Investing
How to Shift From Saving to Spending in Retirement
October 15, 2015
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Consider the following two options:

1) You are 55 years old and have $800,000 today to cover your retirement spending, starting at 65.

2) You are offered $4,000 in monthly income, starting on your 65th birthday and lasting until you die.

Which one would you prefer?

If you chose option two, you’re not alone. Most people prefer a known monthly payment to the complex decision of investing a lump sum to cover their financial needs during retirement. Income versus a nest egg is conceptually more closely tied to what most of us are ultimately interested in for retirement—maintaining our standard of living, continuing to travel, and so on.

Traditional pension plans and Social Security have historically filled that role. Today, however, employers are moving away from defined benefit plans, and individuals are concerned about future Social Security benefits. Yet, while the benefits of building a nest egg are well-recognized, relatively few people know whether their retirement savings can generate sufficient annual lifetime income to meet their goals.

In other words, while the concept of retirement “accumulation,” or amassing a lump sum during one’s working years, is widely understood, the other side of the equation—the drawdown or consumption of one’s nest egg—is less familiar to many people. And with longer lives, our accumulations may need to stretch into income that lasts 20 or even 30 years.

How does focusing on an income stream help investors overcome suboptimal behaviors?

As retirees begin to spend their savings, not knowing how much income they can count on will affect their consumption patterns. For example, some households tend to be conservative in drawing down their savings during retirement. One study found that such retirees withdrew just 2 percent of their assets per year until age 70.5, and 5 percent after that (in line with the IRS’s required minimum distribution). Both percentages were below the investment returns during the same period. For other families, the withdrawal rate increases rapidly when personal retirement account assets fall below $50,000.

A perhaps even more difficult problem facing households is when to retire, and studies suggest that in trying to solve it many resort to simple rules of thumb. For example, one study found that 47 percent of those employed on their 65th birthdays retired within 12 months, a higher rate than those for 64- or 66-year olds. This suggests that their decision was driven by the old mandatory retirement age acting as a mental anchor, rather than personal goals and circumstances.

Why have people been reluctant to annuitize their wealth?

We know that one way to draw down wealth in retirement is to stay invested while taking income. Since this can be a daunting task to do on your own, without the help of a financial advisor, and because more of us are risk-averse, one would think that annuities  might be a more popular option. Yet the size of the annuities market, $1.9 trillion, is a far cry from the nearly $9 trillion parked in individual retirement accounts (IRAs) and employer-sponsored defined contribution (DC) plans.

The debate on why annuities are not more popular is ongoing. Cost is often raised as an objection, yet fees and charges alone are unlikely to explain the low annuity adoption.

As for behavioral reasons, an annuity purchase usually requires taking some action, such as comparison shopping. Considering the wide range of choices available and complexity of many of these products, even small steps like making a phone call can be overwhelming. That’s why annuities included in DC plans tend to have higher adoption rates.

Framing also matters. Framing an annuity  as an investment rather than as future spending tends to reduce its perceived attractiveness, as its “return” depends on the age at death. Also, while economists think of annuities as a risk-reducing strategy that helps smooth out a future consumption stream, an individual may feel like he’s taking a big lump sum, which he perceives as (nominally) guaranteed, and gambling it on an annuity whose value is contingent  on how long he lives. This can be especially damning for a loss-averse  investor.

Finally, according to the endowment effect, once you own something, you’re reluctant to give it up even for an identical thing. In the same way, having to write a check in a DC plan to buy an annuity may appear unappealing. This is especially true for an unsophisticated investor for whom the loss of a large sum of money today may mentally dominate a number of small payments to be received in the future.

How can individuals shift their investment behavior from accumulating a nest egg to spending in retirement?

The task of bridging the gap between our lump sum savings and the life outcomes most of us are saving for may seem intimidating. To start, it helps to focus on how much we want to spend in the future, rather than how we should invest our retirement accumulations or what kind of financial products may best achieve our objectives.

Many people derive comfort from thinking about an income stream that is relatively stable over time, even it if implies putting off current spending. Annuities, as I’ve discussed, are one way to convert at least a portion of a nest egg to a lifetime income stream. Tools such as BlackRock’s CoRITM can help estimate how much retirement income could be generated when annuitizing one’s current savings.

Yet even for those who choose not to annuitize, the ability to visualize a monthly or annual payment can result in more thoughtful planning around asset allocation, when to retire and how to appropriately draw down savings.

 

Nelli Oster, PhD, is a Global Investment Strategist for the BlackRock Investment Institute. She writes about behavioral finance for The Blog and you can find more of her posts here.

 

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Source: BlackRock Blog Retirement
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