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Having Your Retirement Cake and Slicing It, Too

How to get comfortable with portion control.

Christine Benz: Hi, I'm Christine Benz for Morningstar. How can retirees wring the most from the assets that they've managed to save? Joining me to discuss that topic is Michael Finke. He is a retirement researcher at the American College, and he'll be speaking at the Morningstar Investment Conference.

Michael, thank you so much for being here.

Michael Finke: My pleasure, Christine.

Benz: I want to talk about people who are getting close to retirement. Many investors' balances are enlarged right now, so that might feel like an impetus to retire. But I also want to talk about a countervailing force, this idea of sequence-of-returns risk. Can you talk about that--why that's potentially a risk factor for people embarking on retirement right now?

Finke: So, let's reframe this question, and let's imagine that, for example, your kid is having a birthday party. And you go to Costco and you buy a cake, and then you get a phone call from your wife and she says, "I'm not sure how many kids are going to show up to the birthday party. It's probably going to be somewhere between 10 and 40 kids." And you're like, "Really? 10 and 40 kids? Like, how do I plan on that?" And she's like, "Well, just when the first kid comes, cut him a slice of cake, and then when the next kid comes, cut him a slice of cake." So the first kid comes, and you're looking at this cake, and you have to make a decision about how big of a slice to give the kid, because if you give him a slice that's too small, they're going to be unhappy. They're going to be like, "What a cheapskate." But if you give them a slice that's too big, if the 30th kid comes in and there is no more cake left, then you have a problem.

So, this is a problem that we all face with retirement is--we don't know how many slices of our retirement-savings cake we're going to need in retirement. So, we don't know how thick to slice each one. Now that's very important because at the very beginning of retirement, that's when we're healthiest, that's when we are capable of enjoying our money the most, but if we cut a really big slice at the beginning of retirement--in the first five years or the first 10 years--then we run this risk that if the 30th year comes, there is not going to be much cake left. And by the time we get to the 25th year, we're starting to then scrimp. We're slicing the cake smaller and smaller because we're afraid that we're potentially going to run out.

So, that is the fear that we all must face. So we have this choice between living well and potentially running out or not living well and potentially having half of the cake leftover because we never get to enjoy it. That's equally bad. I think that something that a lot of people don't think about--is what happens when you don't eat half the cake. That means that of your retirement resources, there was a certain amount that you could have enjoyed, but you didn't. 

Now, is it bad that you end up passing it on to others? That's not bad if that's your goal. But remember, in the defined-contribution system, that money, the reason that taxpayers subsidize, is so that we live better in retirement. And if we're not actually enjoying the money, which many people don't feel comfortable enjoying the money, that's a problem. That's what an economist says is an inefficiency. Like why did we save the money in the first place if not to actually enjoy it.

Now, let's add an additional complexity. Let's say that when you bake the cake yourself, you put in a special kind of yeast, and that yeast could cause the cake to get larger over time. So maybe by the time the 10th kid comes in, the cake is even bigger, and you can give everybody a big slice of cake because the cake continues to expand. Or that yeast may not actually rise the way you expect it to. In that case, the cake starts to shrink, and you're going to have to cut those slices smaller and smaller, and you may have started out by cutting a really big slice because you expected the yeast to rise, but it didn't.

That's what happens when you take risk with an investment portfolio. Why do we take risk? We take risk so that we can live better because our expected return is higher. It means that we can cut off bigger slices of the cake at the beginning of retirement because we expect that it's going to expand over time--but what if it doesn't expand over time? That's also what it means to take risk--is we have to accept the possibility that that cake is going to shrink. Then what happens? It means that our retirement is going to be even worse.

That sequence-of-returns risk is when the cake starts shrinking and all of a sudden we're forced to slice even smaller pieces of the cake as we live longer, and we've essentially failed at the game of retirement, if that happens.

So, if we get a bad sequence of returns, it means we just don't have as much of the cake to actually use in retirement because we got unlucky. And all of us, when we invest in risky assets, we have to acknowledge that we face the risk that we're going to be unlucky.

Benz: Right. I think that's a fantastic metaphor, Michael. Can you talk about the tools in investors tool kits to help manage this risk of being unlucky and coming into retirement and encountering a crummy market environment right out of the box? It seems like asset allocation, you touched on, rightsizing the risk in your investment portfolio, managing your withdrawal rate. Can you talk about other tools that retirees have in their tool kits when they're thinking about coming into retirement and maybe encountering a weak market right at the start?

Finke: Of course, the problem is that we don't know how many slices we're going to need to cut, so we end up cutting small slices because that's optimal because we're risk averse. But what would happen if, at the very beginning of retirement, we would create an agreement with someone else--and if we run out of cake, they come and give us a new cake, so they replace the cake and everybody gets a slice.

