The new scope of financial literacy
by P.E. KelleyMr. Kelley is managing editor of this magazine. Connect with him at email@example.com.
I asked a financial advisor recently to explain how she conveys the urgency of a life insurance or annuity purchase to her clients, and she responded immediately by saying ‘I simply ask them what year they expect to die, so I can begin planning for them accordingly.’ Notwithstanding her stab at stand-up comedy, her point was clear: many of our clients may not have a realistic concept of their own longevity, betraying a deficiency in what has become known as ‘longevity literacy.’
To this end, the TIAA Institute published a far-reaching study this year that identified trends in client behavior when trying to plan for what has become a rapidly emerging norm: living beyond 100 years. The study, Longevity Literacy: Preparing For 100-Year Lives? revealed that most adults have a very poor longevity literacy, which in turn tends to make them financially fragile.
Benny Goodman is VP, Research & Strategic Program Initiatives, TIAA Institute. He has written extensively on the topic of creating effective accumulation plans, using both investment accounts and life-annuities, and then developing appropriate decumulation strategies post-retirement. He spoke with Advisor Magazine about the new and formidable challenges that consumers now face in securing adequate retirement income, within the fiscal realities of a new longevity.
PEK: Your research reveals a conundrum when comparing a variable annuity with systematic withdrawals from investment accounts (assuming similar investment returns): the annuity will generally outperform. How do we convey this very basic equivalency to our clients?
BG: In my experience, I’ve seen that when some people get to retirement, they may have upwards of a half a million dollars in their accounts. Financial planners owe their clients more than just plans to help them accumulate assets and some well-wishes. Most people do not understand how to generate income from their savings that will last the rest of their lives.
Savings are exposed to market risk that can erode account balances before or in retirement, as we saw in The Great Recession of 2009 and the economic contraction during the coronavirus pandemic. And fifty percent of the population can expect to live beyond the average life expectancy in retirement, exposing them to longevity risk.
The practical reality is that most individuals cannot insulate themselves from risk on their own. Annuitizing a portion of a portfolio’s assets can help mitigate these issues.
PEK: You demonstrate that delaying the start of an annuity by five years may cost 5% in future income, which delaying ten years may cost 15%. Please talk about the time factor and the cost of delay.
BG: The concept is based on something called “mortality credits.” When buying an annuity, you join an annuity pool. Every time someone dies early (before he spent all the money he contributed) the leftover money stays in the pool and is shared by all those still in the pool. The money becomes a mortality ‘credit’ for those who did not die. These mortality credits allow the former to get lifetime income. They start adding value from the day someone enters the pool. Those who purchase the annuity at a later time were not in that pool and do not get that credit. Purchasers only receive mortality credits for those people who died after the purchasers joined the pool. Lower mortality credit means lower lifetime income. Mortality credits have value by adding to income.
PEK: How do economic variables, such as inflation, impact the cost of delaying the start of an annuity?
BG: Let’s assume that those who delay annuitization take the same income using a withdrawal strategy. In which case, once they do annuitize, they draw less income from a smaller account balance. With less money, inflation becomes a bigger problem.
Of course, delaying annuitization can be used as a way to help keep pace with inflation, through what we would call ‘laddering’. It is hard to imagine anyone ever recommending full annuitization. If the partial annuity income is not keeping pace with inflation, more annuity income can be added later.
As this is done on the individual level, it can be personalized to meet the individual need. While inflation might be 3% or 4% or more for society as a whole – based on an “average basket of goods” – that may not be the effect of inflation on the individual retiree. There are many retirement experts who believe that retirement spending looks like a “smiley face” with high income needs in the early years that then reduce, and then climb late in life due to health care needs. If so, then inflation can be managed later in life.
PEK: How do today’s contracts address a client’s reluctance to annuitize, given the possibility of early death and subsequent forfeiture of principal?
BG: In the scenario of a typical single life annuity (not necessarily a TIAA annuity), and assuming 5% interest, people typically think of an annuity as “giving the insurance company $100,000 and getting back about $7,500 a year for life – but if you die tomorrow, you lose your $100,000.” This is not how the vast majority of annuities work. Much more often a ‘guarantee period’ is included.
