occupation and a reduction in the hourly wage. The structure of defined benefit pension plans, whose benefits are usually based on preretirement earnings, may also hinder phased retirement, as may health insurance. ERISA does not impose explicit non-discrimination requirements on health insurance plans, and employers could, for example, restrict coverage to older part-timers by imposing a tenure test. But employers may be reluctant to discriminate in this way.16 Buy Outs. Research shows that the incidence of early-out incentives peaked in the mid-1990s at around five offers for every 100 workers aged 55 to 59, and subsequently declined. Cash offers averaged six to eight months‘ salary.17 Offers that included enhancements to pension benefits were somewhat more generous. Recipients of early-out incentives were typically career employees with defined benefit pension plans who were close to retirement. About one third of recipients accepted their offers. Recipients were less likely than non-recipients to remain in the labor force, although the magnitude of the difference declined over time, and may reflect a selection effect. 11
Friedberg and Webb (2005).
12
Ruhm (1990).
13
Center for Retirement Research at Boston College (2006).
14
For a review of the literature, see Hurd and Rohwedder (2006).
15
Hamermesh (2005).
16
Hutchens (2007).
17
Brown (2002).
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Gaps in Research Researchers typically characterize retirement as irreversible. In reality, there is a substantial amount of re-entry into the labor market. Little is known about the factors that affect re-entry— whether it is a response to boredom, financial shocks, a misjudgment of financial preparedness for retirement, or labor demand shocks. What People Do in Practice Most individuals in defined benefit pension plans retire by age 62, and most other workers by age 64. As mentioned above, only a minority of employees take phased retirement.
2. Social Security The Facts Currently, an individual can claim retired worker benefits between ages 62 and 70. The Full Retirement Age (FRA), at which full benefits can be claimed, is 66 for individuals born between 1943 and 1954 and will rise gradually to 67 for individuals born in 1960 or later. The procedure to calculate benefits involves four steps. First, a worker‘s previous earnings are restated in terms of today‘s wages to reflect wage growth. Second, earnings for the highest 35 years are averaged and divided by 12 to arrive at Average Indexed Monthly Earnings (AIME). Third, the Social Security benefit formula is applied to AIME to produce the Primary Insurance Amount (PIA), the benefits payable at the FRA. The formula is designed so that it replaces a larger proportion of low wage earners‘ lifetime income. Finally, benefits claimed before the FRA are actuarially reduced while those claimed after the FRA are increased. Upon attaining age 62, a spouse of a retired worker who has claimed benefits can claim a spousal benefit if that amount exceeds the amount payable by reason of his or her own earnings record. The amount of the spousal benefit equals 50 percent of the retired worker‘s Primary Insurance Amount, subject to an actuarial reduction if claimed before the claimant‘s FRA. There is no delayed retirement credit for the spousal benefit. Spouses of deceased workers are also entitled to a survivor benefit of 100 percent of the primary worker‘s benefit if that exceeds their own benefit, and subject to an actuarial reduction if the survivor benefit is claimed before the spouse‘s Full Retirement Age. Social Security claimants suffer a reduction in benefits if they earn more than $12,960 in years before they attain the FRA or if they earn more than $34,400 between January 1 of the year they attain their FRA and the date they attain that age. There is no reduction of benefits with respect to earnings in periods after that date. Future benefits are actuarially increased to compensate so that, in theory, the earnings test should not affect a non-liquidity constrained individual‘s labor supply.
