Image: Olivia S. Mitchell. Credit: Prcboettner, CC BY-SA 4.0, via Wikimedia Commons Article republished from BusinessThink. Read the original article here.
With population aging on the rise, important challenges must be addressed to help people avoid outliving their savings and other assets in retirement, according to one of the world’s foremost pension economists.
A key obstacle to helping people prepare financially for retirement is their lack of financial literacy, as only one in three adults worldwide is financially literate, said CEPAR Partner Investigator Olivia S. Mitchell, IFEBP Professor of Insurance/Risk Management and Business Economics/Policy at The Wharton School of the University of Pennsylvania.
Improving financial literacy
Financial literacy deteriorates with age, according to research by Professor Mitchell, who explained that both men and women experience declining financial literacy in later life. For example, older men experience a one percentage point drop per year in financial literacy over age 70. Women also experience similar systematic declines in financial literacy with age, compounded by the fact that older women tend to have slightly lower levels of financial literacy going into retirement.
“The problem that we face with financial literacy declining over time, is that even if you were in a position to manage your assets and drawdown sensibly at age 70, what happens when you’re 85 or 95? Many of you may have parents, grandparents, or relatives in that age range, and what you realise is that it starts to get pretty tough,” said Professor Mitchell, who recently delivered a keynote presentation at the Advancing the Retirement Phase of Superannuation hosted by UNSW Sydney’s Innovations in Risk, Insurance and Superannuation (IRIS) Knowledge Hub, Business Insights Institute and the Centre of Excellence in Population and Aging Research (CEPAR).
“There is a general lack of understanding of longevity, we see systematic biases in how people predict their own longevity. In particular, if they underestimate how long they’re going to live, they might not save enough, or they might draw down too quickly,” she said.
Impatience, retirement savings, and health
At the event, which brought together industry and academic leaders to discuss how the superannuation industry can support members in maximising income and mitigating risk, Professor Mitchell also told the audience that her research demonstrates that many older people heavily discount the future. This can lead them to under-save and overspend in the earlier stages of their retirement, leading to their potentially running out of money in later life.
As a result, older people tend to be “quite impatient” with regard to important decisions around retirement savings. “By impatient, what I mean is that they have a high discount rate, so they don’t think enough about future decisions. I’m not making a value judgment; rather, this is what the evidence shows. If you look at older retirees, many need to consider carefully how much to save or spend – and they make financial decisions differently compared to the young,” she said.
Professor Mitchell also noted that she has found that more impatient people tend to be much less healthy, have a higher body mass index, and are less likely to undertake end-of-life planning. “For example, many lack a living will that tells their next of kin what they would like in terms of medical treatment at the end of life, and they tend not to have a power of attorney," she said. "Therefore, being too impatient gets in the way of some of these key financial decisions."
Longevity risk and deferred annuities
Professor Mitchell, who is also a Research Associate at the National Bureau of Economic Research, has studied how to help people better understand longevity risk. Many are aware of their potential life expectancy, or their average expected years remaining, but very few correctly perceive the chances they might live a very long time in old age. Thus, giving people information about life expectancy tends not to alter their behaviour. This is because “people can readily access online retirement calculators to learn about their life expectancy,” she said.
"By contrast, when we tell people about their likely longevity, or the tail risk associated with living longer than their expected lifespans, this information does change their views and behaviours. For instance, it increases people’s chances of favouring lifetime income products such as annuities (insurance products that pay a lifetime income regardless of lifespan).” This is an inexpensive metric that financial advisers or insurers could provide their clients, thereby helping them make better saving and withdrawal decisions. She also added that “deferred annuities are a particularly attractive feature that we need to think more about.”
“Our goal is to try and figure out the optimal default annuity and then tailor that information very specifically to households,” she said. Using the US as an example, she compared consumption of older individuals who bought a deferred annuity using their 401(k) at retirement, with those who did not. One model simulation, calibrated to real data, showed how much more such an individual could enjoy with a deferred income annuity, especially from the age of 80 onwards. Her research showed, at age 85, a retiree having a deferred annuity payable from age 80 receives about $1000 more per year, and $4000 more by age 95.
“Ultimately, what we’re trying to do is make headway into what (Nobel Prize-Winning economist) Bill Sharpe has called the ‘nastiest problem in finance:’ striking a balance between having enough income to meet your retirement needs, and having enough to get through your life," she said.
Understanding annuities and reducing retirement regret
Professor Mitchell pointed out that many older people have a poor understanding of longevity risk, that is, the risk that they might outlive their life expectancy and live a very long time in later life. "As a result, they regret the financial decisions they made when younger,” she said. In an experimental survey, she queried two groups of people age 70+ about their survival probabilities and key decisions they had made earlier around finances, insurance protection, and retirement outcomes. This study sought to understand how regret levels changed once retirees knew about their chances of living a long time.
Overall, she found that 52 per cent of retirees regretted not having saved more, and many also regretted having stopped working too soon or not having purchased aged care insurance. Then she asked survey participants: “if you could do it all over again, would they have purchased a lifetime payment (an annuity from an insurance provider)? About one-quarter did regret not having purchased an annuity," she said.
"Yet when older retirees were informed about their actual chances of living a long time, this boosted regret by 42 per cent. If you explain longevity risk to them earlier in life, when they’re young enough to avoid making financial mistakes, then you have some opportunity for leverage.”
This regret also stems from a misunderstanding of how insurance works, according to Professor Mitchell, who said that consumers often see annuity products as a risky gamble. Yet she explained that “if you buy homeowner’s insurance, or auto insurance, that’s even riskier in the sense that your money’s worth and the expected value of the payback from homeowner’s insurance or auto insurance, versus the premium, is about half the value of a life annuity," she said. "By contrast, most life annuities provide peace of mind for a decent price.”