The Future of Retirement Income in...
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Presented by: Michael S. Finke Professor & Director, Retirement Planning and Living Department of Personal Financial Planning T EXAS T ECH U NIVERSITY The Future of Retirement Income in America
Transcript of The Future of Retirement Income in...
Presented by:
Michael S. FinkeProfessor & Director, Retirement Planning and Living
Department of Personal Financial PlanningTEXAS TECH UNIVERSITY
The Future of Retirement Income in America
Growth in DC assets vs. assets in public and private defined benefit (DB) pensions
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
$8,000
1974 1979 1984 1989 1994 1999 2004 2009 2014
IRAs DC plans Private-sector DB plans State and local government DB plans Federal DB plans
Net Tax Benefit for US DC Plan Participation
15.00%
25.00%
35.00%
45.00%
55.00%
65.00%
75.00%
Authors calculations, Percentage benefit of saving over 30 years vs. taxable account at 9% in a 50/50 portfolio
Defined Contribution Plan Balance by Income Age 43-50
$0
$100,000
$200,000
$300,000
$400,000
$500,000
$600,000
$700,000
$800,000
0 1 2 3 4 5 6 7 8 9
Median 75% 90%
Source: 2008 National Longitudinal Survey of Youth
Defined Contribution Plan Balance by Age Group
$0
$100,000
$200,000
$300,000
$400,000
$500,000
$600,000
25-34 35-44 45-54 55-64
20% Percentile Median 80% Percentile
Financial Literacy Particularly Low Among Less Educated Americans
0
10
20
30
40
50
60
70
Basics Borrowing Investing Protection
<HS HS Some Coll College Grad
Source: Texas Tech Financial Literacy Assessment Project
What Did Near-Retirees Wish They Had Done to Prepare for Retirement?
0%
10%
20%
30%
40%
50%
60%
Started Saving Sooner Saved More Invested MoreAggressivelySource: TIAA CREF, 2014
Concern About Retirement Finances
Explanations for Low Saving“A crucial fact is that the human brain is basically a mammalian brain with a larger cortex. This means human behavior will generally be a compromise between… animal emotions and instincts, and… human deliberation and foresight.”
C. Camerer (Cal Tech), G. Loewenstein(Carnegie-Mellon), D. Prelic (MIT), 2004, Neuroeconomics: Why economics needs brains. Scandinavian Journal of Economics,
106(3) 79
Two systems in the brainAreas of the prefrontal cortex are associated with rational, higher cognitive thought.
The more central limbic system is the immediate reward system (“dopaminergic”).
The “dual-self” model
Dual-self exampleRead & van Leeuwen (1998). 200 participants. People who were not hungry, chose the unhealthy snack for delivery in one week
26% of the timeThey chose the unhealthy snack for immediate consumption
70% of the time
← Next Week
Right Now → 26%
70%
Another Example
Retirement Saving and Dual Self• We save more when we don’t think about it• We don’t get around to saving if we have to
think about it
Source: Choi, Laibson, Madrian & Metrick, 2001
Organ Donation Opt-In vs. Opt-Out
Source: Johnson and Goldstein, 2003
Automatic vs. Optional
050
100150200250300350400450500
SS WealthDC Assets
Author’s calculations using data from Gustman and Steinmeier, 2014
Auto Escalation
0
2
4
6
8
10
12
14
16
Didn't Escalate Saw an Advisor Accepted Escalation
Pre-Advice1st Raise2nd Raise3rd Raise4th Raise
Benartzi and Thaler, 2004
Post PPA Studies(June 2013 for employees hired 2010-2012)
0%10%20%30%40%50%60%70%80%90%
100%
Voluntary Automatic Auto NoIncrease
Auto Increase
1 year2 years3 years
Source: Clark, Utkus and Young, 2015
Participation Rates
Auto-Enrollment & Projected Savings
Impact of Having a DC Plan
-0.8
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
Hyperbolic Have a DC Hyperbolic with DC
Predicted Wealth
Source: Guo and Finke, 2015
What Else We’ve Learned• Defaults are incredibly powerful
Source: Choi, Laibson, Madrian & Metrick, 2001
Percent Saving Exactly the Default Rate
Automatic Investing Revolution
