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By Aron Szapiro and Christine Benz | 09-07-2016 10:00 AM

Looking Abroad for Retirement Innovation

Morningstar research reveals several retirement drawdown lessons that could help improve the U.S. system.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. How does the system for retirement drawdown in the U.S. compare with those of other foreign countries? Joining me to discuss that topic is Aron Szapiro. He is director of policy research for Morningstar.

Aron, thank you so much for being here.

Aron Szapiro: Thanks so much for having me.

Benz: So, Aron, you did a really intriguing paper about retirement drawdowns in the U.S. versus some other foreign countries. But before we get into that, let's talk about what we're talking about when we use that term, drawdowns. How is that different from the rest of retirement planning?

Szapiro: Sure. So, in a defined contribution system, people have to build up assets while they are working and then when they get to retirement, they have to decide what they want to do to convert those savings into lifetime income. And that process of converting those savings and then drawing them down, spending them in retirement, is what I'm focusing on here and what I mean when I talk about drawdown.

Benz: OK. So another question before we get into your findings is, as someone who focuses on policy, what do you think is the virtue of comparing the system in the U.S. versus other foreign countries?

Szapiro: So, other countries, at least to the extent that they have similar systems to the U.S., might do things that are innovative, a little bit different that we could learn from. And of course, the U.S. is kind of, in a lot of ways, first at many things and so we have a more mature system. Other countries have learned from us and done innovative things. And so, we can see what they have done and see if there are any lessons we can learn from them.

Benz: OK. So, you compared the retirement drawdown system here versus that of some other foreign countries. Switzerland, Australia, Chile, Singapore, Canada, and the U.K.--that was on your shortlist. How did you winnow it down to that list of countries?

Szapiro: Yeah, I was looking for a few things. I wanted countries that showed some variety. I mean, looking at a couple of countries that do similar things is not as interesting. I wanted countries that had done new things, innovative things or made recent changes. And I needed countries that had clear, established oversight in their drawdown system and a mature drawdown system. Countries that are still primarily defined benefit aren't that interesting because of these policy choices don't affect that many of their citizens. So, when you look at different outfits that do this kind of research GAO, OECD, The World Bank, these are the countries that tend to get the most attention because they meet those criteria.

Benz: OK. So you looked at a few separate issues within the retirement drawdown space. One of the ones that you looked at was this idea of guardrails in retirement. So I'm spending from my portfolio. I've hit my retirement years. And guardrails around prematurely depleting my assets. Here in the U.S., apart from telling me I can't withdraw prematurely or that I have to take money out at the end, toward the end of my retirement life, there aren't those guardrails. So let's talk about how that compares to what's going on in other foreign markets.

Szapiro: Yeah, it's interesting. So, of the countries I looked at, several are--or four had some kinds of limits on what you could take out and when. And there are two broad ways that these are limits are imposed. The first is, you simply have a regime where it says you cannot take out more than X percent at a certain age based on the assets you have. So that's sort of a limit just on how much you can take out.

The other kind of guardrail that's put in place are countries that say you have to annuitize a certain percentage of your assets or assets below a certain account balance. And so those are sort of the two broad ways that countries force people to prepare for longevity risk, the risk that they might outlive their savings.

Benz: So I want to talk specifically about the annuity question. But before we get into that, the Department of Labor a few years ago mandated that 401(k) plans started giving participants a little bit of a snapshot of, OK, you have $100,000 saved today; here is what this will look like as a stream of income throughout your retirement. Does that get us in the right general direction?

Szapiro: I think it gets us kind of in the right general direction. I want to say that I think it's a great initiative. We know from behavioral research that when people see a large account balance, they often think that they have a lot more wealth than they really have. I mean, they know how much wealth they have, but they don't know how that translates into income. And so, I think it's great the department is mandating this.

That said, it doesn't actually show people how to take that money and convert it into that kind of theoretical income calculation. So I think there is more work to be done in helping people figure out how to do this. But it does give people kind of a general sense of how much they should be taking out. So it is sort of a step in the right direction.

Benz: OK. So let's look at this annuity piece and talk about there are a small handful of the countries that you examined where workers are required to partially annuitize a portion of their retirement nest egg. Let's talk about that.

Szapiro: Sure. So, Singapore requires workers to annuitize the first chunk of their retirement savings and then they can optionally annuitize more. As I understand it from talking to our experts there, voluntary rates of annuitization in Singapore are also very high. So this policy might not be as strong a nudge as it would be in other places where people would be more reluctant to annuitize on their own.

