What You Need to Know
- Out of fear of running out of money, many retirees spend less than they could comfortably withdraw.
- Households spend more if they hold their wealth as guaranteed income, and not as investments, as they age.
- Retirees without a pension should consider buying an income annuity or delaying their Social Security claim.
Workers in the defined contribution era generally retire with a lump sum of assets. As fewer workers retire with a pension, the percentage of retirement income funded through guaranteed income is likely to continue declining as well.
The implications of this change on retirees is unclear. There is evidence from previous studies that many spend far less in retirement than they could comfortably withdraw from savings.
Deciding how much to spend each year in retirement from investments is complicated when both the length of retirement and asset returns are unknown.
Unknown longevity presents a tradeoff in which a retiree can either spend generously and risk outliving savings, or spend conservatively and live a less enjoyable retirement. A retiree who prefers not to accept the risk of outliving savings will spend less.
An alternative to spending from investments is to transfer the risk of an unknown lifespan to an institution, such as a pension, the federal government or an insurance company. A rational, risk-averse retiree who does not transfer longevity risk will spend less each year than if they had purchased a fairly priced income annuity.
Failing to Annuitize
Economic theory predicts that a retiree with similar annuitized wealth will spend more than a retiree with an equal amount of non-annuitized savings. The lifestyle that retirees give up by failing to annuitize is referred to by economists as the annuity puzzle.
Retirees may also experience behavioral costs from failing to annuitize. Retirees who are behaviorally resistant to spending down savings may better achieve their lifestyle goals by increasing the share of wealth allocated to annuitized income.
This could take the form of delaying claiming Social Security retirement benefits, choosing a job with an employer pension or purchasing an income annuity.
An annuity can not only reduce the risk of an unknown lifespan, it can also allow retirees to spend their savings without the discomfort generated by seeing one’s nest egg get smaller.
‘A License to Spend’
Annuities may also give retirees a psychological license to spend their savings in retirement. Surveys reveal a clear preference among retirees to live off income, and many don’t feel comfortable spending down assets to fund a lifestyle.
This is surprising since funding a lifestyle is presumably what motivates retirement saving to begin with, and few retirees indicate a desire to pass on significant wealth at death.