What you don’t know can’t hurt you, according to the old saying. When it comes to retirement planning, though, the old saying doesn’t apply.  


Most people understand, at least superficially, that the sooner they begin planning for retirement the better. Putting money aside now rather than later means that you will have more assets in the long run. What many people don’t know, however, is the amount of money they will need to live on in their golden years.


To be specific, they seriously underestimate the possibility that they may outlive their assets, according to experts at Wharton. Indeed, Olivia S. Mitchell, professor of insurance and risk management, has this strong dose of advice: It may be a good idea for people to assume that they will need the same level of income during their retirement years that they need now.


Mitchell, executive director of Wharton’s Pension Research Council, says people tend to focus on the “accumulation phase” of retirement planning – those years on the job when they are socking away money and making decisions as to how that money should be allocated among stocks, bonds and cash investments. What they do not give much thought to is how much income they will need after they stop working.


“A lot of people don’t have very good information about what their expenses will be during retirement,” says Mitchell. “We know from our research at the Pension Research Council that there’s a substantial underestimation of the need for long-term care and nursing home insurance. People also don’t understand what medical costs may be in retirement. And many people don’t focus enough on the risk posed by inflation. We haven’t had a lot of inflation lately, but even a low rate over 30 years of retirement can erode one’s nest egg.”


Perhaps the most neglected facet of retirement planning is longevity risk. “People tend not to think about mortality; it’s not a question people willingly face,” according to Mitchell. “When people do think about mortality, at best they think about life expectancy. But they may not understand that about half of all people live longer than their life expectancy. Women especially can live into their 90s or even reach their 100th birthday.”


Lack of Preparation

Any number of studies has shown that people are not properly prepared for retirement. In a May 2003 survey conducted for MetLife, a major life insurance company, people aged 56 to 65 were asked a series of questions designed to test their knowledge of retirement and income-planning statistics. On average, those surveyed answered only five of 15 questions correctly.


Among other things, a majority underestimated the life expectancy of a 65-year-old and did not think that longevity was a significant risk in planning for retirement. When asked, “What is the greatest financial risk facing retirees?” only 23% correctly answered longevity risk. Another question asked: “An individual who reaches age 65 has a life expectancy of age 85. What are the chances he or she will live beyond that age?” Only 37% gave the correct answer, which is 50%.


Another study – conducted by Watson Wyatt, a human resources consultancy, and reported in the Aug. 23/24 issue of London’s Financial Times – examined how the bear market in equities over the last three years has affected people’s retirement plans. The study, which included 4,500 United Kingdom residents aged 50 to 64, found that about one-quarter of respondents had experienced losses of 25% to 50% in their stock portfolios, while about one-fifth had lost between 11% and 25%. Many of those surveyed said they have had no choice but to postpone retirement.


Survey results released Aug. 12 by Merrill Lynch show much the same thing. Only 47% of Americans interviewed as part of Merrill’s Retirement Preparedness Survey were either “somewhat confident” or “very confident” that they will have saved enough once they retire. That was down from 90% in 1998, a year when the bull market was still surging. Moreover, one-third said they believed that they will not be able to retire at age 65 and only 20% said they were “very confident” in their overall investing ability.


In a prepared statement, Cynthia Hayes, a Merrill Lynch executive, said, “We know that Americans have traditionally under-saved for retirement, but these 2003 survey results serve as a wakeup call – for plan sponsors, individual investors and financial services providers.”


Wharton’s Mitchell points out that people with high incomes are not necessarily the best retirement planners. “Research has shown that retirement-saving shortfalls run up and down the income scale and wealth scale,” Mitchell says. “In some cases, shortfalls were worst for people with high earnings. Of course, these people are in a position to save a lot, but people with high earnings also spend a lot. They don’t necessarily set money aside.”


The Inertia Factor

Brigitte Madrian, a professor in Wharton’s business and public policy department, says many workers do not plan properly for retirement because of sheer inertia. Madrian has conducted extensive research into the design of 401(k) plans at 30 large U.S. companies over the last few years and how they affect employees’ savings decisions.


“The striking thing that has come out of this research is the importance of plan design in encouraging people to save money,” Madrian says.


One key feature of 401(k) plans is that they offer a slew of choices concerning the amount of money people can contribute, how people want to allocate their assets and, perhaps most important, whether employees want to participate at all. For many years, there was a presumption that having a lot of options was the best approach to take in designing plans because it offered employees freedom of choice. But many companies found that their 401(k) plans had anything but universal participation rates despite the plethora of choices.


Madrian found that while it makes sense to offer choices to people who are somewhat knowledgeable about investing, options and flexibility actually confuse many workers. Hence, many decide not to take part in their company’s 401(k). Madrian has studied one solution to overcome this inertia: Rather than requiring employees to sign up for a 401(k) plan, companies can automatically enroll them and require them to overcome their inertia only if they wish to drop out. Companies that have tried this approach have found that 401(k) participation rates rise sharply.