Now, wouldn't that be the right deal at the very beginning of retirement? If it happens that 35 kids come in, then someone is going to come in with a second cake from Costco, and they're going to save the day. Well, that's the idea of what's known as a "contingent deferred annuity." So that sounds like a very complex idea, but it's actually not that complex. It's saying that if you run out of money because your investment returns were not high enough or you live too long--only under that contingency is that annuity payment going to spring.

Let me start out by saying: First of all, if you take no risk, and you're only investing in bonds, annuitization is more efficient because you can spend more every year because you know you're not going to run out. Another alternative is what's known as a "deferred income annuity." With a deferred income annuity, we set aside maybe $100,000 at the beginning of retirement to buy, for example, a qualified longevity annuity contract that kicks in at the age of 80 or 85. So, we know that even if we run out, we're going to get this source of income that's always going to appear at the age of 80 or 85. But what happens if the markets do really well, and we don't need that deferred income annuity. That was essentially a waste. We took $100,000 that we could have spent at the beginning of retirement, and we bought a second cake and the guy comes in with a second cake, and we're like, "We've got plenty. We don't need it." So that was a waste.

Now, with a contingent deferred annuity, like a guaranteed withdrawal benefit--it's a guaranteed minimum withdrawal benefit--it only springs under the contingency that you've run out of money. And in many ways that is the most efficient way to draw an income in retirement, especially with a risky portfolio, because there is always this possibility you're going to spend more because you expect to get a risk premium from your investments. But if you don't and you get unlucky and you live a long time, then the annuity will spring and you will be able to receive a lifetime income after that point. And of course, you're going to have to pay for that. And so maybe you're going to have to pay 1% per year for that insurance. Well, that may be a lot cheaper than actually getting a deferred income annuity in present value terms, and if you just have an investment portfolio that is unprotected, then you're exposing yourself to that potential risk. And because you're exposing yourself to the risk of sequence of returns or longevity, it means you're either not going to spend enough or you're going to have to accept the possibility that you could run out if you get unlucky.

Benz: This is a variable annuity product. You referenced 1% as a potential fee drag associated with that product. But I think that oftentimes these fees can run so much higher, maybe closer to 3%. So, how do investors think about balancing those costs against some of these attractive features that you've outlined?

Finke: Yeah, these are products that have a large theoretical value, but there is a lot of variation in the amount of money that you're paying for the different elements of that. So, you could be paying--overpaying--for the cost of your investments. You could be overpaying for the cost of insurance. And I think you and I have both been calling for increased transparency for some of these products to make it easier for consumers to compare among different types of products. So, what is the credit quality of the insurance company? How much am I paying for the protection? How much am I paying for the investments themselves? Having greater clarity will allow people to make better choices about those types of products, but we can't simply dismiss those products because they provide protection that you cannot get with a regular portfolio, and the amount of money that you're paying for that protection is sometimes framed by financial advisors as an expense, but it is not an expense. You're paying for insurance. You're receiving an insurance benefit from it, and if you're not paying for that insurance, then you're exposed to the risk of potentially running out.

Benz: People tend to under-annuitize relative to what the academic research would suggest they should do. Can you outline some of the factors why financial advisors tend to shy away from the products and why individual investors may also do so?

Well, I mean, it has everything going against it. You're taking a lump sum of money and you're trading it to an insurance company for a promise of income. One of the big problems we have with the defined-contribution system is people frame their savings as a nest egg, but they don't frame it as income, which means that if I've saved $1 million for retirement and someone comes up to me and says, "You probably should take $300,000 and buy yourself a floor of lifetime income." It's painful to go from $1 million to $700,000 and all I get is a promise of income, which is relatively low right now because we're in a low interest-rate environment and people are living longer. It's expensive to buy income, and oftentimes people don't want to face the cost of buying income because it's depressing, frankly. I mean, it's the reality that we live in. But you can certainly spend more with that money than if you try to build, for example, a bond ladder. You can live better, but I think that psychological element of spending so many years focusing on the nest egg. And many people tie their feeling of self-worth to the value of their nest egg. And then to willingly see that nest egg get smaller, that takes a lot of courage. It takes a different way of thinking, and I think what the government is trying to do now in terms of presenting your lump-sum value in terms of the amount of annuitized income you could generate from that money is going to give people a lot greater clarity and is going to, I hope, help with the framing to make it easier for people to take some of their lump sum and turn it into income.

Benz: Michael, interesting insights as always. Thank you so much for being here.

Finke: My pleasure. Thank you, Christine.

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