You probably aren’t even aware that you’re doing it, but you are. You are “optimizing imperfectly” when it comes to taking money from your defined benefit, 401(k), and other retirement plans.
Instead of putting some of your money earmarked for retirement in a life annuity, a product that would give you guaranteed income for life, you’re taking a lump sum. And that, according to a just-published paper from the National Bureau of Economics, may not be in your best interest.
“Guaranteed lifetime income, such as in the form of annuities, is incredibly valuable for retirees,” said Jeffrey Brown, a professor at University of Illinois at Urbana-Champaign and a co-author of the paper, Framing Lifetime Income. “It is the single best way on a risk-adjusted basis to maximize one’s ability to spend in retirement without concerns about running out of resources. Every other strategy either exposes the individual to more risk, or reduces one’s ability to consume.”
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And the reason why you are not buying annuities, according to Brown and his co-authors, has to do framing. If you think about annuities as an investment, you’ll never buy one—even if it’s the right means to an end. But if you think about annuities more as way to fund your expenses in retirement rather than an investment you just might consider buying one.
“This research shows that people value annuities when they are presented in a context where people are prompted to think about spending and consumption,” said Brown. “But when they are presented in a framework that emphasizes investment features, people tend not to like them.”
This, said Brown, is really important because the reason people save for retirement is so that they can spend and consume. “But we have built a retirement system in the U.S. that for too long has only focused on building wealth,” said Brown.
So what do other experts have to say about the paper?
John Olsen, president of Olsen Financial Group and co-author of “The Advisor’s Guide to Annuities,” agrees that consumers’ preference for or against buying an immediate annuity are subject to “framing effects.”
“… we have built a retirement system in the U.S. that for too long has only focused on building wealth.”
In essence, Olsen said the “Framing Lifetime Income” paper confirms a belief he’s held for years. “That being, annuities are all about income and that they should be discussed that way,” he said. “When a planner recommends allocating a portion of the client’s portfolio to immediate or what are sometimes called ‘payout’ or ‘income’ annuities and focuses on the annuity in terms of the portfolio as a whole, he will likely get more resistance/refusal than if he had discussed the planning in terms of the income it would guarantee, not in terms of lump sum values.”
Other factors work against annuities
Olsen also thinks other factors besides framing are working against Americans who might otherwise purchase, when appropriate, annuities. “The investment-oriented language of most 401 plan literature and documents may be creating an environment that conditions individuals to prefer lump sums over annuities,” he said.
Others share that point of view. “It’s unfortunate that we have so much framing that looks at things from the investment perspective,” said Joseph Tomlinson of Tomlinson Financial Planning. He noted, for instance, advertisements that ask viewers, “What’s your retirement number?”
What can be done to fix this? “The answers are far from obvious,” said Tomlinson.
Many employers, he said, look at offering lifetime income choices in defined contribution plans as a hassle and/or a potential legal liability. And other employers such as Ford and GM are actively pushing employees to trade in their defined-benefit pensions for lump sums. “So the tide seems to be running the wrong way,” Tomlinson said.
What’s more, Tomlinson said it’s not easy to educate consumers about matters like this. “Perhaps there’s a role for government in requiring disclosures that present defined contribution balances as both accumulations and in income terms,” Tomlinson said. “But the danger there is ending up with multi-page documents developed by committees of lawyers, which plan participants ignore.”
By way of background, lawmakers and regulators have explored laws and rules that would require retirement plans to disclose retirement account balances in term of income and some firms are providing plans participants with such information.
Anna Rappaport, president of Anna Rappaport Consulting, believes that employee benefit plan sponsors and financial advisers can play a big role in influencing what employees and clients do with their assets postretirement depending on the way they frame the conversation with them.
Olsen, for instance, plans to put the findings from the “Framing Lifetime Income” paper into practice. “After reading this paper, I think I’ll focus more on spending, rather than income—on the result of the income stream rather than the source,” Olsen said.
So what might you do or consider given the findings from the Framing Lifetime Income paper?
Two action items come to find for Rappaport. First, when contemplating what to do with the money in your various retirement accounts, think first about your expenses and how you plan to fund those expenses, and second, consider what the implications are for your assets.
Plus, you need to consider how long you need to fund your expenses, she said, noting that people often underestimate life expectancy. By way of background, research from the Society of Actuaries finds that planning horizons are too short for many people and they don’t understand longevity. Visit the SOA’s website, Longevity and Retirement, to learn more about longevity.
According to Rappaport, there’s a logical order to consider with regard to creating lifetime income and flooring. “The needed floor can be defined by focusing on consumption projections,” she said. “Income should be compared with the floor. A floor can be thought about both in terms of current consumption or reduced consumption. A reduced consumption reduced to a minimum level might be defined as the minimum acceptable level of consumption—that would seem to be the minimum for a floor.”
Given that, she said, retirees and pre-retirees ought to focus first on Social Security claiming strategies to increase their income. “Late claiming allows added income to be ‘purchased’ at an attractive cost,” said Rappaport.
Next, she recommends looking for ways to reduce the gap between regular expenses and income by paying off your mortgage, if there is one. To be fair, there’s some debate whether doing so is a good idea or not.
And the next step, if there is still a gap between necessary expenses and income, is to develop strategy for more lifetime income. Read Designing a Monthly Paycheck for Retirement – Society of Actuaries. A life annuity, including inflation-protected annuities, is the only way to have income guaranteed for life, she said.
The second action item to consider is this: Don’t forget that there are trade-offs to using one strategy over another, and that it might be wise to incorporate life income into a financial portfolio, and think about different “mixes” of solutions, Rappaport said.
“In most situations, mixed solutions should be considered as well as doing all of one thing,” Rappaport said. “This is a matter of both mind-set and tools.”