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The biggest unanswered question about retiring in America

Donald Smitherman, 98, kisses his wife Marlene at the end of a dance in Sun City, Arizona, January 5, 2013. REUTERS/Lucy Nicholson
Donald Smitherman, 98, kisses his wife Marlene at the end of a dance in Sun City, Arizona, January 5, 2013. REUTERS/Lucy Nicholson

By Allison Schrager

America has moved to a system where nearly everyone is expected to save and invest for their retirement. Yet remarkably little attention has been paid to the big question: what should people do with their money when they actually retire? Neither the government nor the financial industry has any good answers. This leaves individuals ill-equipped to figure it out for themselves. Before the bulk of baby boomers reach retirement they will need a better solution. That will require the government and the financial industry to define their role in how people finance their retirement.

Starting in the 1980s many countries (America, Chile and later Australia, Britain, Sweden, Switzerland, Singapore and other Latin American and Nordic countries) moved to a regime where individuals had to save and invest to finance their retirement. Prior to this, pensions from the government or employers provided stable, predictable, and often inflation-adjusted income. As the typical retirement lengthened and populations aged, the old way looked unsustainable. Personal accounts, which shift the burden to individuals, became more popular. The individual account solution has well-known problems associated with the saving stage: people don't save enough, pay too much for investment funds, and do not understand investment risk they are exposed to, as the recent economic crisis revealed. As these programs evolved, so have solutions and better regulation. Countries like Australia, Switzerland and Chile require people to save a large fraction of their income. Sensible and reasonably priced default investment options and savings rates help people make better decisions. Some countries, like Switzerland, provide a minimum return on the accounts' assets. But even with best practices for the saving phase, major questions remain: When people arrive at retirement, what are they supposed to do with their life savings? How much can they spend each year and how should they invest their assets?

Those questions don't have easy answers. If you over-spend you might run out of money. If you spend too little you needlessly scrimp. The cost of investment risk is bigger post-retirement because you don't have years of future returns and income ahead of you. It's further complicated by uncertainty. Most people don't know how long they and their spouse will live. Aging diminishes ability to manage money and increases vulnerability to fraud. Research by economists James Poterba, Steven Venti and David Wise found many American retirees barely spend their wealth beyond what's required. But they liquidate their assets, often selling their home, once they or their spouse has a significant health event and dies. Many people die with almost no assets left over.

Economists have traditionally suggested that people buy an inflation-indexed annuity that makes payments for life. An annuity is a contract, typically with an insurance company, in which you pay a premium and the insurer pays you, at regular intervals, for a specified period or your lifetime. The payments might be linked to investment performance, inflation, or a fixed nominal amount. A real, fixed life-annuity ensures you won't outlive your assets and will get predictable income, just like the defined benefit pension or state benefits do. But that comes at a cost of no liquidity or option to leave money to your heirs if you die early. The liquidity issue is significant in America where healthcare expenses aren't entirely covered by Medicare. The Employee Benefit Research Institute estimates that an American couple will need at least $227,000 in order to be certain they'll be able to pay for their post-retirement health expenses. There's wide variability around that estimate and it doesn't even include long-term care. Retirement only ends one way and death tends to be an expensive event. It's understandable that people are reluctant to turn over their life savings to an insurance company, but that leaves them vulnerable to investment risk and over or under-spending.

Currently in America the only post-retirement requirement is you must withdraw a minimum percent, based on age and marital status, of your retirement account each year. But this rule was not intended to be an optimal drawdown strategy; it was meant to ensure people paid taxes on their tax-deferred retirement accounts. Simple rule-of-thumb strategies, like spending 4 percent of your assets, have proven inadequate and don't address investment risk.

Instead, the government should encourage people to annuitize at least some of the money in their retirement accounts with an insurance company. That might mean favorable tax treatment, or requiring people to buy an annuity. We have polices to encourage retirement saving in order to overcome behavioral biases, myopia or financial illiteracy that lead to bad decisions. Retirement spending and investing requires the same guidance and standards.

Similar issues exist abroad. Australia and Switzerland force their citizens to save a large share of their income, but then don't provide many requirements about spending down the money. Culture, history and some light tax incentives play an important role. In Australia, more than 70 percent of non-public employees take large lump-sum withdrawals from their retirement accounts. They spend some of it and manage their drawdowns themselves. If Australian retirees run out of money they can claim a means-tested state pension, which most Australians live on. Switzerland experienced the opposite result; more than 80 percent of Swiss retirees annuitize their pension accounts.

Other countries offer more structure. Britain used to require people to buy an annuity by age 75. But this proved unpopular, especially in the current low interest rate environment where annuities are very expensive. After 2011 the requirement became less demanding. Now Britons must receive a minimum amount of guaranteed income from some source: annuity, defined benefit or state plan. Chile requires retirees to choose between two spend-down options. They can either make regular withdrawals based on a government-provided formula and their account balance. Or they may buy an annuity, assuming the annuity value is larger than a defined amount. Most Chileans opt for the annuity. Chile has one of the world's more competitive and well-functioning annuity markets.

Whether or not the government does more to favor annuities, the retirement income question also requires solutions from industry. The annuity market has a bad reputation in America because of confusing terms; high, opaque fees; and large surrender costs. Annuity prices also vary with interest rates. This exposes retirees to another source of risk when they buy an annuity. Not surprisingly, few Americans buy income annuities. That may change as more people retire with a 401(k) and need lifetime income. A feasible product offering guaranteed income and liquidity that people will buy has become the Holy Grail in the industry. So far there aren't any good solutions that the market has embraced.

If the government relies on the market to provide income for many of its citizens, it must regulate the annuity market. If a large insurer goes out of business and can't pay retirees' income, will the Federal government step in to make payments, similar to deposit insurance? There's also scope for regulation to ensure that annuity terms and pricing are transparent and competitive. A better annuity market will require more transparency, competition and wider participation. Thoughtful regulation can ease public distrust of annuities.

The world's most sophisticated economies moved to individual accounts to finance retirement, but that's an incomplete solution. So far the half-solution hasn't been a problem, because few have retired with them, yet, as their primary source of income. But as more baby boomers reach retirement that will change and we'll need better answers, preferably before they get there.