Say a retired husband and wife determine that they need $50,000, in addition to Social Security and any pension, in order to have a comfortable retirement.
The Wall Street retirement income approach would typically have them invest $1,250,000, assuming a 4% withdrawal rate adjusted for inflation. However, this approach does not guarantee the retirees will not run out of money early.
Another approach would be to find an immediate annuity that provides the same $50,000 income that would increase with inflation. When last priced, such an annuity was available for a single premium of $1,050,000.
The immediate annuity solution costs less, increases with inflation, and solves the problem of running out of money. However, it will seldom be selected. The reason: Although immediate annuities are often the most rational solution, retirees have consistently voted with their pocketbooks for non-immediate annuity solutions.
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Another strategy may do a better job of solving the retirement puzzle than the planning approaches currently used. This is to use an income-based approach to retirement that takes into account the way people really make decisions. This behavioral retirement approach recognizes that a consumer does not have an overall “low” or “high” risk tolerance, but that the perceived risk of each retirement income decision is defined by what the consumer will do with that income.
So, retirees will choose safe, less risky assets to fund an income that will always be there to cover food, housing, medical and other essentials. However, they will choose riskier assets to fund expenses they view as non-essential or luxury, such as travel costs, because they know that if the riskier assets perform poorly, the retiree can always cut back on those expenses, but if those assets do well, the retiree can fly first class instead of coach.
In short, consumers mentally create sub-accounts that link together the income producing asset and the expense.
Realizing this enables providers to better position products to solve retiree needs by showing retirees how the asset matches the expense from a risk perspective.