“The standard 401(k) plan is set up so that you’re not a participant unless you take some action to enroll – by logging onto the company’s benefits website or calling the company’s benefits hotline,” explains Madrian. “When you have that kind of enrollment mechanism, only two-thirds of employees participate in the plan. But several companies over the past few years have made a very simple switch: They just automatically enroll everyone in the plan. Employees don’t have to stay; they can log on or call the benefits hotline and opt out of the plan. When companies set up this kind of arrangement, they see participation rates among employees who are subject to automatic enrollment go up to something like 90%.”


Companies that have adopted automatic enrollment do not immediately deduct contributions from people’s paychecks. Employees are typically given 30 or 60 days to opt out, after which contributions are deducted.


No figures are available for the number of U.S. corporations that have adopted automatic enrollment, but Madrian says companies that have taken this approach have been satisfied with the results. In addition, she notes, the Internal Revenue Service approves of the idea.


Some companies are reluctant to embrace automatic enrollment. Since many workers do not want to be bothered making choices about contribution amounts or asset allocation levels – at least not right away – companies must do it for them by default.


“And this would be okay if companies picked default levels that worked well for most employees, but most companies have picked rather lousy defaults,” according to Madrian. “They deduct only 2% or 3% of an employee’s income and put it all into a money market fund because they’re afraid of putting employees’ money into an equity mutual fund or bond mutual fund that could actually have a negative return. Now, that’s the fear that companies have, but I think that fear is unwarranted. Companies could choose instead to put employees’ money into a combination of lifestyle funds [consisting of stocks and bonds], as well as money market funds, which would be less risky, until employees got around to making their own decisions.”


A 401(k) can play a major role in accumulating assets, but asset accumulation alone may not necessarily address a key risk of growing old – the chance that an investor could outlive his or her retirement assets. Mitchell and Madrian agree that people who wish to avoid this possibility may want to consider purchasing an annuity.


Annuities at a Glance

An annuity is a contract sold by an insurance company under which the person buying the annuity is guaranteed a regular stream of payments over a period of time. There are many kinds of annuities. Deferred annuities are designed to accumulate tax-deferred assets over the long term and are usually used to produce a steady income at retirement. Immediate annuities, by contrast, begin making annuity payments right away and are typically bought with a lump-sum contribution. There are two types of deferred annuities: fixed annuities, which pay a fixed rate of interest guaranteed by the issuing company for a specified period, and variable annuities, whose value fluctuates depending upon the performance of the stocks, bonds or other vehicles in which the annuity’s principal is invested.


The most important feature of a variable annuity, from the standpoint of eliminating longevity risk, is that it can be structured so that it throws off income for as long as the person who bought the annuity is living. What’s more, a variable annuity can be structured to provide a death benefit that guarantees that a beneficiary will receive, at minimum, what the annuity purchaser contributed to the account if the purchaser dies before the income payments commence.


One downside to variable annuities is that they may have higher annual expenses than other retirement vehicles, such as individual retirement accounts and 401(k)s. A drawback to fixed annuities is that market interest rates may rise while the annuity’s rate remains the same.


Annuities can serve as an important component of a person’s overall retirement savings plan. A person may wish to buy an annuity at the same time that he or she holds assets in stocks, bonds or mutual funds.


But Mitchell stresses that an annuity should be primarily viewed as a form of insurance, not as an investment. “The most important function of an annuity is to protect against you outliving your assets. At the end of the day, it’s an insurance contract. Many people who have written about annuities in newspapers and magazines don’t understand the fundamental insurance characteristic. They see it as an investment, but an annuity and an investment are really two different things. You don’t buy an annuity just to make money. You buy it to make sure that when you’re 97 years old you have income coming in. Do you think of health insurance as an investment? Not really. Medical insurance helps protect against large medical bills. Now, having said all of that, there are variable annuities that do offer an investment feature and that can be beneficial. But the simplest, plain-vanilla annuity involves putting down a sum of money and knowing that the insurance company will pay a monthly income for as long as you live.”


How Much Will You Need?

So, just how much will you need to live on during retirement?


Merrill Lynch, for instance, recommends that people assume that they will need 70% of their pre-retirement income each year after they retire: if your annual income is $100,000 today, you should figure you will need $70,000 after retirement.


But Mitchell says that may not be enough. “Financial planners have traditionally espoused 70% or 75% as the replacement rate gold standard. But if you look at what people want to do when they retire, most say they’d like to spend about the same amount of money as they did before retirement. Maybe they won’t need to pay to park downtown or spend as much on clothes as they did when they were working, but maybe they’ll decide to travel or take up expensive hobbies like golf. My suggestion, which I know will depress people, is to assume that you’ll need a 100% replacement rate. If you end up having more than you actually need, you’ll be in better shape. Socking away more money while you’re working and working more years before retiring – that’s a good form of insurance.”