The same thing is true in Switzerland where, for one of the tiers of retirement people have to annuitize 75% of their assets. Again, voluntary rates of annuitization in Switzerland are quite high. So there is certainly a cultural thing happening.

And then in Chile annuities are not required but they are highly incentivized. The annuity market is national, it's well-regulated. And the contrast when a retiree looks at what they could get if they draw down given the limits on what they could pull out, they'll have a declining pattern of withdrawals. And that decline accelerates over time. And so, the annuity looks very appealing because the annuity is a level payment over time. And that actually has incentivized a lot of middle class and above Chileans to annuitize. Annuitization rates are quite high there compared to other countries.

Benz: OK. So let's talk about the virtue of annuities as part of a retirement drawdown plan. I know probably our Morningstar.com viewers watching, their hackles immediately go up when they hear the term annuities. They think of products that maybe really complicated or certainly very costly. You're not talking about variable type products with heavy commissions and all that stuff?

Szapiro: Right. We're just talking here about what you would normally refer to as a single premium immediate annuity and even that sounds more complicated than what it is. These are simple products. You give an insurance company, or in some cases, a state-run annuity system, a certain amount of money, $100,000 or whatever it is, and they give you for the rest of your life a monthly payment of, in that case, a few hundred dollars. So, it's a very simple transaction and it protects the retiree against the risk that they might outlive their savings. So, yeah, we're just focusing on pretty simple products.

Benz: But there has been a lot of academic research sort of looking at why people don't annuitize. So, let's talk about some of those.

Szapiro: Yeah. So, there's this thing in behavioral economics called the annuity puzzle looking at why people don't annuitize. And it does seem that people are pretty happy when they see their Social Security benefit, people who are in defined benefit plans are quite happy to have them. But when you show people a large lump sum, they are more reluctant to turn that into an annuity and part of that of course is that people have bequest motives, part of that is that right now annuities are quite expensive because interest rates are low. But some of it--the annuity puzzle existed even when interest rates were quite a bit higher.

There's also a lot of academic research from outside academics as well as people inside Morningstar that shows depending on a retiree's goals annuities can be a very valuable part of their asset allocation or their product allocation because it is a ballast against longevity risk. So I think that there is a lot of room for people to--I guess I would say I think people in the U.S. are probably somewhat under-annuitized relative to their goals even if they have strong bequest motives.

Benz: OK. Another issue that you looked at in the paper was the issue of what you call universal pensions, and so the version of that in the U.S. is Social Security. So, you compared Social Security to other universal pension systems in these countries that you examined. You found that Social Security is actually pretty generous from a drawdown standpoint.

Szapiro: It really is. Our system is quite generous. First of all, it is truly universal. It's not means-tested. Lots of other countries such as Australia that are rich, developed countries have means-tested a universal type pensions. So that means every retiree can count on it for at least some of their retirement income as long as they worked and paid into the system. So that right of the bat makes the U.S. pretty generous, and then the actual benefit, the actual replacement rate for Social Security is quite a bit higher than basically every other country that I looked at and almost every other country in the world. So it really is quite a generous system, and I think sometimes we think of it as being something a little bit extra or not having this importance but it's a very--the present value of Social Security is a very large asset for most retirees and it's something that is a great feature of our system.

Benz: You note though that there's room for improvement there, too, that specifically in helping people make better claiming decisions, that there are potentially some things that policymakers could look at?

Szapiro: Absolutely. So, I think most retirees, we look at the data, are claiming Social Security before their "normal retirement age" and very few are delaying until 70. If you think that many people are a little under-annuitized, delaying Social Security, which would increase the value of that benefit for the rest of that retiree's life--and for that retiree's spouse's life if the primary owner were to pass away first--could be very valuable thing. And I don't think that information is getting to people yet. I mean, I know in the kind of finance and policy world everyone says, oh, people should delay Social Security, but we're not seeing people doing that and that would make a strong system even stronger.

Benz: One thing I often hear from our Morningstar.com readers is, they say, well, I'm going to take it now and invest it. But my counterpoint is always, that's a really high hurdle. You've got a guaranteed rate of return that's something like, what, 8%?

Szapiro: 8%, yeah.

Benz: 8% for every year you delay past full retirement age.

Szapiro: Right. It's a very, very good deal and particularly it's a very, very good deal in the current interest-rate environments where an annuity from the private sector would cost twice as much.

Benz: OK. Aron, interesting research. Thank you so much for being here to discuss it with us.

Szapiro: Thanks so much for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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