Morningstar Magazine - October/November 2016 - 20

Dispatches Retirees Need Help Converting Savings into Income U.S. policymakers can learn a lot from other countries' approaches. POLICY Aron Szapiro As the U.S. retirement system matures, retirees need to consider the best way to allocate their savings to ensure predictable, secure income. For their part, U.S. policymakers need to consider the best ways to encourage these retirees to allocate and draw down their assets to ensure that they last through retirement. Other countries have very different approaches than does the United States, and these approaches may offer lessons to both U.S. policymakers and retirees. The need to ensure that people make good decisions in retirement is more acute than it once was because defined-contribution plans have overtaken defined-benefit (or traditional pension) plans as the dominant type of retirement plan in the United States. In 1975, 33 million Americans participated in private defined-benefit plans and just 11 million were in defined-contribution plans. By 2013, according to the U.S. Department of Labor, defined-contribution plans had swelled to 92.5 million participants, while private defined-benefit plans covered just 39 million participants. The department's statistics further indicate that 13% of defined-benefit participants were in "frozen plans," in which they could not accrue additional benefits. The only sector in the U.S. economy with continued definedbenefit availability was the public sector, where about 80% of workers continued to have access to a traditional defined-benefit plan. Unlike defined-benefit plans, defined-contribution 20 Morningstar October/November 2016 plans require participants to save for their own retirement (often with an employer match), and critically, they require participants to determine how to convert that income into a lifetime retirement stream. When retirees determine how to ensure that their assets will last a lifetime, they face trade-offs between taking on risks and generating enough return to reach their goals. The key risks retirees face are investment risk, or the risk that their assets will fall in value when they need them; longevity risk, or the risk that retirees will outlive their assets; and inflation risk, or the risk that their assets will lose purchasing power over time. Retirees' goals obviously include generating sufficient income to maintain their standard of living and may also include desires to leave a bequest to descendants, maintain liquidity for unexpected expenses, or minimize the volatility of income in retirement. International Context I examined the retirement systems in Australia, Canada, Chile, the United Kingdom, Singapore, and Switzerland to see what lessons U.S. policymakers could learn from other approaches to helping participants convert savings into lifetime income. Most countries provide a backstop by providing at least some level of universal retirement benefits. However, these universal benefits vary enormously between countries. In some countries such as Chile, universal benefits are just a minimum level of income, while in countries such as the United States, the United Kingdom, and Canada, universal benefits make up a substantial portion of many peoples' retirement incomes. The biggest way countries vary is in the extent to which they encourage retirees to manage their risks by buying annuities. (For this article, I use the term annuity to mean a single-premium immediate annuity, which provides a stream of income for life in exchange for a lump sum premium, thus helping retirees address investment and longevity risk in retirement. This is the type of annuity policies encouraged in some countries.) There is a wide consensus in the academic literature that most retirees should annuitize a large portion of their assets to avoid the risk of running out of money in retirement. This phenomenon is known as the annuity puzzle, a term coined by Nobel-prize winner Franco Modigliani in 1986. (That's not to say there aren't downsides to buying an annuity. After all, when a retiree purchases a fixed annuity, there is no chance of enjoying the potential gains of investing in riskier assets, and retirees who annuitize fully will lose access to liquid assets they may need for an unexpected expense, as annuitizing is irrevocable in many cases.) In the United States, retirees often eschew annuities and usually rely on some form of "programmed withdrawals," which are a series of payments from a retirement account that follow some rules about how much to withdraw. For example, a programmed withdrawal may be as simple as calculating 4% of a retiree's assets at retirement and distributing this amount as a monthly payment, with annual increases for inflation. But U.S. policymakers can learn from other countries' approaches to helping retirees generate lifetime income: 1 Protect Retirees... From Themselves The United States has comparatively few mechanisms to protect retirees from themselves. Many countries impose limits on withdrawals from defined-contribution accounts, or at least offer educational material to discourage retirees from spending their nest eggs too quickly. In contrast, the United States has almost no mechanism to encourage or require retirees to plan for a long retirement. In fact, Canada, Chile, Singapore, and Switzerland all limit that amount of money participants can withdraw in retirement. Australia, the United States, and the United Kingdom (after recent reforms), do not limit withdrawals, but the United States stands alone with no national educational campaign to help people consider the best way to convert their savings into lifetime income.

Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2016