Is Underspending a Fiduciary Problem?
There is debate about whether fees or commissions lead to better outcomes for retirement savers. But one aspect that hasn’t been discussed enough is that the loss of welfare from underspending is likely much higher than from choosing one or the other fee method.
Unspent savings is an ignored fiduciary problem.
In his amazing book on retirement-income analysis, Bill Sharpe evaluates retirement spending strategies using a pie chart that shows how big a slice goes to spending, bequests, and fees. For the portion of a client’s savings devoted to lifestyle, the goal is to maximize what goes to spending. But a conservative fixed-withdrawal strategy such as the 4% rule leaves too much to unintended bequests. And because assets are inefficiently large for many luckier retirees later in life, it also results in higher fees for managing these assets.
Most respondents in consumer surveys don’t indicate a strong desire to pass money on to others after they die. But most of them die with a lot of assets and money in the bank. Economists refer to this phenomenon of leaving unspent retirement joy on the table as “unintended bequests.” There are a lot of studies on unintended bequests that try to figure out why people leave so much of their wealth to others without wanting to do so.
Having too much money when you die may not seem like a bad thing. That isn’t the way economists see it, however. There are only two places your retirement savings can go: you can spend it on things like vacations, a motorhome, going out to dinner, or giving gifts to grandkids or a charity, or you can die, and the money will be spent by others.
Which gives you more happiness?
Economists use a measurement of joy called “utility” to estimate the amount satisfaction received from spending (or gifting while alive). We can estimate the utility from spending while alive and compare it to the utility we get (while alive) from knowing others will spend our money after we’re dead. Most people get more utility from spending or gifting while alive than gifting after they pass.
Imagine that retirement is a game. An average 65-year-old healthy woman has five rows of 5 squares that she can lay the chips she’s saved over a lifetime. These squares represent the amount she will spend that year from 66 to 90. How would you allocate the chips? Would you lay more on the early years when you’re healthy and have full mental faculties? Would you simply lay as few chips as possible to pass them on after the game of life?
Michael Bloomberg noted that “the best financial planning ends with bouncing the check to the undertaker.” Bloomberg is a notable philanthropist, and he’d rather give his money away while he can enjoy seeing others benefit from his wealth. While he may have been motivated to build wealth for most of his life, he recognizes that the failure to acknowledge his own mortality might lead to making the wrong choices about spending his wealth in old age.
Humans have a hard time admitting that they’re going to die. There is a concept in psychology known as “mortality salience” that identifies the common response to being reminded that we’re not going to live forever. We will do anything we can to avoid having to face any important financial decision that forces us to admit mortality. This is why life insurance is not called the more accurate death insurance – it would be even harder to sell.
I have done interviews with retirees who tell me that they are proud of the fact that they have more money at the age of 75 than they did when they retired at the age of 65. They are careful to avoid spending on frivolous things and are proud of their thrift.
“You must really want to give that money to your kids,” I ask. Most don’t. They don’t want to admit that there’s no third option.
Mortality salience, using a retirement savings lump sum “number” as a savings goal, and the good-old habit of thrift (spending less than our income) combine to prevent many retirees from making optimal spending decisions during their lifetime. After all, we’ve spent most of our lives believing that wealth accumulation was the most important objective of investing, and we cannot pivot our thinking when retirement starts.
What AUM-compensated advisor would fight against these instincts to encourage a client to behave differently when they’d get paid less for their troubles?
The fiduciary problem with fixed-withdrawal rules
A little-discussed inefficiency of withdrawing a fixed amount from a retirement portfolio (such as the 4% rule) is the high average unintended bequest amount that occurs when retirees are blessed with good luck and longevity. Retirement economists like me often focus on the downside of sequence of returns risk, which makes the 4% rule risky for a small percentage of retirees who get unlucky early in retirement.
But what about the lucky retirees who get a better sequence of returns? Why shouldn’t they spend more to benefit from the upside of taking market risk? Why should their heirs and their financial advisor be the only ones who end up spending the wealth generated from taking investment risk?
A retiree who gets lucky faces the risk that a big slice of their retirement pie will go to a bequest that they may not value very much. Any strategy that doesn’t allow retirees to spend more when investments do well presents a risk that too high a percentage of savings will be allocated to an outcome that provides little utility.
In my research with David Blanchett, we found that retirees who receive a guaranteed-lifetime income such as a pension spend considerably more than someone who has an equivalent amount of wealth. For example, at a 7% annual payout rate on an income annuity (SPIA) for a 65-year-old woman, she will spend significantly more if she has a pension of $21,000 than if she has an extra $300,000 of retirement savings.
Why? The answers appear to be behavioral and rational. We should optimally spend more when we annuitize wealth because we transfer the idiosyncratic risk of not knowing how long we’re going to live to an institution. In other words, we can spend as if we’re going to live to the average longevity – in this case about 89 years for a healthy 65-year-old woman. Without transferring the risk, she will rationally spend less to make sure she’ll still have money left if she lives to age 95 or 100. In other words, failure to annuitize will result in a larger unintended bequest because a retiree will rationally spend less of her savings to compensate for the risk of not knowing how long she will live.
The other reason is behavioral. Most people feel like they have the license to spend income from a pension or Social Security, but spending from savings feels different. We are uncomfortable with a nest egg getting smaller even if it means that we’re using our savings for the retirement spending goal that motivated us to transfer dollars from a paycheck into a 401(k).
The availability of fee-compensated annuity products has softened advisor opinions about the use of annuities since there isn’t the tradeoff of losing AUM income. But annuities give retirees the license to spend their savings through either an automatically generated income payment such as a SPIA or the ability to make withdrawals for a lifetime (such as a GLWB).. An advisor has essentially sacrificed a portion of their slice of the present value of retirement wealth to give a retiree the license to spend their savings and reduce the value of their unintended bequest.
Too many advisors and clients ignore goal-based retirement-income planning designed to optimize a client’s spending and legacy. Many instead focus on an asset-preservation goal that often leads to highly inefficient strategies such as framing dividends as income or overweighting high-yield bonds, sacrificing tax and portfolio diversification efficiency.
A goal-based approach places the emphasis on using a client’s financial resources to get the most from the money they’ve saved. It also creates a conflict of interest between the asset-compensated advisor and client. Recognizing this conflict is essential to considering which forms of compensation and regulation will result in the best outcomes for retirees.
Michael Finke, PhD, CFP®, is a professor of wealth management, WMCP® program director, and the Frank M. Engle Distinguished Chair in Economic Security Research at The American College of Financial Services.
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