Making Retirement Saving Work SmarterPublished: July 05, 2000 in Knowledge@Wharton
With lengthening life expectancies, many retirees face the prospect of outliving their savings. Moreover, most people are unaware of the need to provide for long-term care in their old age, even though one-fourth of the elderly will ultimately require such care. Yet only half of all Americans say they've thought about saving for retirement, according to recent surveys, and many of these are uncertain as to whether they're setting aside enough for their golden years.
Olivia S. Mitchell, executive director of Wharton's Pension Research Council, and finance professor Zvi Bodie of Boston University explore these grave issues and propose some fresh approaches in their introductory chapter of a book forthcoming from the University of Pennsylvania Press. The book, entitled Financial Innovations for Retirement Income, will be published in 2001.
The authors note that the strong stock market and recent low inflation rates lead some investors to believe that this will continue forever. But there have been times, as in 1974-75, when there was both high inflation and poor stock performance. What has gone around can come around again.
A good retirement plan tries to reduce the risks by hedging, insuring and diversifying, the authors point out. The problem for the financial advisor trying to accomplish all those goals for an individual is to keep the plan simple enough to understand. Advisors need to help workers and retirees learn how to incorporate uncertainty into their thinking. Advisors themselves need to understand peoples' risk tolerance and willingness to change behavior, so that they can include in their planning models an understanding of how participants might use retirement products
Mitchell and Bodie look at some innovative products that can help people to provide for their future financial security. One is a hybrid pension plan known as the cash-balance plan. This has elements of a defined-benefit (traditional pension) plan and a defined-contribution plan (such as a 401(k)). Unlike some pension plans, cash-balance plans do not provide incentives for early retirement. That reality, coupled with the fact that they are portable (employees can take them with them when they leave an employer) makes them seem more fair, and hence more attractive, to younger employees. By eliminating rewards for early retirement, these types of plans encourage people to work longer, which helps build savings and thus ensures greater retirement security.
Inflation-indexed bonds are another new product. These can offer households a long-run hedge against the risk that their retirement savings will decrease in value due to big hikes in the cost of living. Offered in the U.K. beginning in 1981, and adopted by the U.S. Treasury in 1997, inflation-indexed bonds can be offered by financial institutions in a variety of durations. Investors can also buy the Treasury's Series I savings bonds, which pay all interest and principal at redemption, when the investor pays income tax on the bonds. These bonds have not yet become popular, partly because they pay low commissions to financial advisors and partly because investors are still attracted by the higher returns of corporate stocks. Insurers and investment firms may begin to offer annuities backed by such bonds, which would greatly help protect people in their retirement.
Another useful product in retirement is the reverse-annuity mortgage (RAM). This is a means to gain access to the value of one's home without actually selling it. For the median household on the verge of retirement, housing wealth amounts to about $150,000. A RAM permits the homeowner to sell part of his net home equity to a financial institution, which then provides the individual with a lifetime annuity paying a fixed monthly income. When the house is sold upon the owners' death, the institution gets the remaining equity.
As more people begin to manage at least part of their own retirement accounts, all types of annuities are expected to become a larger component in investors' portfolios. Loads (administrative costs) for many annuities have fallen sharply in recent years. Also, with longer life expectancies for retirees and the resulting increased risk of the need for long-term care (LTC), some have proposed that an annuity integrated with LTC insurance would reduce the problem of people seeing their annuity income drained by the need for prolonged health care.
As nation ages and Baby Boomers approach retirement, there is a tremendous need for better understanding of retirement risks, Mitchell and Bodie contend. Retirement planning modelers must incorporate more sophisticated information on retirement risks. Better decision-making tools are needed to help users decide how much to save, how to invest, and when to spend. The essential tools of risk managementhedging, insurance, and diversificationshould guide those in the retirement planning business.
The authors conclude that additional innovative financial products are needed, to better manage the costs and benefits of financial instruments to ensure the security of an aging population. To this broader perspective of the retirement accumulation process should be added more financial education for the population at large.