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Why Retirees Need to Adjust Their Mental Accounting

Karen Wallace, CFP®

Michael Kitces is a partner and the director of wealth management for Pinnacle Advisory Group, co-founder of the XY Planning Network, and publisher of the continuing education blog for financial planners, Nerd's Eye View. You can follow him on Twitter at @MichaelKitces.

Karen Wallace: Hi, I'm Karen Wallace for Morningstar. Research suggests that when we mentally account for our money, we tend to separate our income and assets into different buckets defined by our priorities. Joining me to discuss that topic is financial planning expert Michael Kitces.

Michael, thanks so much for being here.

Michael Kitces: Thanks, Karen. Thanks for having me.

Wallace: You wrote an article recently about how we mentally account for our money, and there are some different ways that people sort of separate those into buckets. Could you explain a little bit about how that works?

Kitces: Yeah. This was some fascinating research that started with a paper that Shefrin and Thaler did a number of years ago where they looked at the way that people categorized their money in their heads--how do we think about all the different assets and income sources that we have. What they found is that most people end up indirectly bucketing their money into three categories.

The first is my current income--the checks that are coming into pay my bills, right? This is why we like paychecks. Just steady income, I can pay my bills. The second bucket is our current assets--do we have money we can tap if we need it for a problem. So, classically, this is our emergency fund, but emergency funds, checking, savings, money market, just like anything that's liquid go-to money. Then the third bucket is kind of the everything else for the future bucket, kind of future income, future assets. This is classically where we put retirement accounts and sort of long-term goal-oriented money.

But there's kind of an implied prioritization to them as well, that first and foremost, we need current income. If I can't pay my bills, I don't really care about my retirement portfolio. Second is, we need to make sure the current assets are filled up? I don't care about saving for future income and future assets until I've got my current liquidity figured out, so that I can pay my bills and handle an emergency. And only then do we get to the third bucket. And it's very powerful when we start looking at how do people make decisions; how do they allocate their money, because we routinely see in practice like this really is how we start categorizing our money in our assets as we live our lives.

Wallace: You made the point that some savers have more than enough in assets but they may feel like they are not as well off because they don't have as much income as they would want to.

Kitces: Right. Income shortfalls or asset shortfalls, current asset shortfalls, can create challenges where we feel less wealthy maybe even than we are. Another really interesting study that came out from the U.K. just a few years ago found that when they looked at just people's happiness and life satisfaction, it was more predicted by the amount of money in their checking accounts than their total wealth or their investments in their retirement accounts.

So, if I've got a bunch of money in my checking account and nothing in my retirement savings, I felt better than having $1 million in retirement savings and nothing in my checking account. If I don't have the cash, I don't feel good, I don't feel comfortable, I don't feel settled. And if I don't have income in a way that income is actually producing for my household, I don't feel settled.

And that I think becomes a real issue when--so the original mental buckets were kind of, those of us who are in our working days. So, my income bucket is pretty straightforward--hopefully, my employer gives me a check on a regular basis. My current asset bucket is pretty straightforward. This is my cash and checking and savings. And then everything else goes into the retirement bucket. When you get to retirement, when you actually transition in retirement itself, you have to reconstitute these buckets in ways that either aren't always natural or we can create some stress for ourselves if we don't have a way to translate them. We see this routinely with retirees that we work with.

There's a person that comes in and says, I've saved all this money, I've got all these buckets of money that I've been saving for retirement, but I'm not getting a paycheck anymore and I'm really freaked about how am I going to pay my retirement bills. So, you spend like $20,000 a year and you've got half a million dollars, this isn't even hard math. You've got way more money than you need. But they are very, very anxious because it's not natural to change the future asset bucket into a current income bucket. You got to do something, buy some bonds, buy some dividend-paying stocks, create a liquidation strategy, like something to translate assets into income.

