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Making It Pretty
Annuities get a behavioral finance makeover
An appreciation for the influences of behavioral finance has had a critical impact on retirement plan designs—so what about applying those principles to the decumulation phase?
To explore the alternatives and implications, Allianz worked with Professor Shlomo Benartzi of UCLA to reach out to a number of academics in the field, several of whom were on hand at a meeting in New York City to present some of those findings and their implications.
The findings, which Allianz said it submitted as its response to the February request for information by the Department of Labor and Treasury Department about retirement income products, was produced under the title “Behavioral Finance and the Post-Retirement Crisis,” broadly defined as being “about outliving your assets.”
Indeed, while the issues attendant with crafting an effective retirement income solution are many, much of the panel’s discussion was oriented toward the challenge presented by longevity risk, simply stated as the risk of outliving one’s savings. To kick things off, Benartzi used the example of 10 high school friends who retire at age 65. Of those, Benartzi said that the first of the 10 would die just four years into retirement, at age 69, while the last in the group to die would, according to statistics, not die until age 99.
This post-retirement crisis is magnified by the poor financial decisionmaking of retirees who, according to the research presented, pay too much attention to recent stock market performance (those retiring after stock market increases of six to 12 months are much more likely to select the lump sum option rather than lifetime income), have trouble making financial decisions, and are “hyper” risk-averse.
“Nudging” the Annuity Decision
Dr. Alessandro Previtero of UCLA highlighted a finding that would seem to defy “common wisdom” about annuities, specifically the reality that, when given choice to pick a lump sum as well as an annuity in a defined benefit plan, the vast majority opt for the lump sum. He cited a study that found that, in a period from 1999 to 2005, only 2% to 6% of retirees elected guaranteed lifetime income when it was available in their 401(k) plans—much lower than expected, and a disparity he referred to as the “Annuity Puzzle” (the puzzle being why people don’t choose annuities).
However, Previtero recently conducted new research with what was described as “a unique dataset of more than 100 defined benefit plans,” covering more than 100,000 retirees. Each of these individuals had to actively choose between guaranteed lifetime income and a lump sum. Because there was no default, they had to decide themselves how to withdraw funds—and Previtero said that 49% of retirees making an active choice between guaranteed lifetime income and a lump sum actually picked the lifetime income option.
He went on to note that defined benefit payouts are typically communicated in terms of producing monthly income, and annuity payout options tend to look attractive to participants accustomed to thinking of those benefits in like terms; but he contrasted that with cash balance plans that often, like defined contribution plans, are communicated in terms of account balances or lump sums. Previtero said he found that retirees in defined benefit plans were 17% more likely to choose the guaranteed lifetime income than their peers in cash balance plans.
The recommendation: Make retirement income solutions available in 401(k) plans and, somewhat ironically considering the panel’s general affinity for using defaults to help participants make better choices, “nudge” retirees to actively make a choice.
Making it Pretty (continued)
Framing
Another study cited was one by Professor Jeffrey Brown of the University of Illinois, who found that, when an annuity choice was presented in a “consumption” frame, in other words as providing monthly income of $650 for life, 70% preferred the annuity. However, when it was presented in an “investment frame” (an investment with a $650 return for life), only 21% opted for the annuity. It was noted that defined contribution plan designs have “taught” people to think of these accounts in terms of investments, rather than pension plans, where participants are more likely to think of the monthly benefit they provide. The suggestion from the researchers: Present the programs with an emphasis on the income they will provide, not the return on the investment made.
Professor Eric Johnson of Columbia University pointed out that, for most of us, “losses loom larger than gains.” That is, investors experience the pain of a financial loss much more acutely than they feel the pleasure of the same size gain—and by a factor of about two to one. However, recent research he conducted with ACLI and AARP found that retirees displayed “hyper” risk-aversion—which meant that they tended to weight losses about 10 times more heavily than gains.
Now, while Johnson said he assumed that this hyper loss-aversion would translate into a preference for products with guaranteed lifetime income, his research revealed that retirees with hyper loss-aversion actually responded less favorably to financial products with more protection and guarantees. Johnson said that it seemed that, to this group, giving up control of their money was viewed as just another type of loss. Consequently, he said that solutions should emphasize that those guarantees and protections were a way to restore, not surrender, control.
Cognitive “Dissonance”
A study by Professor David Laibson of Harvard University reported a significant decrease in “analytic cognitive functioning” as people age, as well as an increase in the occurrence of dementia. For example, after age 60, the prevalence of dementia roughly doubles every five years, and the research suggests that, by the time people reach their 80s, more than half will suffer from either dementia or other “significant cognitive deficits.” The older adults that Laibson studied also showed marked declines in “numeracy”—the mathematical skills needed to cope with everyday life and to understand information in graphs, charts, or tables, and they also had “great difficulty” understanding simple measures of risk. The optimal age for making those decisions? 53.
A suggestion to counter this problem: solutions, “including investment strategies and public policies that encourage people to make binding decisions earlier in life and prior to the onset of cognitive impairment.”
One of the reports included in the handouts was based on an interview with Professor Brigitte Madrian of Harvard University, who suggested that one-size-fits-all defaults are ill-suited to helping different groups of participants achieve optimal results. Before setting defaults, she said, plan sponsors would be well-advised to evaluate the potential impact of inertia on different types of retirees, and said that policymakers should make it easier for sponsors to customize decumulation options by eliminating nondiscrimination rules that require all retirees—even those with unique needs—be presented with the same default payouts.
