The Living Too Long Problem

I think the folks at WalletPop must be running some kind of obvious headline contest. Yesterday they carried Airlines Rake in Billions from Extra Fees and Majority of Social Network Users Share Too Much. And today we get Study: Longer Life Can Bring Pension Money Woes.

I’m willing to forgive WalletPop some for that last one. They are a bunch of kids who probably have not thought much about retirement. They do not yet realize that one of the biggest challenges in retirement planning, maybe even the single biggest one, is the somewhat counter-intuitive fear of living too long.

If you are retiring on an old-school pension or annuity, which will pay you a certain amount every month as long as you are around to cash the checks, then living a long time is not much of a fiscal danger. Social Security works the same way.

But if you reach that golden moment of retirement with a pile of money that needs to last as long as you do, longevity risk is a tough problem. Interestingly, it has a fairly tidy solution, but nobody likes it.

There are basically three choices. You can pick an age, 90 for example, and manage your finances such that you will have enough to live until then and hope for the best. Perhaps if you live that long you will be so adorable that your kids, who may be retired themselves by then, will take care of you.

Alternatively, you could sip so slowly from your nest egg that it does not shrink. If you think you can get a 7% return on your investments, and inflation runs at 3%, then drawing 4% from your kitty to live off each year should leave it the same size in real terms from year to year. In other words, under this scheme you could afford to live forever.

The third way is to take your savings and buy an annuity that will pay you money for the rest of your life. Annuities are sold by insurance companies and they are indeed a form of insurance, in this case against sticking around for too long. So they are a nearly a perfect solution for the longevity problem.

Alas, there is a deal-breaker. If you spend all your money on an annuity then you won’t have anything to leave to your heirs. That might seem like a minor concern, but I think it is the unspoken reason that annuities have never been very popular.

There seems to be a cultural taboo against admitting it, but most American retirees, and would-be retirees, at least aspire to option #2 above, the make the money last forever plan. There is nothing wrong with that. As a parent I can attest to the primal urge to spend money on kids, including the commonplace desire to leave them a usefully large endowment when we go.

The problem is that if a retiree does not buy an annuity, setting up what is a nearly foolproof retirement income scheme, they are putting themselves in the role of the manager of a very small pension fund. And as I have said before, the problem with making everybody their own pension fund manager is that then almost everybody has a completely incompetent pension fund manager.

Of course, as the GAO report from the WalletPop post reminds us, those with a sizable nest egg to manage are the lucky ones. (They would probably object that luck had nothing to do with it.) Social Security provides at least half of the income for 64% of households with at least one member over 65. Overall, investments provide only 13% of total income for those households. (Social Security is 37%, employment is 30%.)

So not only is the manager over his head, the pension fund is seriously underfunded.

Whether because of a lack of resources or aversion to buying something that will evaporate upon death, annuities are widely shunned, and the GAO report shares a few hard numbers to illustrate just how widely shunned. 6% of American households own an annuity. That sounds mildly encouraging until you learn that virtually all of those are of the variable kind, really a tax-advantaged investment contract, rather than the sort that would provide a cure for longevity risk. Only 3% of annuities sold in 2008 were of the “fixed immediate” type that would be appropriate for a new retiree.

The degree to which we prefer to have a pile of money over a certain income for the rest of our lives is further illustrated in the GAO report by a survey they cite that asked people if they would be willing to swap their future Social Security payments for a lump sum. Only 41% chose the normal payments when the lump sum was actuarially equivalent.

The GAO report laments this state of things without suggesting a cure beyond the ever-popular call to increase financial literacy and the currently fashionable idea to streamline the many different regulatory agencies that are involved. Calls for more financial literacy are popular because “literacy” always has positive connotations and nobody really knows what the term means. Reducing and rationalizing regulators is almost always a good idea, but this particular problem has nothing to do with regulation.

This is one of those “we have met the enemy and he is us” things. Longevity risk has a direct and somewhat obvious cure, but almost all of us find it repugnant. Increased financial literacy will not change that.

No Comments

  • By Dan, May 5, 2010 @ 10:32 pm

    I always thought it was best to split the difference. Take some of your money and get an annuity so that you are assured of some income forever while keeping some in your retirement account that you can invest and hopefully leave some for your heirs.

  • By joewatch, May 5, 2010 @ 11:07 pm

    Good stuff. I didn’t know much about this topic before you brought it up since I’m so far from retirement. But my parents are close to retirement, so a fixed immediate annuity is a great idea for them. Vanguard has a bunch with all sorts of nice features. http://www.bogleheads.org/wiki/Immediate_Fixed_Annuity_-_SPIA

    You might have to change your blog title to goodmoneyadvice!

  • By Grey, May 5, 2010 @ 11:36 pm

    People are living so long that their kids are elderly when they pass away. I haven’t thought about inheriting my parents money, but only about hoping they are prepared to shoulder the burden of what expensive care they may need. Any inheritance would only serve to bolster my retirement funds – and I can’t plan on getting anything, since they may need it themselves. You have to plan your retirement while you work, so it will be done if they pass on money. If either parent lives to 90, the “kids” would be 55-70.