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Summary of Academic Literature Researchers have calculated the claiming age or combination of claiming ages that maximizes the expected present value of lifetime benefits for individuals and couples.18 This literature shows that—in theory—people with short life expectancy should claim early and people with long life expectancy should claim later. For single people, it suggests that men should claim early and women should claim later. But married women should generally claim immediately because the period over which they receive their own benefit will typically end when their husband dies. Married men should postpone claiming if their goal is to maximize the household‘s lifetime benefits because delay increases not only the value of their own benefit, but also that of the survivor benefit. In a forthcoming study, other researchers quantify the benefit of delay for a nationally representative sample of individuals born between 1931 and 1941.19 They confirm the findings of the previous study, but find that the benefits of delay were typically small. For the average couple, delaying claiming from age 62 until the optimal age would increase the expected present value of benefits by under 4 percent. The study shows that although the age of claiming has little effect on the expected present value of total benefits, it has a substantial effect on the proportion of those benefits that is paid to the surviving widow. A rational and far-sighted household that chose to claim early would compensate for the smaller Social Security benefit by accumulating an appropriate additional amount of financial wealth during the husband‘s lifetime for consumption by his widow. Few households are both rational and far-sighted, and research shows that early claiming by the husband is associated with an increased risk of widow poverty.20 In another study, researchers show that the favorable tax treatment accorded to Social Security provided a further incentive to most retired taxpaying households to delay claiming, even when this necessitated drawing down tax-preferred financial assets.21 Households that delay claiming are able to obtain additional amounts of longevity insurance on approximately actuarially fair terms. The calculations of expected present value fail to take account of the value of this insurance and understate the optimal delay.22 A substantial body of literature concludes that the Social Security earnings test significantly reduces labor supply.23
18
Munnell and Soto (2005).
19
Sass, Sun, and Webb (2007 forthcoming).
20
Gruber and Orszag (1999).
21
Mahaney and Carlson (2007).
22
Coile, Diamond, Gruber, and Jousten (2001).
23
Friedberg and Webb (2006).
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Gaps in Research Social Security will have a lower expected present value to high-mortality households. But it is not clear to what extent the household‘s mortality beliefs should influence its claiming decision once account is taken of the longevity insurance value of Social Security, as even high-mortality households usually face at least some risk of surviving to advanced old age. What People Do in Practice Most claim their benefits as soon as possible and almost all before the Full Retirement Age (see Figure 2). 70% 60%
Women Men
59% 54%
50% 40% 30%
23% 17%
20%
11% 8% 8% 10%
10%
6%
4%
0% 62
63
64
65
66 and over
Figure 2. Percent Distribution by Age of Initial Social Security Benefit Awards, 2005 Source: Munnell and Soto (2005) calculations from U.S. Social Security Administration (2007)
3. The House The Facts Most households enter retirement owning their home. It is usually their largest asset apart from Social Security and in most cases is owned mortgage free. In 2004, 83.3 percent of households 65 and older were homeowners, with a median house value of $140,000. Only 30.4 percent of these households had a mortgage, and the median balance was only $43,000.24 Most households appear to show a desire to ―age in place.‖ This desire is evidenced by the small percentage of households that move, let alone migrate to sunnier climes, and the persistence of high home ownership rates into advanced old age, with the house typically being sold only after a precipitating shock such as entry into long-term care or the death of a spouse. 25 26
24
Munnell, Soto, and Aubry (2007).
25
According to the AARP, 1990 and 2000 Census Special Tabulation on Aging, Administration on Aging, only 22.8 percent of individuals aged 60 and above in 1990 moved during the previous five years. The corresponding figure for 2000 was a similar 23.8 percent. In both years, only 4.5 percent moved to a different state.
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Nor is there much attempt to access housing equity. Homeowners do as much trading up as trading down. And, although take-up of reverse mortgages has grown rapidly, only 43,131 loans were granted in 2005.27 Summary of Academic Literature The existing literature is mostly descriptive. In addition to documenting trends in home ownership, it reports that the average household could increase consumption by 10 percent, and low-income households by as much as 25 percent through a reverse mortgage.28 Recent research has shown that the amount that can be borrowed against the eventual sale proceeds, which depends on house prices and interest rates as well as on the ages of the members of the household, is subject to considerable volatility. Figure 3 shows the percentage of a $200,000 house that could have been borrowed on a reverse mortgage from 1975 to 2005 at ages 65, 75, and 85, assuming that reverse mortgages had been available throughout that period. The very low percentages in the early 1980s reflect the exceptionally high interest rates at that time. But the amount that could be borrowed has fluctuated considerably even in recent years, and households should not view housing equity as a substitute for adequate savings in financial assets. 29
05 20
02 20
9 19 9
6 19 9
3 19 9
0 19 9
7 19 8
19 8
4
1
Age 6 5 Age 75 Age 85
19 8
19 75 19 78
80% 70% 6 0% 50% 40% 30% 20% 10% 0%
Year Figure 3. Percentage of House Value That Could Be Borrowed at Ages 65, 75, and 85, 1975-2005 Notes: 1) This figure assumes a $200,000 house, a 1.5 percent lender’s margin and the closing cost estimates used in AARP’s online reverse mortgage loan calculator. 2) HECM loans have only been available since 1990, so
26
Venti and Wise (2004).
