11/30/2015

Buying an Income for Life

I am in my mid-twenties, and often think about how much I need to be saving for retirement. I never feel like I am putting in enough money for retirement.  This article from CNN Money had some ideas for retirement I didn’t know about. The article didn’t specifically put the information in economic ideas, but these are mine.
I had never thought of retirement in an economic mindset before. Marginal costs could be seen as your spending, and marginal revenues could be the amount that is to come out of you retirement account. To maximize the benefit of your retirement account, marginal costs should be about equal to marginal revenue.

Having a set amount of money in a retirement account doesn’t mean you are going to have a perfect retirement. Natural disasters, accidents, illness, inflation, and rising costs all take their toll on your time to relax. Retirement involves risk.

In retirement, you typically live off an investment account that has been accruing money over the time you were working. There are many types of retirement accounts and ways to invest. The article talks more about a specific way to have money to spend, called an annuity. An annuity is receiving an amount of money over a number of periods. In the retirement aspect, you can purchase an annuity to guarantee yourself some cash flows.

An annuity can hedge the risk faced by retiree’s. The CNN article says a typical $100,000 annuity can bring in $555 a month for a man and $530 a month for a woman. The type and amount of the annuity you pick depends on preferences and needs. The point is “to ensure that you won’t run out of income late in life” (Updegrave, 2015).  By spending some money early in life for an annuity, you can still have money in savings for retirement and the risk of casualties.



Reference

Updegrave, W. 2015. Make sure your retirement savings last a lifetime. Retrieved from:http://money.cnn.com/2015/11/25/retirement/retirement-savings-annuity/index.html?iid=SF_LN 

9 comments:

Dr. Tufte said...

Jake Eliason: 100/100

I'm glad you're motivated to think about retirement early and often.

Yes, this is an economic problem; really more of a finance problem, but economists still think of finance as the sub-field that got away ;-)

I would not describe it as marginal revenue and marginal costs, but rather marginal benefits and marginal costs. Some of the same principles apply as in profit maximization, but the end goal — usually something like never having your nestegg fall below a certain amount — leads to different conclusions about how to behave.

Theoretically, retirement planning is very complex. We usually don't even talk about that too much until Ph.D. level classes. Each detail brings new mathematical needs: uneven contributions, uneven withdrawals, volatile rates of return, uncertain date of death, how much interest you have in leaving a bequest, and so on.

But, there's good news! Most of this can be finessed in a spreadsheet using a technique called Monte Carlo analysis. This is covered in either Bruce Haslem's FIN 6200 class, or in my ECON 6100 class.

LightningMcQueen said...

Dr. Tufte, I can see why topics related to retirement planning would be more of a focus in Ph.D. level classes. Those variable factors cause a great deal of uneasiness in some people and place differing valuations on the implicit benefits of having guaranteed income. For me, I completely agree that it is an excellent thing to be thinking about and planning for retirement early on. I’m sure most people want their nest egg as large as possible before retirement. Although I may retire with investments sufficient for me needs and wants, there still is a high value placed on the idea of guaranteed income.

In talking with my wife, I gave her a hypothetical scenario of having enough money for retirement. I then asked her how much value she would place on having an amount of guaranteed income every month in addition to our pool of assets. She responded very much in the affirmative that having guaranteed income would make her feel MUCH more comfortable. It is interesting to think about weighing the cost of the benefits of timing, amount, annuity type, etc. I never really thought of this as an economic decision though. Thanks for pointing this out Jake!

Brett Bodily said...

I find retirement planning and discussions fascinating. It brings the "nerdiness" out. The big question for me is the opportunity cost. There are so many retirement options out there and so many companies that offer those different plans, you have to ask yourself, which is the best? This depends a great deal on how comfortable the individual is with risk. And the horizon predicament- how long you have left until retirement. I would bet most people are risk adverse and their choices would be more along the lines of, "slow and steady wins the race". People want that guarenteed rate of return, that guaranteed monthly payment and if they work hard and make good decisions they can get it.

Dave Tufte said...

LightningMcQueen: 47/50 (you wrote "for me needs" instead of "for my needs" ... unless you were trying to sound like Mr. Krabs ;-D

Brett Bodily: 47/50 (" And the horizon predicament- how long you have left until retirement." is two fragments, but not a sentence. It's also missing a question mark.).

LightningMcQueen:

I think there is some evidence that women tend to prefer the guaranteed check each month more than men do, so I'm not surprised at what your wife said.

Now maybe this personal story bears a little bit on that. My wife wanted an annuity with guaranteed income out of my retirement when we had an option to choose that about 20 years ago. But when she inherited some money from her family a few years ago, I suggested she put it into an annuity, and she rejected that option. So the source or perceived ownership or beneficiary may have something to do with the choice.

BTW: as far as investment vehicles go, I think unbiased financial professionals will tell you that the fees are often too high on annuities.

Brett Bodily:

As to the wide variety of plans out there, research back in the 90's showed that most of this was "cheap talk". That's the name used in economics and finance for product differentiation that seems important but isn't. That research showed that the proliferation of plans is possible because there are a wide variety of investment choices that are ... just as good as each other. People pretend that the differences in rates of return are in percentage points, but they mostly turned out to be in basis points (hundredths of percentage points), and not many at that.

As someone who works on the border of macroeconomics and finance, your observation that most people are risk averse hits a raw nerve. Not only are they risk averse, but often really stupidly risk averse (and I don't mean "stupidly" in a nice way). Casual investors are often willing to give up very large sums to protect against very unlikely possibilities (and then they go out and ride their cycles without helmets). I think this is a big contributor to the lack of nest egg for many people. And to a certain extent we do this when we tell people to invest conservatively when they are older — except that life expectancies have increased a lot since we started giving that advice.

Jim Craig said...

As one who strongly believes that a course in personal finance should be required in high school and in college, and that part of those courses should be an introduction to retirement planning, I am excited to see a discussion on this blog about retirement.

Developing a retirement plan early in life, and the right plan, can be one of the most important and rewarding financial decisions one can make. Not only thinking about, but acting on retirement planning at an early age can have a huge payoff in retirement. I would venture to guess that few teenagers, college students, or even adults for that matter take into consideration opportunity costs, as they relate to retirement, when they make purchases for the newest in electronic gadgets and other want based purchases. But since this blog is about purchasing annuities for retirement I will focus on that by looking a little deeper at some of the drawbacks of annuities; the benefits having been previously mentioned in other posts. Professor Tufte mentioned one of the largest drawbacks of annuities, the high fees. Annuities can often have commission fees, maintenance fees, and contract fees associated with them. It is always a good idea to find out, up front, what fees are attached to any annuity you are contemplating purchasing.

In addition to the high fees, there are tax consequences to consider. The withdrawals from an annuity receive different tax treatment than other types of investments. The income may be distributed to you as interest income, capital gains, or a return of your investment depending on when the withdrawals begin and what portion of the annuity is being distributed to you. If the distribution is made from interest earned on the annuity it is taxed as interest income and does not receive the lower tax rates associated with capital gains and dividends.

Lastly, there is the loss of liquidity to consider. Once an annuity is purchased it becomes difficult and costly to get the money out of the annuity. There are usually penalties and tax consequences for early withdrawal of income from an annuity. In essence you are giving up the right to your money in exchange for a guaranteed payment for life.

It is important when planning for retirement to make wise, informed decisions before investing your money. It is usually helpful to consult a trusted professional for advise and guidance in retirement planning. As the phrase says, "nothing is certain except death and taxes." Since retirement planning has to do with both of these certainties it is probably a good idea to devote some time, thought, and research into retirement planning and decisions.

Captain Jack said...

This is a bit of a sore spot for me when it comes to our education system. On one hand I understand that the depth and scope of retirement planning is well suited for Ph.D. level studies but on the other hand isn’t retirement planning one of the essentials of life? I would strongly support financial and retirement education in high school and basic finance/money management classes being taught in middle school and elementary. As I am employed in the finance industry I know that this action would cause more competition and my income may be reduced but I think it would be well worth it. I would probably have a much lower social security tax, the emotional and unnecessary swings in the stock market would be limited, debt crisis’s such as the last housing/mortgage debacle would be reduced and overall the economy would be better off. At least the concepts of "spend less than you make" and "saving a little early is better than saving a lot late" should be well understood before adulthood. These are not difficult concepts to demonstrate or grasp yet if you do not have a basic lesson on them they can seem like Ancient Greek.

Dave Tufte said...

Jim Craig: 47/50 (you wrote "advise" instead of "advice").
Captain Jack:

Jim Craig:

This is all good, but where's the ManEc?

Why don't we teach (or require) more personal finance classes? Perhaps this is because students who learn personal finance in school are less likely to enter teaching as a career.

Why do annuities typically have higher fees? Perhaps this is because they are mostly offered by insurance companies (who have the tools to both hold the money and generate checks on a regular basis), thus limiting the market.

How do people judge the tradeoff of liquidity for guaranteed income? This is a tough one, because liquidity is easy to talk about but hard to measure.

Captain Jack:

Oh ... I didn't mean to imply that we couldn't farm out some teaching of personal finance at lower levels, just that to be really good at it is surprisingly difficult.

And ... I don't think Jim Craig (and others) will appreciate this much ... but I think most retirement planners in the private sector are following detailed directions from higher ups, without much deep understanding. And that's coming from someone who really doesn't know much about this, but merely knows of the texts they use at places for Wharton on this stuff.

Now, I'm sympathetic to Captain Jack's and Jim Craig's views about personal finance education. But, my life experience has taught me that there's more to this than people being uninterested or uneducated. People don't just find personal finance boring, hard, or foreign. Some of them find it offensive or limiting. And others do not find monetary wealth as comforting as physical wealth. In the end, I think there's a bigger nut to crack here: we need to be thinking about what personal finance advice people will value than what advice will help them increase (the financial advisor's definition of) value or risk.

Captain Jack said...

I didn't see a grade by Captain Jack, was that just a mistake?
I totally agree on the part about retirement planners just following directions and not having a deep understanding. They do have to be well educated and pass some fairly difficult tests but after that it seems like they just have the standard software that spits out all the numbers. The offensive or limiting comment is also true, few want others to teach them about the realities of falling short financially in retirement.

Dave Tufte said...

Captain Jack: 47/50 (you meant "crises" not "crisis's").

Yes, that was a mistake. I catch those eventually, but you beat me to it.

I agree with what you said about "offensive and limiting", but I meant something less obvious.

On offensiveness, I've talked to quite a few people who feel that the values of others are being imposed on them when they're asked to do financial planning. They simply don't see it having as much value.

On limiting, I've met people who find holding financial assets more nerve-wracking than holding real assets. They sometimes see investment in a real asset, even one that depreciates (like a car) to be sounder for them personally. They would rather make a pretty good investment in a real asset, than make an excellent investment in a financial asset, because that limits them from managing their own potential for bad behavior. Basically, I'm more comfortable buying a car than saving for retirement because there's a chance I'll pull that money out early to pay off my credit cards.