We live in a world where pensioners have increasing flexibility in how to invest their retirement savings. In many developed countries, a newly minted pensioner can now choose to keep here pension fund assets in the fund and turn it into a lifetime annuity, take it out of the pension fund and manage it, or purchase a private annuity. And those are just the basic options.
But the problem with annuities is that in a low-interest world, they don’t look attractive anymore. I used the UK government’s Pension Wise online calculator to estimate how much annual income I would receive if I had saved £133,000. UK law allows you to take out 25% of these savings tax-free and invest the remainder in a lifetime annuity. The £133,000 was chosen so that I could calculate the annual annuity income per £100,000.
And the answer is… drum roll… £4,800. Not per month, but per year. And that income is then still taxable (though if you have £4,800 in annual taxable income you don’t have to pay taxes anyway because you’ll be homeless and living under a bridge).
Yet, what you get from an annuity is guaranteed income for life and that is worth more than most people think. Wenliang Hou from the Center for Retirement Research at Boston College surveyed Americans about their perception of risks in retirement and then compared these perceptions with the true risk of different factors.
The key challenge is that most retirees perceive their longevity risk (i.e. the risk of outliving your assets) as significantly lower than it really is. Meanwhile, they perceive market risks as much higher than they really are. Here is the estimated remaining life expectancy for US men and women at age 65 in comparison to the true life expectancy at that age. On average, people live about 7 years longer than they expect.
Estimated life expectancy at age 65 vs. true life expectancy
Source: Hou (2020).
The best way to deal with this longevity problem would be to invest in an annuity or ideally a deferred annuity that kicks in once you turn 75 or so. This way, the annuity becomes cheaper and the retiree can use most of her nest egg to invest herself. The study of Hou shows that pensioners should be willing to give up about 25% to 30% of their retirement nest egg to insure against longevity risk. With the rest, they can do other things.
However, with annuity income so low due to low interest rates, most pensioners don’t insure against longevity risk but rather invest the money themselves. At which point they fall into the next trap. When asked in different ways about how risky they think stock market investments are, pensioners vastly overestimated the volatility of the stock market.
While the true annual volatility of the US stock market is c15% the answers pensioners gave equated to a stock market volatility more than twice that.
Estimated and true stock market volatility
Source: Hou (2020).
The result is that pensioners don’t take invest in annuities and then invest too much of their nest egg in bonds and other low-risk assets and too little in stocks. Their lack of financial knowledge and their subjective fears screw them over twice.
Hou even tries to calculate the optimal allocation to stocks in retirement portfolios based on objective risks like longevity risks, market risk, and health risks and compares this to the optimal allocation to equities if the subjective assessments of pensioners are used. The results are instructive. In the optimal portfolio based on objective risks, a 65-year old pensioner should invest 85% of her assets in stocks. Even at age 100, 52% of the assets should still be invested in stocks. This is roughly two to three times as much in stocks as current conventional wisdom tells pensioners to do. And about two to three times as much as pensioners are wont to do given their subjective assessments of the risks they face.
It is high time we review the investment advice we give pensioners.