As baby boomers retire and start spending their nest eggs, they will need new financial products to make their money last, according to speakers at a recent Wharton Impact Conference titled, “Managing Retirement Payouts: Positioning, Investing and Spending Assets.” The conference explored emerging patterns in spending during retirement and debated new ideas to help retirees manage their finances after leaving the workforce.

According to Olivia S. Mitchell — executive director of Wharton’s Pension Research Council and director of the Boettner Center for Pensions and Retirement Research, the conference’s sponsors — a significant amount of research exists on the adequacy of retirement saving and the transition from traditional pension plans to today’s do-it-your-self programs. Now, with the Baby Boom generation on the brink of retirement, analysts are becoming concerned about how those savings will be spent.

“We decided it was high time to turn our attention to the ‘decumulation’ phase of retirement security,” said Mitchell. “Our focus today is forward-looking. How do, and how should, people think about managing their money in retirement?”

Financial service providers, researchers, and regulators “have devoted substantial attention to the ‘accumulation’ portion of the life cycle — focusing people on saving more for retirement and diversifying their retirement savings,” she continued. “What has been sorely missing is a concerted analysis of risk management during the retirement payout phase.”

One way retirees deal with post-retirement spending is to go back to work. One-third to half of all workers who partially or fully retire return to some level of employment, according to Sewin Chan, associate director of public policy at the Robert F. Wagner Graduate School of Public Service at New York University. Chan presented a paper she wrote with Ann Huff Stevens, professor of economics at the University of California, Davis, titled “Is Retirement Being Remade? Developments in Labor Market Patterns at Older Ages.”

“When we think about retirement, the traditional path goes something like this: Work. Work. Work. Retire,” Chan said. “But many people also take a more gradual retirement and reduce the amount they work before making a permanent exit from the workforce. And then there are people who reverse their retirement and go back to the labor force once they exit.”

These so-called “bridge jobs” can last as long as five years, with those partially retired working a median of 16 hours a week and 40 weeks a year, according to Chan. The decision to return to work may also alter investment patterns in retirement, she suggested: “Someone might be willing to take on a riskier portfolio in early retirement knowing they can return to the labor market after awhile.”

Less on Food, More on Entertainment

Despite concerns about the level of retirement saving, Erik Hurst, professor of economics at the University of Chicago’s Graduate School of Business, contended that most — perhaps a majority — of U.S. workers seem to be saving enough for a secure retirement. Hurst argued that drops in consumption following retirement do not prove that retirees have undersaved. Rather, he has found that much of the decline in spending by retirees is concentrated in work-related categories, primarily transportation, clothing, and food consumption outside the home. Using diaries that track food expenditure and nutrition intake, he concluded that retirees spend more time producing food at home at a lower cost than while working. At the same time, he noted, entertainment expenditures rise in retirement. “They’re eating out less, but they’re still going to the golf course as much.”

Hurst acknowledged that despite his overall findings, there may be a substantial fraction of retirees who have not saved enough for a comfortable retirement period. When it comes to spending on food, those in the bottom quartile of pre-retirement wealth reported declines of more than 30% in expenditures, while those in higher wealth brackets reported declines ranging from only 9% to 14%.

Those who leave the workforce unexpectedly, perhaps due to poor health, may also experience sharper declines in expenditures beyond what might be associated with the end of their working lives, Hurst added. “The average household seems to plan well. But there is a segment — perhaps upwards of 25% — that doesn’t plan well and these people do experience a decline, maybe as a result of a health shock. The focus should be on understanding who these households are and what they’re about.”

For many retirees, the biggest chunk of their net worth is tied up in their homes, and recent dramatic increases in real estate prices have prompted interest in how retirees might tap that equity to finance retirement.

Housing values rose approximately 40% between 2000 and 2005. Home equity typically makes up more than 60% of individuals’ net worth, according to Wharton real estate professor Todd Sinai and finance professor Nicholas Souleles. They examined how much housing equity might be available for spending during retirement in a paper titled, “Net Worth and Housing Equity in Retirement.”

No matter how much their home has appreciated, Sinai noted, retirees still need to pay something for housing after they stop working, regardless of whether they sell the house and cash in on their real estate appreciation.

To gauge how much of that equity would be available for non-housing consumption in retirement, Sinai and Souleles constructed two models. Using current reverse mortgage programs before fees, they projected that the median 90-year-old household could spend up to 75% of its housing equity, while a 65-year-old could consume half the equity. According to another model based on an idealized reverse mortgage offering maximum liquidity, the range was wider. By age 90, the amount of home equity available for consumption would rise to 84%, or about $94,000, while the median 65-year-old household could only tap 34% of its housing equity, or about $36,000. The paper notes that 15% of those households would have no housing equity available.

“We have had a sizeable increase in housing values leading to an increase in net worth, but not all of that is consumable,” Sinai concluded. “We need to take that into account: The fraction that is consumable has not changed, although there is a real change in what is available to seniors as housing values have gone up.”

Living to 110

Much of the conference research touched on how to avoid outliving one’s assets in retirement. Mitchell noted that accumulation-type annuity products have been around a long time, but little attention has been devoted to payout annuities, which are financial contracts that guarantee a steady income as long as the customer lives.

“Now that boomers are reaching the crucial realization that retirement is no longer a dream but soon a reality, the question arises as to how people will avoid outliving their assets,” she said. “To this end, an inflation-linked lifetime income annuity product has a very important place in many boomer portfolios. The challenge is to get boomers to understand first, how long they may actually survive in retirement, and second, how to protect against living too long. Only then will it be possible to get boomers to take longevity risk seriously. Personally, I am planning (and worrying about!) living to 110.”

Mitchell explored a piece of this so-called “annuity puzzle” in a paper she wrote with Jeffrey R. Brown, professor of finance, and Marcus Casey, a PhD candidate in economics, both from the University of Illinois at Urbana-Champaign, titled “Who Values the Annuity from Social Security? New Evidence from the Health and Retirement Study.”

Brown pointed out the “disconnect” between the value of life annuities and a lack of interest in buying them. The disconnect will grow increasingly important as defined-benefit retirement plans that guarantee income for life wane, but are not replaced by the voluntary annuity market, he said. “People ought to find annuities valuable.” In practice, Social Security is an annuity, “but beyond that, few people use annuities in retirement.”

Brown cited several explanations for the slow take-up of current annuity products, including:

  • Public perception of high prices;

  • A desire to pass savings along to heirs;

  • Consumers’ need for liquidity to hedge against medical expenditure shocks;

  • Retirees’ tendency to defer thinking about death;

  • Reliance on Social Security benefits;

  • The lack of inflation protection in most existing products.

“But the puzzle remains,” said Brown. “At the end of the day, this research still doesn’t explain why retirees are slow to annuitize.”

The authors surveyed respondents in the 2004 Health and Retirement Study, and asked 1,000 people aged 50-64 to imagine they were 65 and receiving $1,000 per month in Social Security benefits. Would they be willing to lower the benefit by $500 a month in order to receive a one-time $87,000 lump sum payment? The authors were fascinated to find that almost 60% of the respondents indicate they would take the lump sum instead of the lifelong Social Security payout stream. Those surveyed do indicate some price sensitivity; risk-averse consumers value the inflation-indexed life annuity at 20% to 50% more than its actuarial value. Yet a 25% price increase would be enough to induce 11% to favor the lump sum. This survey was conducted before the 2005 debate on the sustainability of the Social Security program, so respondents were not asked whether they anticipated that future benefits would be curtailed.

Marketplace Battlefield

Sometimes the retirement payout marketplace seems to be a battlefield, with boomers advised either to fully annuitize, or to avoid annuities completely, according to Mitchell. She added: “Our research and that of others suggest there may be room for compromise, which will make consumers better off.”

Some of the products that could play this role are deferred and tiered annuities that pay more in the event of disability and nursing home need, inflation-linked payout products, and variable annuities giving investors access to equity even in retirement. Phased withdrawal plans can also benefit from inflation protection in the form of Treasury Inflation Protected Securities (TIPS), Mitchell said.

One new approach for managing retirement financial risk may be the “lockbox” proposed by William F. Sharpe, co-founder of Financial Engines and an emeritus professor at Stanford University’s Graduate School of Business, who received the Nobel Prize in Economic Sciences for his work in developing models to aid investment decisions. Sharpe led the presentation of a paper titled, “Efficient Retirement Financial Strategies,” co-written with Jason S. Scott, who directs the research and development group at Financial Engines, and John G. Watson, a fellow at Financial Engines, a retirement consulting firm.  

Sharpe challenged accepted rules for retirement savings and spending used by financial planners, such as the “4% rule” which suggests retirees may consume a real value equal to 4% of initial wealth as long as 50% to 75% of the retiree’s portfolio is invested in equities. “We started looking at some of the rules of thumb through financial economists’ eyes, and to be perfectly frank, we didn’t like much of what we saw,” said Sharpe.

The problem with traditional retirement security strategies is that they are split into two parts: an investment strategy and a spending policy, he argued. “These really need to be interlocked and integrated. To the extent they are not, you can get results that are not as good as your client deserves.”

Sharpe’s research team proposes a “lockbox” strategy in which fractions of initial wealth are allocated to virtual accounts, or lockboxes. The money in each lockbox is independently invested, and each year the retiree spends only the contents of that lockbox designated for that year. “The point is that each lockbox has a strategy which is efficient vis-a-vis its year of maturity. Therefore, the whole thing is efficient.”

Sharpe said the “lockbox” concept also protects against age-related problems in savings and retirement spending. “The lockbox maximizes my expected utility at my current age versus 20 years older — or dead. I don’t want to wait until I get there because I’ll be drooling and I won’t know what utility it is. It allows me to think now about the future me and act in loco parentis for my senile and elderly self.”

Mitchell noted a sense of optimism regarding the development of future products that will be useful for managing risk in retirement. “Risk management research has already been driving mutual funds and insurers to cooperate in the retirement space to better meet retirees’ interest in both capital market access and minimum guarantees,” she stated. “More deferred products will likely be interesting in the future — for instance, guaranteed income streams that switch on at some pre-specified age, such as 75 or 85.”

She pointed out that in Germany and the UK, deferred annuities have been mandated by the government to protect people against running out of money too soon.

In her closing remarks at the conference, Mitchell encouraged the researchers to bend their talents to this area and told them: “The theme that comes through is that it’s not just ‘either-or’ — it’s not just about annuitization or investment. Instead, there is a much richer set of financial innovations for an aging world that we must help bring to the global marketplace.”