For example, this retiree might choose to include a 20-year guarantee period, which says you will get income for life with a minimum of 20 years of payments. So even if the retiree dies 11 years after purchase, someone will get a check for the remining 9 years.
If the retiree lives 50 years, he will get a check for all 50 years; as the 20 years is a minimum not a maximum. The beauty of a 20-year guarantee is that it ensures (and insures) that the annuity purchaser cannot lose; with the tradeoff being a smaller check.
So instead of $7,500 a year per $100,000, the check might be about $6,900. However, with 20 years guaranteed, the purchaser will get back at least $138,000.
Another simpler option is the “refund” feature, which says if the retiree dies before receiving $100,000 of income on the $100,000, a lump sum for the difference will be set to the estate. Again, the income will be less than $7,500 a year, but it takes away the angst of thinking that ‘if I die young, I lose.’ TIAA offers options that allow an annuity buyer to know they won’t “lose money.”
PEK: Likewise, how real is the prospect of outliving one’s assets today?
BG: It’s very real. Data from EBRI indicates that about 40% of Americans face the risk of running out of money in retirement.
Now, not many people continuously spend and then one day look at their account and say, “Oh no! There is no money left!” But well before that day, they will start adjusting their spending downward so as to make sure they don’t outlive their money. And some have to make drastic and painful decisions, like choosing between paying for rent or healthcare; to pay for the electric bill or for medicine. Some retirees will even take half the dosage of their prescribed medicine to conserve it. It may even require that retirees move in with a child rather than live in poverty. In certain family dynamics, living with elderly parents is expected, but it may not be ideal for many.
PEK: Your research identifies the enticing concept of Longevity Literacy, and the advent of ‘preparing for 100 year lives.’ What does your research reveal about client understanding of the longevity risk?
BG: TIAA Institute research indicates that more than half of the people surveyed underestimated their longevity or just do not know it at all, what we call poor longevity literacy. The Social Security Administration (SSA) projects an average life expectancy for a 65-year-old to be 20 years (a little less for males, more for females); and remember that 50% of people will live longer than that. But if many people think that they will only live 10 or 15 years in retirement, the risk of having to drastically reduce their lifestyle when it is too late to get another job grows dramatically.
PEK: Please talk about current mortality calculations and the averages of life expectancy. What do clients need to understand about this?
BG: SSA data indicates that the ‘average’ 65-year-old will live to 854. Step one is getting people to understand that basic fact. Remember that 50% of us are ‘above average’ life expectancy and for them, living into your 90s is quite possible. This alone is a very good reason to include an annuity in your retirement portfolio Now, let’s look at the two possible tracks one can take:
(1) I don’t buy an annuity.
- a) I live a long time and have to reduce my spending later in life.
- b) I die young and leave money to my survivors.
(2) I buy an annuity.
- a) I live a long time and receive income for the rest of my life.
- b) I die young, but because I choose the refund feature, my survivor gets a check for the difference between the income I received and my principle.
I would suggest that retirees need to worry more about themselves than their children.
PEK: What are the implications of longevity and mortality when advising married couples or domestic partners? How does this interplay with the challenges of financial planning?
BG: Excluding gender, if there is a 50% chance a 65-year-old dies by age 85, then there is only a 25% chance that both members of a 65-year-old couple to die by age 851.
Think about a two-sided coin with heads and tails. The coin has a 50% chance of landing on one side or the other. Now take two coins – what are the odds they both end up on tails? Twenty-five percent (assuming independence).
When financial advisors talk to their clients about retirement planning, they must convey that there is a 75% chance that at least one of them will still be alive by 85. And there is a 50% chance at least one of them lives into their 90s1. That is why many planners use 95 to 100 years as a time horizon.
It is better to prepare for a long life, than to prepare for a shorter life and outlive assets, have to reduce spending, and make difficult choices. Once longevity is taken into consideration, an annuity can become even more valuable.