Pop Quiz: How much of a lump sum would a 65-year-old need to generate an extra $500 a month for the rest of his life?
A soon-to-be-published study by Chris Browning, a doctoral student in the division of personal financial planning at Texas Tech University, found that even people with good math skills who scored well on overall measures of financial sophistication had trouble coming up with a reasonable estimate.
Here’s the answer. Assuming an average life expectancy of 84 and a return of between 3% and 10%, that 65-year-old would need $50,000 to $85,000 to bankroll the monthly bonus.
Most of the subjects in Browning’s study, even the more-sophisticated ones who understood the relative risk and likely return of different financial instruments, made wildly inflated guesses of more than $500,000. (That would be correct if the 65-year-old had another 146 years to live, Browning says.)
Browning’s study was designed to help explain why demand for annuity products is low even though pure theory suggests they can provide great benefits to retirees by countering the risk of outliving one’s savings. The results suggest that “while people might have financial sophistication in one area of financial markets, it doesn’t necessarily translate to others,” he says. In other words, understanding the stock market may not help individuals evaluate a complex product like an annuity.
Demand for annuities may pick up if retirees’ anxiety about securing stable income is compounded by a new political push to boost adoption of the products. In a recent survey by MetLife, 55% of American workers said they would rather receive their nest egg slowly over the course of their retired lifetime than as a lump sum, while only 9% said they’d prefer to manage the lump sum. MetLife, which sells annuities, has a financial interest in promoting this finding, as well as the fact that 44% of survey respondents said they would like their workplace retirement plan to include an annuity option.
Insurance companies aren’t the only ones promoting annuities. The Obama administration has indicated its support for annuities, and the Department of Labor will hold hearings in mid-September on promoting lifetime income options as part of retirement plans. Among other issues, the hearings will cover the question of whether 401(k) statements should be required to include an estimated monthly benefit if the current account balance were annuitized.
This renewed interest in annuities comes amidst a decline in the number of defined-benefit pension plans that pay retirees a fixed amount each month. There were more than 170,000 such plans in 1986, and as of 2007 there were fewer than 50,000 such plans, according to MetLife data.
“You’re seeing all of these defined-benefit principles being brought into the defined contribution market,” says Jody Strakosch, the national director of MetLife’s Retirement Products group. In other words, there’s a move to make 401(k)s look a lot more like traditional pensions.
The movement makes sense because when most workers retire, they have little or no experience managing a large lump sum of money, says Marc Pearlman, an investment advisor who specializes in behavioral finance. For some, the transition from spending to saving is painful, “like throwing a car from drive into reverse with no neutral,” Pearlman says. “Some people go on spending sprees, but a lot of people just get paralyzed,” he says.
Income annuities can purchased that allow you to have an inflation hedge for rising costs. This is very important when you’re talking about setting up an income stream that will last for the next 20 – 30 years. The cost of everything is going to go up during retirement, so you want to make sure your income will as well. Call us today to find out how an income annuity could fit in to your overall retirement income plan at 1-866-983-4222.