0
5
10
15
20
25
30
35
40
Age 20-29 Age 60-69
% Invested in Target Date Funds
ICI Factbook, 2014
Solution to Highly Variable Asset Allocation
Monthly Average Risk Aversion Values and S&P 500 Index Level
500
700
900
1100
1300
1500
1700
4.00
4.25
4.50
4.75
5.00
5.25
5.50
Jan-06 May-07 Sep-08 Feb-10 Jun-11
S&P
500 I
ndex
Lev
el
Risk
Ave
rsio
n Sc
ore
Month
Average Risk Aversion S&P 500 Index Level
Max = 5.405
Min =4.525
Avg = 4.949
$ From Portfolio to Fund Spending
$
Wealth
Income
Saving
Consumption Dissaving
Retirement begins End of life
Retirement According to the Life Cycle Hypothesis
25
Longevity Risk
Unknown Planning Horizon
Macro/Market
Investment VolatilityInterest Rate Volatility
Public Policy and TaxationSequence of Returns
Inflation
Rising Costs of Living
Personal Spending
Health & Long-Term CareHelp Other
Family MembersDivorce
Fraud/Theft
Retirement Income Risks
26
Idiosyncratic Longevity Risk
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 101 103 105 107 109 111 113 115
Prob
abilit
y of D
eath
Prob
abilit
y of S
urviv
al
Age
Longevity: The Income/Longevity Gap is Expanding
14
15
16
17
18
19
20
21
22
1912 1917 1922 1927 1932 1937
Year
s Aft
er A
ge 6
5
Year of Birth
Higher Income
Lower Income
28
Wealthier People Tend to Live LongerChange in average additional life expectancy (in years) at age 55, by wealth, between cohorts born in 1920 and 1940
5.95.3
4.94.6
4.23.9
3.63.3
2.71.7
3.12.4
1.81.4
10.5
-0.2-1
-1.6-2.1
-3 -2 -1 0 1 2 3 4 5 6 7
Richest 10%81%-90%71%-80%61%-70%51%-60%41%-50%31%-40%21%-30%11%-20%
Poorest 10%
Change (in Years)
WomenMen
Source: Barry Bosworth, Brookings Institution29
Some Perspective on ProbabilitiesProbability of a 65-year-old living to age 95, based on different mortality tables.
7% 13% 1% 19%
20% 29% 6% 43%
Male Female Both ≥1
Average American
Healthy American
25% 33% 8% 50%Healthy American in 15 Years
Source: Social Administration 2010 Periodic Life Table, Society of Actuaries 2012 Annuity Mortality Table30
How Much Can You Spend in Retirement?
0%
2%
4%
6%
8%
10%
12%
14%
1900 1910 1920 1930 1940 1950 1960 1970 1980
Initi
al S
usta
inab
le W
ithdr
awal
R
ate
Retirement Year
Source: Ibbotson31
DEAD
Real Spending
Age 65 Age 95
Assumptions About Spending
32
Using Treasury Inflation-Protected Securities (TIPS) or Bonds to Buy Income
-$250,000
-$50,000
$150,000
$350,000
$550,000
$750,000
$950,000
65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95Age
Bond Portfolio 0.5%
Bond Portfolio 1%
Spending
$40,000 Inflation Adjusted Real Return Determines When you Will Run Out
Current Real Treasury Bond Rates 5 Year = 0.31%10 Year = 0.41%20 Year = 0.61%30 Year = 0.76%
Inhe
ritan
ce
Source: Finke, 201533
Using Portfolios to Fund Retirement Income:Deterministic vs. Stochastic
Deterministic – You know exactly how many years of inflation-adjusted income you can buy with TIPS.• Real interest rate, annual spending determine
when you run out of money
Stochastic – unknown variance in bond returns (inflation, risk premium) and real stock returns• Real risk premium on equities and bonds = higher
or lower potential portfolio size than with TIPS• Sequence of returns matters
34
PortfolioValue $
Age 66 Age 67 Age 68 Age 69 Age 70
$800,000
$1 Million
$600,000
$400,000
$200,000
$1.2 Million
$759,000
Spending = $40,000 Real
$982,625
$565,175
+35%
-20%
$1.28 Mill
$743,024
-20%
$719,991
$409,064
$283,099
$550,267
$927,727
$531,776$508,084
$982,622$958,930
$696,925$672,641
$380,165
$640,517
$361,211$336,927
$181,223
$1.21 Mill
$394,957
$697,604$721,887
$1.25 Mill
$740,841
$1.28 Mill
$950K Bond Only
50% of Retirees
25% of Retirees
12.5%
6.25% 3.125%
Age 65 (or 85)…
+35%
Using Risky Investments in RetirementHypothetical Example: 50/50 Chance of -20% or 35% (7.5% Average)
Source: Finke, 201535
Simulating Retirement Outcomes
Source: Finke, 201536
Retir
emen
t Wea
lth
Age 70 75 80 85 90 95 100
SUCCESS!
