Annuities give retirees a ‘licence to spend’, say experts

It is no secret that, for fear of running out of money, many retirees live exceedingly frugal lifestyles.

For some, it’s the fear of not having enough savings to last through retirement. For others, it’s wishing to leave an inheritance.

Some have homes worth more than a million dollars but have very little to live off day to day.

It may also come as no surprise that households spend more if they hold their wealth as guaranteed income, and not as investments, as they age.

Read more: Your retirement ‘pay cheque’

According to new research from retirement and wealth management experts David Blanchett and Michael Finke, choosing to buy an income annuity could give retirees a ‘licence to spend’ in retirement.

“Workers in the defined contribution era generally retire with a lump sum of assets. As fewer workers retire with a pension, the percentage of retirement income funded through guaranteed income is likely to continue declining as well,” the pair write for Think Advisor.

“The implications of this change on retirees is unclear. There is evidence from previous studies that many spend far less in retirement than they could comfortably withdraw from savings.

“Deciding how much to spend each year in retirement from investments is complicated when both the length of retirement and asset returns are unknown.

“Unknown longevity presents a trade-off in which a retiree can either spend generously and risk outliving savings or spend conservatively and live a less enjoyable retirement. A retiree who prefers not to accept the risk of outliving savings will spend less.”

Read more: How much can you confidently spend in retirement?

They posit that if the risk of an unknown lifespan to an institution were the responsibility of the federal government, insurance company or financial institution, retirees would feel free to spend more each year.

“Economic theory predicts that a retiree with similar annuitised wealth will spend more than a retiree with an equal amount of non-annuitised savings,” they say.

“The lifestyle that retirees give up by failing to annuitise is referred to by economists as the annuity puzzle.”

Retirees failing to annuitise are behaviourally resistant to spending down savings and would better achieve their lifestyle goals by increasing the share of wealth allocated to annuitised income.

“An annuity can not only reduce the risk of an unknown lifespan, it can also allow retirees to spend their savings without the discomfort generated by seeing one’s nest egg get smaller,” they say.

“Annuities may also give retirees a psychological licence to spend their savings in retirement.”

This is something Australia’s superannuation minister Jane Hume would like to see happen.

The senator has gone on record expressing frustration at retirees’ unwillingness to spend super capital rather than living off interest derived from savings, and has called on them to use their savings “more efficiently” when in retirement.

She says retirement savings could be used in a better way, but concedes that “the complexity of the system and the lack of simple, clear and independent information is holding Australians back from finding the best product for their circumstances”.

Read more: Senator urges retirees to use their savings ‘more efficiently’

The Retirement Income Review found that many Australians retire with more savings than previous generations, and yet live extraordinarily frugal lives.

A number of reforms rolling out from 1 July signal the first step to reducing the complexity of the system.

The federal government has also agreed to support the development of more efficient retirement income products, labelled ‘Comprehensive Income Products for Retirement’, or CIPRs.

Still, many surveys show retirees prefer to live off income, and many don’t feel comfortable spending down assets to fund a lifestyle.

“This is surprising since funding a lifestyle is presumably what motivates retirement saving to begin with, and few retirees indicate a desire to pass on significant wealth at death,” says a new research paper by Mr Blanchett and Prof. Finke.

The paper analysed the composition of wealth related to spending in retirement using data from the US Health and Retirement Study (HRS).

It revealed strong evidence that households that hold more of their wealth in guaranteed income spend significantly more each year than those with money tied up in investments.

“A household with a generous pension and no savings will spend more than a retiree with enough savings to buy an annuity that provides the same income as the pension,” says the paper.

“By holding household wealth constant, the analyses show that households are spending more not because they are wealthier (since financial assets can be converted to guaranteed income); rather it’s the form of the wealth they hold that impacts spending in retirement.

“Retirees will spend twice as much each year in retirement if they shift investment assets into guaranteed income wealth.”

While the findings seem critical of investing, it should be noted there are forms of investment, such as exchange traded funds (ETFs), that allow for more liquidity than traditional funds and investments.

Read more: ETFs: What are they, why consider them and how to start investing now

Overall, the researchers found that shifting savings to lifetime income can provide retirees with the psychological benefit of being given a “licence to spend” accumulated savings.

How do you hold your wealth in retirement? Do you have an annuity? Do you think you could use your savings better, as Senator Hume suggests? Why not share your thoughts in the comments section below?

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