  • By Keith Morris, May 6, 2010 @ 12:00 am

    I plan to live forever, so option 2 sounds good. Is it reasonable to expect a 7% return on investments at that age, or am I more likely to want to have my money somewhere even less risky?

  • By ShannonS, May 6, 2010 @ 2:28 am

    I thought one problem with buying an annuity was inflation. If you lived long enough, the payment would not longer be enough. Better than having nothing, but how much better?

  • By Mike Piper, May 6, 2010 @ 7:48 am

    ShannonS: You can get an inflation-indexed fixed annuity.

    Frank: I’ve been talking a lot about annuities on my blog recently, and from the feedback I’ve received, I’d argue that there are additional reasons people stay away from single premium immediate fixed annuities.

    1. They don’t understand them. At least, not as well as they understand stocks, bonds, and mutual funds.

    2. They have a negative connotation just because they’re annuities. People remember reading somewhere that “annuities are a rip off.” (Because some types of annuities are rip offs.)

    3. They think that they can get away with a withdrawal rate much higher than they probably can. If you think you can safely use a 6% withdrawal rate, why bother with an annuity that only pays 5.5%?

    I think some additional education could help to alleviate those points at least.

  • By Trent McBride, May 6, 2010 @ 8:26 am

    What if the company who sells you the annuity goes under?

  • By Mike Piper, May 6, 2010 @ 8:45 am

    Trent: As far as I know, every state has a guaranty association that will step in. That said, the maximum amount guaranteed varies by state (usually $100,000 or $300,000), so it’s definitely important to look into.

  • By Lance, May 6, 2010 @ 10:12 am

    “But if you reach that golden moment of retirement with a pile of money that needs to last as long as you do, longevity risk is a tough problem. Interestingly, it has a fairly tidy solution, but nobody likes it.”

    Well, there’s another tidy solution that nobody likes that you also failed to mention…

  • By Lance, May 6, 2010 @ 10:37 am

    Mike– That has perils of its own. It’s not obvious to me which state’s limits are relevant– the state of the insurance company, the state you live in when you purchased the annuity, the state you live in when you need to make a claim, or something else entirely? A quick and easy guide to the perils and pitfalls would do a world of good, but I don’t think one exists.

  • By Kosmo @ The Casual Observer, May 6, 2010 @ 10:40 am

    “If you spend all your money on an annuity then you won’t have anything to leave to your heirs.”

    Maybe you’ll be lucky enough to have heirs that realize that you don’t owe them anything :)

    I really don’t expect to inherit anything from anyone, ever. If some money trickles down from somewhere, great, but I don’t feel that I should be entitled to a dead person’s money (nor am I holding my breath waiting). They earned it, they can spend it any way they want.

    If you like the idea of an annuity setting you up for life, I’d say go for it and don’t worry about the heirs.

  • By Mike Piper, May 6, 2010 @ 10:46 am

    Lance: I can’t speak to other states, but I’ve checked here in Illinois before.

    In our case, it’s determined by whether you’re an IL resident at the time of insolvency. More info here.

  • By Lance, May 6, 2010 @ 10:49 am

    Mike– Interesting. If that’s the typical rule, then it would seem prudent to get an annuity no bigger than what the state with the lowest limit covers. After all, there’s no telling when or where you’ll move in the course of retirement.

  • By Frank Curmudgeon, May 6, 2010 @ 11:54 am

    Mike: I think your three more reasons why annuities are shunned are excellent and for all I know bigger than the desire to leave something to the kids. The wanting to leave something motivation is interesting to me because I think people are shy about admitting it. And there might be yet a fifth pychological reason: handing over your life savings in exchange for an annuity is just too final. It would be your last significant financial decision.

    The belief that you can do better than the return offered by a fixed annuity (your #3) is not as silly as it sounds. Annuities are risk-free fixed income instruments, besides being an insurance policy against longevity. I’ve always thought a hybrid product that gave a retiree the return (and risk) of equities but with longevity protection would be useful. A contract that guaranteed you a monthly payment that was a set multiple of the S&P 500 Index level for life, for example. Of course, if you think annuities are hard to explain now….

  • By Patrick, May 6, 2010 @ 1:35 pm

    “Longevity risk has a direct and somewhat obvious cure, but almost all of us find it repugnant.”

    You mean, jump off a bridge when your money runs out? Or are we still talking about annuities?

  • By Allan, May 6, 2010 @ 1:38 pm

    It would be easier for people to buy an immediate annuity if they had whole life insurance in force at retirement. This gets around the issue of wanting to leave money to heirs and giving up control of all money. Cash values in the policy are very liquid. The annuity gives you a higher payout than bonds also.

