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The living-too-long problem

Making everyone their own pension fund manager means that almost everyone has an incompetent pension fund manager.

By Karen Datko May 17, 2010 3:37PM

This guest post comes from Frank Curmudgeon at Bad Money Advice.


I think the folks at WalletPop must be running some kind of obvious-headline contest. Recently they carried "Airlines rake in billions from extra fees" and "Majority of social network users share too much." And then we got "Study: Longer life can bring pension money woes."


I'm willing to forgive WalletPop some for that last one. They are a bunch of kids who probably have not thought much about retirement. They do not yet realize that one of the biggest challenges in retirement planning, maybe even the single biggest one, is the somewhat counterintuitive fear of living too long.

If you are retiring on an old-school pension or annuity, which will pay you a certain amount every month as long as you are around to cash the checks, then living a long time is not much of a fiscal danger. Social Security works the same way.


But if you reach that golden moment of retirement with a pile of money that needs to last as long as you do, longevity risk is a tough problem. Interestingly, it has a fairly tidy solution, but nobody likes it.


There are basically three choices. You can pick an age, 90 for example, and manage your finances such that you will have enough to live until then and hope for the best. Perhaps if you live that long you will be so adorable that your kids, who may be retired themselves by then, will take care of you.


Alternatively, you could sip so slowly from your nest egg that it does not shrink. If you think you can get a 7% return on your investments, and inflation runs at 3%, then drawing 4% from your kitty to live off each year should leave it the same size in real terms from year to year. In other words, under this scheme you could afford to live forever.

The third way is to take your savings and buy an annuity that will pay you money for the rest of your life. Annuities are sold by insurance companies and they are indeed a form of insurance, in this case against sticking around for too long. So they are a nearly perfect solution for the longevity problem.


Alas, there is a deal-breaker. If you spend all your money on an annuity, then you won't have anything to leave to your heirs. That might seem like a minor concern, but I think it is the unspoken reason that annuities have never been very popular.


There seems to be a cultural taboo against admitting it, but most American retirees, and would-be retirees, at least aspire to option No. 2 above, the make-the-money-last-forever plan. There is nothing wrong with that. As a parent, I can attest to the primal urge to spend money on kids, including the commonplace desire to leave them a usefully large endowment when we go.

The problem is that if a retiree does not buy an annuity -- setting up what is a nearly foolproof retirement income scheme -- he's putting himself in the role of manager of a very small pension fund. And as I have said before, the problem with making everybody their own pension fund manager is that then almost everybody has a completely incompetent pension fund manager.


Of course, as the GAO report (.pdf file) from the WalletPop post reminds us, those with a sizable nest egg to manage are the lucky ones. (They would probably object that luck had nothing to do with it.) Social Security provides at least half of the income for 64% of households with at least one member over 65. Overall, investments provide only 13% of total income for those households. (Social Security is 37%, employment is 30%.)

So not only is the manager over his head, the pension fund is seriously underfunded.


Whether because of a lack of resources or aversion to buying something that will evaporate upon death, annuities are widely shunned, and the GAO report shares a few hard numbers to illustrate just how widely shunned. About 6% of American households own an annuity. That sounds mildly encouraging until you learn that virtually all of those are of the variable kind, really a tax-advantaged investment contract, rather than the sort that would provide a cure for longevity risk. Only 3% of annuities sold in 2008 were of the "fixed immediate" type that would be appropriate for a new retiree.


The degree to which we prefer to have a pile of money over a certain income for the rest of our lives is further illustrated in the GAO report by a survey they cite that asked people if they would be willing to swap their future Social Security payments for a lump sum. Only 41% chose the normal payments when the lump sum was actuarially equivalent.


The GAO report laments this state of things without suggesting a cure beyond the ever-popular call to increase financial literacy and the currently fashionable idea to streamline the many different regulatory agencies that are involved. Calls for more financial literacy are popular because "literacy" always has positive connotations and nobody really knows what the term means. Reducing and rationalizing regulators is almost always a good idea, but this particular problem has nothing to do with regulation.


This is one of those "we have met the enemy and he is us" things. Longevity risk has a direct and somewhat obvious cure, but almost all of us find it repugnant. Increased financial literacy will not change that.


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