27
Reverse mortgages are loans available to households aged between 62 and 90, the interest on which is rolled up and repaid on death or earlier sale of the property. Take-up equals annual origination volume for Home Equity Conversion Mortgages to 30 September each year reported by U.S. Department of Housing and Urban Development and available at www.nrmlaonline.org. 28
Venti and Wise (1991); and Rasmussen, Megbolugbe, and Morgan (1995).
29
Sun, Triest, and Webb (2007).
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amounts for 1975 to 1989 represent the percentages that could have been borrowed had they been available. Source: Eschtruth, Sun, and Webb (2006)
Gaps in Research Recent research shows that baby boomers have more valuable homes than previous birth cohorts, but also have larger mortgages.30 It is not clear to what extent this additional debt has been consumed or invested in financial assets, and to what extent changes in tastes and preferences, financial deregulation, and declines in nominal interest rates, which increase effective mortgage duration, have affected household behavior. It is therefore extremely difficult to extrapolate boomers‘ gross housing wealth and mortgage debt to retirement. Although numerous studies have explored optimal asset decumulation strategies, these almost invariably focus solely on financial assets and ignore the house. But the optimal portfolio of financial assets of a homeowner is likely to differ from that of a similarly wealthy renter who faces higher fixed costs in retirement and rental uncertainty. Even among owners, the optimal portfolio allocation will likely differ depending on whether the house is held solely for the flow of housing services it provides or whether the household intends to tap the balance of the value of the house through a reverse mortgage. Calculations of the additional income that households could obtain from a reverse mortgage typically assume that the house would otherwise pass as an unintended bequest. But little is understood about households‘ motivations for retaining housing equity or the true strength of the bequest motive. Recent survey data suggest that one motivation for retaining ownership of the home may be that it functions as self-insurance against medical and long-term care costs.31 However, although patterns of housing wealth decumulation are well-documented, it is unclear what proportion of housing wealth is, in fact, spent on such costs. This uncertainty makes it difficult to make recommendations with regard to reverse mortgages. If housing wealth would otherwise pass as an unintended bequest, then the amount that can be borrowed represents ―found money.‖ But if housing equity functions as self-insurance against end-of-life expenditure, then households need to consider their expenditure priorities, and whether that insurance can be more effectively obtained in the insurance market. What Most People Do in Practice Most households enter retirement with little or no mortgage debt, and ―age in place‖ for as long as their health and finances permit. Only a small minority tap their housing equity through reverse mortgages.
30
Coronado, Maki, and Weitzer (2006).
31
Munnell, Soto, and Aubry (2007).
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4. Insurance Products The Facts Long-term Care Insurance. A 65-year-old man has a 27 percent chance of requiring long-term care at some point, and a 65-year-old woman a 44 percent chance.32 In 2000, the average cost of nursing home care was $143 a day. Only about 10 percent of the elderly have long-term care insurance, and this insurance covers about 4 percent of total expenditures. Medicaid provides means-tested insurance. Single individuals must spend down almost all their assets before qualifying for Medicaid, but non-institutionalized spouses are protected by spousal protection rules. These rules protect the house and between $20,328 and $101,640 of financial assets, depending on the state of residence. Medicare and Medigap Policies. Part B of Medicare covers medical care and services provided by doctors and related expenditure. Beginning in 2007, individuals with incomes over $80,000 and couples with incomes over $160,000 face higher premiums. Part D of Medicare covers prescription drugs. Medigap policies insure the health care costs and co-pays not covered by Medicare. Life Insurance. Seventy-eight percent of elderly married households own some kind of life insurance; 50 percent own term-life policies, and 57 percent own whole life policies. 33 The median policy size is only $10,756. Summary of Academic Literature Long-term Care Insurance. Simulation models show that Medicaid crowds out even actuarially fair long-term care insurance and imposes a substantial implicit tax on the purchase of such insurance, even for households with a bequest motive and strong preference for non-Medicaid care.34 Medicare and Medigap Policies. Although the take-up of Medicare Part D appears quite low, this reflects high levels of pre-existing coverage. Taking account of coverage under Medicare HMOs; employment-based coverage, and Medicaid, almost 93 percent of Medicare eligible individuals now have some kind of prescription drug coverage, up from 79 percent before the program was introduced.35 Respondents‘ stated reasons for declining Part D suggest that people knew what they were doing and that confusion was not a significant factor, although there appears to be a low level of take-up for the low-income subsidy among eligible households. Although only 28 percent of households have Medigap coverage, supplementary coverage increases to 89 percent once account is taken of coverage under Medicare HMOs, Medicaid, and
32
Brown and Finkelstein (2004).