Likewise, we see a lot of retirees that get very unsettled, so we look at their portfolio and, they have more than enough retirement assets to cover all of their retirement needs and we could sell anything like that if we need to, to generate more cash. But there's not a whole bunch of money in their checking accounts, they are anxious. We don't feel comfortable, we don't feel settled. And so, these buckets apply, I think, equally well and equally relevant in retirement. It kind of creates this--I call it a hierarchy of retirement income needs that, yeah, I got to have some retirement assets, but I'm not happy with my retirement assets unless I've also got some liquid cash. I'm not happy with my liquid cash unless I've also got current income to feed that cash bucket so I can pay my bills on an ongoing basis.

And I'll admit even sometimes we as financial advisors we get a little bit more focused on the big retirement bucket and not necessarily as much on the, are you comfortable with your current cash and are you comfortable with how income is producing to supplant that cash? And if we don't have strategies for that, it makes us very uncomfortable with our retirement, ironically even if mathematically there's more than enough money there. It's got to fit all the buckets as well for us to actually feel settled and comfortable.

Wallace: And one point you made that I thought was really interesting was that--you've seen it in your practice and elsewhere--is that an annuity would be a great solution for a lot of these income needs, but it's not a very popular solution.

Kitces: Right. We kind of have these divisions in the industry about what kind of products we're associated with tends to be our view around retirement. So, a lot of portfolio managers really like sort of asset-based retirement. We're going to accumulate assets. But people get very unsettled if you can't translate it to income. A lot of folks that come from the annuity side of the industry and actually a lot of the economics research says, well, if you just want to make certain you've got enough retirement income for your lifetime and never outlive it, just buy a lifetime annuity.

It's not hard. You write one check. You can't outlive the money. That's that. Yet, when we look at the industry statistics, almost no one buys lifetime immediate annuities with most or all of their retirement wealth. It's fewer than 1% of people. It's mathematically optimal, nobody does in practice or very few people do it in practice. And when we try to dig into figure out why, I think it comes back to this hierarchy that if I've got all my assets but no clear way to generate income, it doesn't feel very good even if I've got enough money, because I can't mentally feel the buckets. But if I put everything into the income bucket, it feels equally unsettling. I don't have my cash reserve if I really annuitize everything, and I have got no future upside.

I started out in the industry as an annuity agent. I wrote my first book on annuities. I've spent a lot of time looking at annuities and looking at how consumers engage with annuities. I've long observed this thing that I call the, "as good as it gets syndrome." So, the good news about buying something like a lifetime immediate annuity is, you can't outlive the money. You eliminate the downside risk of outliving your money because the checks keep going as long as you've got a heartbeat. The bad news though is, it ain't ever getting better than this either. The challenge of annuitizing your wealth is you can't outlive it, but you can't improve upon it because there's nothing left to be invested.

And so, when I find a lot of retirees sit down and in practice and say, so, here is how it's going to work. If you annuitize your wealth, you can't outlive your money, but you're never going to have any improvement in your lifestyle beyond what it is today. Where you are right now, this is as good as it gets. And that doesn't feel very good for most people. Even if there's a little bit of downside risk, like, I need a little bit of hope, I need a little bit of upside, I need a little bit of opportunity that like maybe some great surprise could still happen and things get better in life in the future.

And again, because that's one of the buckets that, we need to cover the current income, we need to cover the current assets, but we need to have some future upsides and future opportunities and future way that it can get better. And that's why I think we see which retirement strategies tend to be popular, which ones struggle, and the ways that we have to think through retirement, that you got to make sure you've got a plan about how all three of those buckets get checked off, right? We can't just go all cash--we won't have any growth in income. We can't go all income, because then we get stuck in the as good as it gets syndrome. We can't just have a giant portfolio and no plan of how to liquidate it or generate income, or you'll be very wealthy but feel poor because the other two buckets feel empty. And so, you have to have a plan for how you satisfy all three to really feel comfortable in retirement.

Wallace: Great. That's definitely something to think about. Thanks so much for being here to discuss this research.

Kitces: Absolutely. Thanks for having me here.

Wallace: For Morningstar, I'm Karen Wallace.