“Obvious” Decisions
An interview with Professor John Payne of Duke University included in the materials said that for lifetime income solutions, retirees are typically presented with materials highlighting the monthly payouts provided by each option—and, for many, the optimal choice is obvious: the highest monthly payout. That, in turn, tends to lead them toward choosing single life annuities (with larger payouts), rather than joint and survivor. In fact, 69% of married women and 28% of married men opt for single life annuities rather than joint and survivor annuities, according to the report. However, that tendency to go for the option that is easiest to understand means that retirees may fail to recognize the implications of their decision on their spouse. —Nevin E. Adams
Someone Else’s Problem
Advisers say Americans’ savings issues self-imposed
According to financial advisers, the largest impediments to Americans’ financial security are self-imposed.
A survey from the Principal Financial Group found advisers said the top three roadblocks to Americans’ financial security are living beyond one’s means (70%), not saving enough (66%), and fear (62%). Rounding out the top five were not saving for retirement early enough during working years (56%) and reluctance to take financial action (55%).
As for how much people should be saving in order to have enough money in retirement, on average, advisers indicated their clients should be saving around 17% of their pay. One quarter of advisers said their clients should be saving 10% of pay, 30% suggested savings of 15% of pay, and 29% of advisers said clients should be saving at least 20% of pay in order to have enough money in retirement.
When asked what the number one factor was that has affected their clients’ overall financial well-being in the last decade, the largest number of advisers (29%) said it was the Dow Jones Industrial Average dropping below 7,000 points in March 2009. Also cited by about one-fifth of advisers each were the collapse of Lehman Brothers in September 2008 (22%) and the real estate market decline (20%).
However, when employees and retirees were asked this question in a recent Principal Well Being Index survey at the end of 2009, Principal said they were most likely to say it was the price of gasoline in September of 2008.
In order to help clients get back on track, advisers are telling clients to pay down debt (72%), increase retirement savings (65%), increase emergency fund savings (57%), spend less money (57%), and talk with their financial adviser more often (56%).
Furthermore, advisers are connecting with clients more actively. Eighty-one percent of advisers are touching base with clients on a regular basis to help them deal with increased financial worry brought on by the downturn in the economy; 71% are providing reassurance to ward off stress; and 65% are helping clients create a financial plan to help them deal with recent financial stress brought on by the downturn in the economy.
The survey, commissioned by the Principal Financial Group and conducted by Harris Interactive, included feedback from a nationwide sample of 650 producing financial advisers, including independent broker/dealers, wirehouse and regional brokerage firms, insurance agencies, independent wealth management firms, banks, and independent asset management firms. —Alison Cooke Mintzer
Exit Strategies
Study says 20% of wirehouse brokers will leave firms in next 18 months
About one in 10 brokers reported that they are very unsatisfied with their firms, according to a new survey.
A study by Aite Group of wirehouse advisers and other brokers found a continued appetite among some brokers to “break away” from their firms, even though it has been lessened by retention packages. Average wirehouse brokers ranked their chance for breaking away at slightly less than 30%, while the average financial adviser at a captive brokerage firm gives it a 23% chance, according to the survey.
Aite noted that the accepted peak of breakaway activities occurred at the end of 2008 and early 2009 during the restructuring of wirehouse firms. The big four wirehouse firms (Bank of America Merrill Lynch, Morgan Stanley Smith Barney, Wells Fargo Advisors, and UBS) saw their combined broker headcount drop by more than 7,000 in 2009, according to the report.
Wirehouses should expect to see more movement, the study suggested. One in four surveyed wirehouse brokers remain either “unsatisfied” or “very unsatisfied” with their employer. The survey found 20% of wirehouse advisers (or 11,000 brokers) will more likely than not break away within the next 18 months. Wirehouses can only count on 15% of brokers as having no appetite to break away, compared to 38% at other brokerage firms.
“While retention packages have greatly reduced brokers’ desire to break away, wirehouses are not yet completely free from worry,” said Alois Pirker, Research Director with Aite Group and author of this report. “Top performers that remain dissatisfied could easily choose to defect, especially as rivals continue to offer unprecedented sign-on bonuses for top talent. Across lower-tier producers (brokers that haven’t been ‘locked in’), wirehouses should prepare to see a continuation of intense breakaway activity.”
Money, reputation, and uncertainty are big drivers for brokers to seek a new firm. Looking for a higher payout is the primary motivation for the largest number of surveyed wirehouse brokers (23%). Other motivations for breaking away include not getting a retention package (19%) and the damaged brand of their firm (16%). Brokers outside of the wirehouse channel list uncertainty at their current employer as their top motivation (33%), followed by getting a higher payout (27%).
When they do break away, many wirehouse advisers are confident they would take most of their books of business with them. Average potential wirehouse breakaways said they could take half of their books of business to a new firm, and more than one-third believe they can retain 75% of their book, according to the study.
If brokers do decide to break away, going to a wirehouse is still the most popular option. About one-third of potential wirehouse breakaways and other brokerage firms would opt for a wirehouse firm. The independent sector is the second most popular destination for wirehouse brokers (26%) and the third most popular for other brokers (24%). Brokers outside of the wirehouse channel show a strong interest in the private bank or family office channels (33%).
The report is based on an Aite Group survey of 159 financial advisers conducted in the fourth quarter of 2009 and included brokers at wirehouse firms (42%); brokers at other self-clearing firms, such as RBC Wealth Management (30%); and brokers at fully disclosed broker/
dealer firms (28%). —Ellie Behling
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