Is This Outcome Worse Than Going Broke in Retirement?

This is the latest in a series of columns about Social Security and retirement income planning.

While there are many emotions associated with retirement, perhaps the most common one is apprehension. Even those with significant wealth socked away worry about what life may bring once they leave the perceived security of a steady paycheck.

Research shows that many diligent savers with sufficient assets to enjoy retirement end up significantly underspending and needlessly sacrificing their quality of life — all due to a fear of running out and a deep sense of discomfort with watching their portfolios shrink after decades of steady accumulation.

This is one reason why the findings of a new research report published by Michael Finke and David Blanchett are resonating with ThinkAdvisor readers. Summarized simply, Finke and Blanchett show that Americans with income guarantees feel a “license to spend” more freely than peers with actuarially equivalent wealth held only in stocks and bonds.

To be clear, this freer spending isn’t putting retirees at higher risk of running out of money late in life. Rather, by shifting a portion of non-annuitized wealth into annuitized wealth, Finke and Blanchett find, the typical retiree feels comfortable spending twice as much each year per dollar of accumulated savings without making late-in-life bankruptcy any more likely.

“Economic theory provides both rational and behavioral explanations for under-spending among retirees with high non-annuitized wealth,” Blanchett and Finke write.

Rationally risk-averse retirees will spend less because they don’t know how long they will live and face the risk of outliving savings. That’s fine as far as it goes, Finke and Blanchett note, but retirees may also exhibit irrational behavioral preferences that make them far less comfortable spending from assets versus spending from income.

These people get used to seeing their asset pool grow over a lifetime of savings, and the mental transition to decumulation — however well planned and controlled — is a big behavioral challenge.

These results should inspire annuity-skeptical advisors (and their clients) to rethink the potential role of guarantees in the pursuit of their desired retirement lifestyle, Finke and Blanchett told me. I’m inclined to agree.

The License to Spend

By holding household wealth constant, the Finke-Blanchett analysis shows that annuitized households are spending more not because they are wealthier — since financial assets can be converted to guaranteed income through actions such as delayed claiming of Social Security retirement benefits or purchasing an annuity. Rather, it is the form of the wealth they hold that affects spending decisions.

The pair’s marginal estimates indicate that investment assets generate about half of the amount of additional spending as an equal amount of wealth held in guaranteed income. In other words, retirees spend twice as much each year in retirement if they hold guaranteed income wealth instead of investment wealth.

“Therefore, every $1 of assets converted to guaranteed income could result in twice the equivalent spending compared to money left invested in a portfolio,” Finke and Blanchett write.

An Income Floor Creates Comfort

The underlying analysis considers a retired opposite-sex couple with a high relative risk aversion against a much more risk-tolerant retired couple. Each holds a portfolio of bonds to fund spending in retirement with an expected return of 4%.

Based on traditional Monte Carlo planning projections, the risk-averse retired couple can maximize expected well-being in retirement by withdrawing 3.8% from their bond portfolio each year, while the risk-tolerant retiree will maximize expected utility by withdrawing 4.9% from the portfolio.

The real insight from the research comes from assuming each couple annuitized a portion of their savings at retirement in order to create an “income floor” that complements their Social Security benefits.