33
Brown (1999).
34
Brown and Finkelstein (2004).
35
Levy and Weir (2007).
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employment-based retiree-health plans. Low-income households are somewhat less likely to have any form of supplemental coverage.36 Life insurance. Research shows that many of the insurance policies held by the elderly are retained primarily as investments.37 Others are ―burial money,‖ designed to provide family members with timely funds prior to the liquidation of the deceased‘s estate. Yet others are term policies acquired at younger ages on which premiums are no longer payable. Gaps in Research The Medicare Part D program is relatively new, and the research findings must be regarded as preliminary. One researcher has proposed using home equity to fund the purchase of long-term care insurance.38 Many of the criticisms made of long-term care policies generally, and discussed below, apply to this proposal, and while recognizing its merits, the authors cannot currently recommend it. What Most People Do in Practice The rate of take-up of long-term care insurance remains extremely low. Medicare Part B coverage is almost universal. Almost all elderly households have some form of prescription drug coverage and insurance covering the gaps in Medicare.
5. Defined Benefit Pensions The Facts In contrast to defined contribution plans, where participation is voluntary and benefits depend on both contributions and the returns on the investments selected by the participant, participation in defined benefit plans is mandatory, and benefits are a function of salary, retirement age, and years of service. Benefits are usually paid in the form of a lifetime income. Only a very small proportion of defined benefit plans have automatic or indeed any cost-of-living adjustment.39 At a 2.5 percent inflation rate, a couple aged 60 faces a 43.4 percent chance of surviving long enough to see the real value of their pension halved.40 Federal law requires that married employees receive benefits in the form of a joint life annuity unless the employee‘s spouse consents to an alternative. An increasing proportion of plans allow commutation of benefits to a lump sum—up from 15 percent in 1995 to 43 percent in 2000 and
36
Pourat, et al. (2000).
37
Brown (1999).
38
Stucki (2006).
39
Munnell and Sundén (2004).
40
Authors‘ calculation based on Social Security Administration population mortality tables for the 1947 birth cohort.
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50 percent in 2005—reflecting conversions of traditional defined benefit plans into cash balance plans. 41 There has been little change in overall pension coverage in recent years, but defined contribution plans have largely displaced defined benefit plans as the dominant form of pension provision (see Figure 4). 70 %
6 3%
6 2%
1983
60%
1992
50 %
2004
44% 40 %
40 % 26 %
30 % 20 % 20 %
12%
17% 16 %
10 % 0% Defined benefit only
Defined contribution only
Both
Figure 4. Workers with Pension Coverage by Type of Plan, 1983, 1992, and 2004 Sources: Munnell, Webb, and Golub-Sass (2007); and updates based on the U.S. Board of Governors of the Federal Reserve System, Survey of Consumer Finances (various years)
Summary of Academic Literature Research shows that the benefit formulas in defined benefit plans act as powerful incentives encouraging early retirement, with participants retiring an average of two years earlier than otherwise similar workers in defined contribution plans.42 Research shows that early-out offers peaked in the mid-1990s at a rate of five offers per 100 workers aged 55 to 59, one-third of which were accepted.43 Offers are typically made to career workers close to retirement, and accepted offers tend to be those with the most generous cash incentives, and enhancements to pension and retiree health benefits. Research shows that households that receive their income in annuitized form are more satisfied with the quality of their retirement.44 Research shows that the great majority of married men (72 percent), but only a minority of married women (31 percent) choose a joint life and survivor annuity.45 This research found that 41
Bureau of Labor Statistics (2000 and 2005).
42
Friedberg and Webb (2005).
43
Brown (2002).
44
Panis (2003).
45
Johnson, Uccello, and Goldwyn (2003).
