The Actuary Magazine, April/May 2005 - Understanding of Retirement Security

Disconnected: 10 Ways Americans Lack a Realistic Understanding of Retirement Security

by Eric T. Sondergeld

Actuaries play an integral role in educating the public about retirement plans.

This article is based on a report titled "Public Misconceptions About Retirement Security", which is a project of the Committee on Post-Retirement Needs and Risks and jointly sponsored by LIMRA International, the Society of Actuaries and Mathew Greenwald & Associates. The report is found on the post-retirement needs and risks page, which is located here. This report uses data from a variety of studies sponsored by different groups, and compiles important information about retirement planning across these studies.

Under the most common patterns of employee benefits offered today, workers will need to accumulate substantial savings before retirement and then gradually draw down those savings after retirement. Therefore, personal knowledge and choices in planning for retirement will be much more important in the future. Unfortunately, many workers and retirees have an incomplete or misleading picture of how much they need to save, how to invest such savings effectively and how to make their money last a lifetime. Clearing up such misconceptions will be essential for people to fulfill their dreams of a comfortable retirement.

The purpose of the "Public Misperceptions About Retirement Security" report is to highlight such gaps in knowledge and lay the foundation for educational programs and other measures to fill these gaps. While perhaps not obvious at first, actuaries can and will need to play a critical role in narrowing these gaps.

Saving too little
Most people (57 percent, according to the 2004 Retirement Con-fidence Survey) have not tried to estimate how much money they will need for retirement. Moreover, those who have calculated this amount often underestimate it. But, what is the right amount to save? In other words, what does retirement cost and how might that cost differ based on the extent to which individuals self-insure retirement risks versus incorporate risk transfer products like annuities and insurance? Actuaries can make a major contribution to this dialogue and in helping people determine the "right" amount for them.

Not knowing when retirement will occur
This is a tough one. How do you plan for retiring earlier than you planned to retire? Many workers will retire before they expect to, and often before they're ready for retirement. Nearly two in five (39 percent) retirees said they retired earlier than planned. Half of these cited health issues (2003 Retirement Confidence Survey). As a result, many of those who retire earlier than planned will not be able to make up shortfalls in savings by working. This relatively common event is not commonly incorporated into retirement planning.

Not knowing when death will occur
As individuals learn to manage their own retirement funds, they may not understand that life expectancy is a very limited planning tool. No one knows when death will occur (except some people very near death), and there is usually a long period over which death might occur. In fact, new retirees who bet on when they will die (by assuming they will live to a certain age, say, life expectancy) will ?win? (or guess the right year of death) less than 5 percent of the time. That is true because the conditional probability of dying at any particular age for, say, a 65-year-old, is less than 5 percent in all years. Approximately half of people at retirement age will live beyond the average life expectancy and many will live long beyond that point, with a substantial risk of outliving their savings.

If you do happen to work for a life insurer and your Web site has a retirement calculator, double check that it doesn?t assume retirement lasts a predetermined number of years or that 100 percent of savings are annuitized, leaving nothing for emergencies, etc. Both types of calculators result in inadequate savings targets.

Not facing facts about long-term care
Many people underestimate their chances of needing long-term care. Relatively few people either own long-term care insurance (one source pegs LTCI penetration at about 8 percent) or can afford to self-insure an extended long-term care situation. The most often cited reason for non-ownership of LTCI is that it is too expensive. However, while people are relatively good at estimating the cost of care, they tend to grossly overestimate the cost of coverage (LIMRA, HIAA, 2002).

Trying to self-insure against long life
Although people say that they find guaranteed lifetime income attractive, in practice they usually will choose to receive retirement plan benefits in lump-sum form. They pass up opportunities to get a lifetime pension or annuity, failing to recognize the difficulty of self-insuring their longevity. While retirement benefits are increasingly being made available in lump sum form, a majority of workers with retirement plans say they desire guaranteed lifetime income in retirement. According to the SOA Retirement Plan Preferences Survey, more than four in five workers prefer to receive their retirement plan benefit in the form of regular payments for life. In addition, guaranteed income has many benefits. Other than the obvious, the higher the proportion of guaranteed lifetime income sources (excluding Social Security) to total retirement income, the more likely retirees are to be satisfied with retirement and the less likely they are to be concerned about outliving their assets.

