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.
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% of their assets per year until age 70.5, and 5% 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% 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?