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retirees appeared to make their decisions based on a rational weighing of costs and benefits, with employees being more likely to choose a single life annuity when their spouse had other sources of income or was unlikely to outlive them. Gaps in Research A substantial literature documents, but does not explain, the very low rates of voluntary annuitization of defined contribution plan balances. There has been almost no corresponding research into the behavior of members of defined benefit plans when faced with a similar choice but who likely face different defaults and trade-offs. This question assumes increasing importance as traditional defined benefit plans are converted into cash balance plans. One study found that only 13 percent of men and 19 percent of women born between 1931 and 1941 who left a defined benefit pensioned job between 1992 and 2000 took a lump sum.46 But the researchers were unable to estimate a take-up rate among households eligible to take a lump sum because they had no means of determining eligibility for lump sums. If only a small proportion of older workers with defined benefit pension plans are eligible for lump sums, then the take-up rate among those eligible may be quite high. In fact, evidence suggests that eligibility rates may be quite low. Although traditional defined benefit plans sometimes offer a lump sum option, they are much less prevalent than in cash balance plans. If sponsors converting to cash balance plans allow older workers to remain in the traditional plan, then only a small proportion of older workers may be eligible to take a lump sum. A potentially significant finding was that households with small amounts of pension wealth were more likely to take a lump sum, although it was not clear whether this reflected differences in eligibility or preferences. Little is known about how households manage the risk of defined benefit plan benefits being eroded by inflation. This question can only be answered as part of a more general investigation of how households manage wealth decumulation and financial risks in retirement. The measurement of wealth decumulation requires high quality panel data covering an extended period of time, and currently available data are of insufficient quality and duration to yield reliable estimates. What Most People Do in Practice Most participants in defined benefit plans retire around age 62 and take a joint life and survivor pension that is fixed in nominal terms.
6. Financial Assets The Facts Stocks have historically earned a higher return than bonds, but are more risky. The additional return is sufficient to justify all but the most risk averse households holding at least part of their
46
Johnson, Uccello, and Goldwyn (2003).
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wealth in stocks. But in 2004 only 48.6 percent of households owned any stocks at all, in pension or non-pension accounts.47 In 2004, 83.3 percent of households 65 and older were homeowners, with a median house value of $140,000. Home equity is rarely spent on general non-housing consumption, and the take-up of reverse mortgages, although increasing, remains low. Households should hold heavily taxed assets within 401(k) and other tax-preferred accounts and less heavily taxed assets in taxable accounts. Rates of voluntary annuitization are extremely low.48 To the limited extent that households annuitize, they choose fixed level annuities in preference to inflation-protected and variable immediate annuities.49 Summary of Academic Literature Recently developed dynamic models of portfolio allocation confirm the folk wisdom of financial planners that long-term bonds are the true risk free asset, because over a long time horizon, the household cares about security of income, not security of capital.50 It has proved quite difficult for academic researchers to translate this finding into decision rules that can be followed by households and their advisers. The household‘s portfolio choice problem is generally not analytically tractable and must be solved numerically. Many such models make unrealistic assumptions, for example that the household faces an all or nothing annuitization decision immediately on retirement, that variable immediate annuities are not available, or that household consumption plans cannot be amended in response to realized investment returns. The most recent research remedies these defects and demonstrates the benefits of partial and gradual annuitization and the use of variable immediate annuities that provide the holder with both longevity insurance and the equity premium.51 Early research argued that households should hold highly taxed bonds in tax-preferred accounts and equities in taxable accounts.52 More recent research has produced more equivocal conclusions, with results depending on such factors as anticipated tax rates and frequency of trading.53 Other research indicates that most households do not locate their financial wealth
47
Bucks, Kennickell, and Moore (2006).
48
The authors are referring to immediate annuities. Sales of deferred annuities are many times higher. Immediate annuities can provide a higher return than equivalent unannuitized investments because wealth is reallocated from those who die young to those who live exceptionally long. A deferred annuity lacks this essential characteristic. 49
Poterba (2001).
50
Campbell and Viceira (2001).
51
Horneff, et al. (2007).
52
Shoven (1999).
53
Dammon, Spatt, and Zhang (2002); Huang (2001); Poterba, Shoven, and Sialm (2001); and Shoven and Sialm (2004).
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efficiently, although the potential gains from reallocation are likely to be small, reflecting the low average levels of non-pension financial wealth.54 A substantial literature calculates the value of annuitization to risk-averse households facing an uncertain lifespan. This literature assumes households and insurance companies selling annuities are able to invest in a single risk-free asset. It finds that single individuals with no pre-annuitized wealth should annuitize immediately on retirement, but that married couples should delay. Households currently entering retirement generally hold a large proportion of their wealth in preannuitized form through defined benefit pensions and Social Security, and this tendency is often sufficient to crowd out additional annuity purchases.55 Recent research shows that rates of decumulation of financial wealth increase with age and are lower among those with high lifetime incomes.56 It attributes these relationships to medical expenses that rise rapidly with age and permanent income. Gaps in Research Although there have been dramatic advances in dynamic portfolio choice models, they still suffer from a number of important deficiencies. First, they ignore the house, the average household‘s most important asset. Second, they generally ignore Social Security and defined benefit pensions. These assets provide the household with longevity insurance but, in the case of defined benefit pensions, expose it to inflation risk. Third, they ignore medical expenditure shocks and the resultant need to retain liquidity. Economic theory predicts that even the most risk-averse households should hold at least part of their financial wealth in stocks. The level of non-participation in the stock market is therefore puzzling and can only be explained by implausibly large fixed costs of participation. Although average rates of wealth decumulation among single individuals are consistent with the predictions of models that incorporate uncertain medical costs, it is not clear to what extent these averages may conceal excessively rapid decumulation among a minority. Many explanations have been proposed for the failure of households to annuitize. It is unclear what weight to attach to each, and therefore difficult to predict whether voluntary annuitization rates will increase as 401(k) and other defined contribution plans displace defined benefit plans among households entering retirement. What Most People Do in Practice Only a minority of households hold any equities. Voluntary annuitization is extremely rare.
54
Bergstresser and Poterba (2002).
55
Dushi and Webb (2004).
56
De Nardi, French, and Jones (2006).
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Rasmussen, David W., Isaac F. Megbolugbe, and Barbara A. Morgan. 1995. ―Using the 1990 Public Use Microdata Sample to Estimate Potential Demand for Reverse Mortgage Products.‖ Journal of Housing Research 6(1): 1-23. Ruhm, Christopher. 1990. ―Bridge Jobs and Partial Retirement.‖ Journal of Labor Economics 8(4): 482-501. Sass, Steven A., Wei Sun, and Anthony Webb. 2007 forthcoming. ―Why Married Men Claim Early: Ignorance, Caddishness, or Something Else?‖ Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston College. Shoven, John B. 1999. ―The Location and Allocation of Assets in Pension and Conventional Savings Accounts.‖ Working Paper 7007. Cambridge, MA: National Bureau of Economic Research. Shoven, John B. and Clemens Sialm. 2004. ―Asset Allocation in Tax-Preferred and Conventional Savings Accounts.‖ Journal of Public Economics, Elsevier 88(1-2): 23-38. Skinner, Jonathan. 2007. ―Are You Sure You‘re Saving Enough for Retirement?‖ Working Paper 12981. Cambridge, MA: National Bureau of Economic Research. Stucki, Barbara. 2006. ―Using Reverse Mortgages to Manage the Financial Risk of Long-Term Care.‖ North American Actuarial Journal 10(4): 90-102. Sun, Wei, Robert K. Triest, and Anthony Webb. 2007. ―Optimal Retirement Decumulation Strategies: The Impact of Housing Wealth.‖ Public Policy Discussion Paper 07-2. Boston, MA: Federal Reserve Bank of Boston. U.S. Board of Governors of the Federal Reserve System. Survey of Consumer Finances, various years. Washington, DC. U.S. Bureau of Labor Statistics. 2000 and 2005. National Compensation Survey, Table 76 and 51. Washington, DC: U.S. Department of Labor. U.S. Census Bureau. Current Population Survey, 1950-2006. Washington, DC. U.S. Government Accountability Office. 2007. Long-Term Care Insurance: Partnership Programs Include Benefits That Protect Policyholders and Are Unlikely to Result in Medicaid Savings. GAO-07-231. Washington, DC. U.S. Social Security Administration. 2007. Annual Statistical Supplement, 2006. Washington, DC: U.S. Government Printing Office. Venti, Steven F. and David A. Wise. 1991. ―Aging and the Income Value of Housing Wealth.‖ Journal of Pubic Economics 44(3): 371-397.
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