  • By jim, May 6, 2010 @ 1:51 pm

    Frank are you the kind of person who thinks anyone under age 45 is a “kid”? ;)

    It seems that the baby boomer generation is the first wave of retirees who primarily have 401k/IRA style cash account retirement investments instead of traditional pensions. Previous generations generally retired with pensions so they didn’t have to worry about this issue. But today people are mostly retiring with cash value retirement accounts for the first time so this is kind of a new situation. When most of the baby boomers fail to plan/manage their retirement spending and run out of money in 5, 10 or 20 years then I think people will start to really see how annuities were a good idea they should have done.

    I like immediate annuities for retirement income. I will probably do a mixed deal like Dan with some money guaranteed via annuity to ensure a basic living standard for life and the rest of the money managed by myself.

  • By jim, May 6, 2010 @ 1:53 pm

    Also if you’re worried about risk of the failure of the insurance company then you can get multiple $100k annuities from different insurance companies to spread that risk around and make sure they’re all guaranteed individually.

  • By Evan, May 6, 2010 @ 2:00 pm

    Frank,

    I recently wrote a guest post on Mike’s site which may useful to calm the fear of leaving nothing to the following generation. I am not sure if you are cool with links so I’ll just describe the strategy.

    You buy a fixed annuity use some of the income, along with other buckets, to live. Then IF YOU ARE HEALTHY you purchase a UL Guaranteed policy with some of the annuity to replace most of the loss of the cash used to buy the annuity.

  • By Boston Steve, May 6, 2010 @ 2:03 pm

    Problem # 1 – Inertia. After years of setting up IRA’s, Money Market Accts, 401s, 403bs, Couch Potato Portfolios, etc. you would have to ditch them all and put all your eggs in one basket.

    Problem # 2 – That basket is run by an insurance company. I don’t know about others experience with them, but I have been totaled screwed over by insurance companies enough not to trust them with the rest of my life.

    Problem # 3. Not having control / ownership.

    After having control of your money you now give it over to someone else. Yes it’s guaranteed and yes they have to comply with the annuity contract but people like to own things themselves.

    My elderly parents moved into one of those retirement village / nursing homes places where you’re taken care of for the rest of your life, but you don’t actually own where you live.

    My father said it was a very unsettling feeling after having owned his own home for decades. Just felt weird to not own his own house.

    Problem # 4. Large fees.

    Random thought # 1. You can always set up separate gift / inheritance accounts for the kids / grandkids. Or even better, if you have the money, give it to them now so you can see them enjoy it.

    Anybody have any thoughts on Ray Lucia’s Buckets of Money or The Grangaard Strategy with or without annuities…..

  • By Adam, May 6, 2010 @ 3:29 pm

    Not to hi-jack…but holy hell..what’s going on with the markets. Frank, post your thoughts.

    Also, on topic, I want my parents to buy an annuity but they won’t do it as they want to leave something to us kids. Who don’t want them to. *sigh*

  • By Frank Curmudgeon, May 6, 2010 @ 5:27 pm

    I’m happy with links.

    I’ve no actual knowledge of what happened this afternoon in the stock market, but my mildly educated guess is that a bunch of Europeans pressed the panic button in response to Greece and the UK election. Since their own markets were by then closed, they dumped everything in NY, and it took a while for the locals to respond.

  • By cybergal5184, May 6, 2010 @ 7:03 pm

    Who knows what the right decision is? I’ve been great about saving money so far but don’t know what to do when the time to spend it comes.

  • By joewatch, May 6, 2010 @ 9:26 pm

    My mother asked me to look into the immediate annuities and the quote I got was $828,743 for $5000 monthly Single life income with installment refund paid to beneficiaries for a 66 yo female. That is a lot of cash to hand over to an insurance company. For the life expectancy, 19 years, that would amount to a 2% average annual return on investment. That sounds bad, but if you think about it, she would have to live to just 14 years to see a positive return, and every year of life after that, the investment returns 7.2% risk-free. That’s not bad at all.

  • By joewatch, May 6, 2010 @ 10:09 pm

    Okay, ignore the above comment. I was trying to come up with the best way to compare an immediate annuity vs. a risk free investment and I think I figured it out. I used a basic retirement calculator http://moneycentral.msn.com/retire/planner.aspx
    and plugged in age 66 for current age and retirement age, age 85 for life expectancy, $828,743 for retirement savings, and 4% for anticipated ROI. Then I put in $60k for annual income in retirement. Using these numbers, my mom would run out of money at age 80 years. This makes the annuity look like a very good deal. Does this look correct?

  • By Evan, May 6, 2010 @ 10:23 pm

    Frank,

    Since you are happy with links:

    http://www.obliviousinvestor.com/using-annuities-to-protect-inheritance/

  • By DIY Investor, May 7, 2010 @ 11:29 am

    Start by defining your goals. Is making sure that you don’t run out of money most important? Then a certain percentage of your investable assets should be in annuities. If you walk around and get hit by a truck that’s ok. Your heirs lose out but that’s not important.
    If leaving money to your heirs is important then stay away from annuities. You can get some with various payout features but they are costly.
    It’s a matter of defining your goals.

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