The Cone of Retirement Outcomes
Source: Finke, 201537
Sequence of Returns Risk by Age
0 10 20 30 40 50 600
2
4
6
8
10
12
14
16
Year
Exp
lana
tory
Pow
er fo
r Eac
h Y
ear's
Ret
urn
Retirement Year
Source: Calculations by Wade Pfau, 201438
Asset Valuations Today
Source: Robert Shiller
05101520253035404550
0
2
4
6
8
10
12
14
16
1881 1906 1931 1956 1981 2006
CAPE
Rat
io
Bond
Yie
ld
Year
10 Year Government Bond Yields Shiller CAPE Ratio
39
Bond Yields & Future 10 Year Bond Returns
y = 0.9466x + 0.0084R² = 0.9203
0%
3%
6%
9%
12%
15%
0% 3% 6% 9% 12% 15%
Aver
age
Annu
al 1
0 Ye
ar F
utur
e Co
mpo
unde
d Bo
nd R
etur
n
Current Bond Yield
Source: Ibbotson40
CAPE Ratios and Future 10 Year Stock Market Returns
y = -0.0035x + 0.1461R² = 0.2384
0%
4%
8%
12%
16%
20%
5 10 15 20 25
Futu
re 1
0 Ye
ar A
nnua
lized
R
etur
n
CAPE Ratio
Source: Ibbotson41
57%
79%90% 93% 93% 93% 93% 92% 91% 90% 88%
3%8%
21%
37%49%
56% 61% 64% 65% 65% 64%
0%
20%
40%
60%
80%
100%
0% 20% 40% 60% 80% 100%
Prob
abili
ty o
f Suc
cess
Portfolio Equity Allocation
Historical Returns Model Forecasted Returns Model
Monte Carlo Simulations
Source: Blanchett 201542
Constant Spending May be Unrealistic
R² = 0.3009
R² = 0.5702
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
60 65 70 75 80 85 90
Annu
al R
eal C
hang
e in
Tota
l Ex
pend
iture
s
Age
Source: “Estimating the True Cost of Retirement” by David Blanchett, Morningstar white paper43
Median Health Care Spending
$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
$1,600
60-64 65-69 70-74 75-79 80-84 >85
Low Wealth Mid Wealth High Wealth
Does Money Make you Happy?
Source: Ho and Finke, 201545
Because Rich Retirees Spend More?Same Cohort Health and Retirement Study Consumption 2000-2008
Source: Browning, Cheng, Finke and Guo, 201446
Financial Wealth Differences
Source: Browning, Cheng, Finke and Guo, 201447
Income & Consumption by Wealth
$0
$10,000
$20,000
$30,000
$40,000
$50,000
$60,000
$70,000
Lowest Wealth Quintile 2 Middle Wealth Quintile 4 Highest Wealth
Average Income Real Consumption
Source: Browning, Cheng, Finke and Guo, 201448
Consumption Gap High Wealth30 Year Retirement, 40% Reserve
$40k $60k $80k $100k $120k
100%
80%
60%
40%
20%
0%
Succ
ess
Rat
e
MinimumSpending
Actual Spending
GAP
Benefit of Late Life Annuities
$0
$10,000
$20,000
$30,000
$40,000
$50,000
$60,000
$70,000
$80,000
$90,000
$100,000
65 70 75 80 85 90 95 100
Difference =QLAC Efficiency
Cost of Buying $100,000 Income at 65
Mortality Weighted Cost of Buying Income
Bond Ladder Vs. QLAC(Assume 4% Bond Return)
$(50,000)
$-
$50,000
$100,000
$150,000
$200,000
$250,000
$300,000
85 86 87 88 89 90 91 92
Invest $125,000 in a Bond Ladder at Age 65
Bond Portfolio Spending
Can Fund $125K QLAC Income Until Age 91
Need to Invest $248,000 at Age 65 to Fund Spending From 85 Until Age 100
$-
$100,000
$200,000
$300,000
$400,000
$500,000
$600,000
85 87 89 91 93 95 97 99
Or Simply Invest $125,000in a QLAC at Age 65
Options for Funding Late Life IncomeHow much would a 65-year old male have to set aside today
to fund same level of spending at age 85?
$0
$50,000
$100,000
$150,000
$200,000
$250,000
$300,000
$350,000
Buy a QLAC Bond Ladder at 4% Bond Ladder at 3%
Cost to Fund $44,623 in Spending at Age 85
Cognitive RiskImmediate and Delayed Average, 2010 Health & Retirement Study
Source: Browning and Finke, 2013
3
3.5
4
4.5
5
5.5
6
60 65 70 75 80 85 90
Episodic Memory
Dementia
Rates of Cognitive Impairment by Age
5
2437
16
29
39
0
10
20
30
40
50
60
70
80
71-79 80-89 90 +
Cognitiveimpairment, notdemenita
Dementia
Source: Agarwal, Driscoll, Gabaix and Laibson, 2010
Age and Financial Literacy
Source: Finke, Howe and Huston, 2013
Financial Literacy and Confidence
0
10
20
30
40
50
60
70
80
90
60 65 70 75 80 85
Financial Literacy Confidence
Source: Finke, Howe and Huston, 2013
Risk Aversion Change and Market Sentiment
0
0.05
0.1
0.15
0.2
0.25
25 or under 26-35 36-45 46-55 Over 55
Equity Allocation and Cognitive Decline
-40%
-35%
-30%
-25%
-20%
-15%
-10%
-5%
0%
LowCognition
AverageCognition
HighCognition
Percentage Change in Equities 2008-2010 by Word Recall
Questions/Comments
Michael S. Finke, Ph.D., CFP®Professor, Department of Personal Financial Planning
TEXAS TECH UNIVERSITY
[email protected]: FinkeonFinance