Not understanding investments
Due to the growth of workplace retirement savings plans, workers are now responsible for managing investments for retirement. However, many workers misunderstand investment returns and how investment vehicles work. For example, workers contributing to a retirement savings plan at work on average expect money market funds to achieve average annual returns of 7.7 percent over five years (John Hancock, 2002 Defined Contribution Survey). Respondents to that same survey rated company stock as less risky than a diversified portfolio of domestic stocks. Assuming this lack of knowledge didn't get in the way of saving a significant amount by retirement, the typical advice when they retire is to start withdrawing some percentage annually (typically 4 percent to 6 percent) from a diversified portfolio of mostly stock mutual funds and then increasing their withdrawals by the rate of inflation each year. Such advice often makes no consideration for income needed or making sure the income lasts for life.

Relying on poor advice
Speaking of advice, a significant portion of retirees and pre-retirees do not seek the help of a "qualified professional" to help them plan their retirements, yet they indicate a strong desire to work with a financial professional. Even if every retiree or prospective retiree sought the advice and guidance of a financial planner or financial advisor, there is no guarantee that the advice would be good. In other words, not all financial professionals understand the myriad issues retirees face and how to best prepare for and manage them. In addition, there are no standard ?qualifications? to help consumers find a qualified retirement professional. There are also no agreed-on professional standards about the correct answers to many retirement planning issues and questions.

Not knowing sources of retirement income
Workers misunderstand what their primary sources of income will be in retirement and may be disappointed when they try to live on the income that's available. They frequently underestimate the importance of Social Security before retirement and overestimate what will be available from other sources. Although the importance of various sources of retirement income may be slightly different for current workers than for current retirees, an understanding of roughly how much income will be needed from each source is crucial to good retirement planning. Two sources of retirement income that will assume increased importance are earned income and home equity. Numerous surveys have shown that a majority of workers plan to work in retirement. Continuing to work into retirement will allow many people to retire that could not otherwise afford to. However, they will need to realize that they may not be able to, or willing to, work forever, if that is their plan. Because so many people will reach retirement age with inadequate savings, their most valuable asset is likely to be their home. While tools such as reverse mortgages have to date been underutilized, actuaries could try to make them more appealing (and perhaps less costly) or develop other creative ways to tap home equity.

Failing to deal with inflation
Inflation is a fact of life that workers usually deal with through pay increases. But after retirement, few people have a way to increase their income to keep pace with the cost of living. Investments such as TIPS (Treasury Inflation Protected Securities) and I Bonds offer some inflation protection, but are not easy to construct a portfolio with that creates lifetime income. In addition, a small number of insurers offer inflation-adjusted immediate annuities. Actuaries should look into ways to hedge the inflation risk so that more such products can be made available to consumers. If that?s not a big enough challenge, consider the following facts:

  1. Social Security increases with the CPI-W, which is based on urban wage earners and clerical workers, not retirees.
  2. The government has created an experimental inflation index, the CPI-E, designed to measure price changes for expenditures of people age 62 and older. Since 1982 the inflation rate of the CPI-E has been higher every year than that of the CPI-W.
  3. Very few private pensions are adjusted for inflation. The bottom line is that income created from savings may need not keep up with inflation, but exceed that growth so overall income is inflation-adjusted.
  4. Income needs in retirement may not be constant in real terms.

Not providing for a surviving spouse
Many married couples fail to plan for the eventuality that one spouse will die before the other. This can have serious consequences, especially when the survivor is the wife. Couples often assume a particular spouse (usually the husband) will predecease the other. They may further assume that the other spouse will die relatively soon after. However, there is a three in four chance that one spouse of a 65-year old couple will survive the other by at least five years.

There are some things we can reasonably expect some people to know. There are some things we can reasonably expect all people to know. What we cannot expect is that the vast majority of people will know enough of these things and take appropriate, responsible action as a result of this knowledge. The question is, what can you do to ensure the maximum number of people plan adequately?

Eric T. Sondergeld, ASA, CFA, MAAA is corporate vice president and director Retirement Research Center for LIMRA International. He can be contacted at: