At Texas Tech University, there is a new center

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1 Planning for Retirement Living: The Financial Implications of Aging Michael Finke Professor, Director of Retirement Planning and Living Texas Tech University Lubbock, Texas Advisers need to help clients manage their portfolios throughout retirement to achieve the best income strategy possible and not run out of money. Avoiding risks and planning for a more satisfying life in retirement is possible once the changing concept of longevity and its associated risks are fully understood. Planning for cognitive and physical changes in old age should be considered part of the responsibility of a fiduciary adviser. At Texas Tech University, there is a new center dedicated to studying retirement planning and living. The motivating idea behind the center is not just to do financial planning but to look more closely at how people live in retirement. This focus led me into a lot of research on different topics that I think are very important when it comes to retirement planning. Changing Ideas about Longevity The first topic to consider is longevity. Before we get to longevity, we have a fun task. Read these 10 words clock, bank, army, apple, rock, worm, sword, cat, desk, and baby and memorize them. Next, consider this question: How long are you going to live? The answer is actually good news; you will probably live longer than you think. At Society of Actuaries (SOA) conferences, you will learn that people are living longer in developed countries. Figure 1 shows that after the age of 65, people have lived a little over a year longer every decade since Interestingly, those who study this type of data used to think that by the time people got to age 65, they would not advance very much in terms of longevity because there is only so long that a human body can live. Every generation of scientists says the same thing, and every generation of scientists has been wrong during the 20th century. The consistent increase in longevity is essentially linear. What does the steady increase in longevity mean for financial advisers? It means that if an adviser has a client who is 75 years old, that client is going This presentation comes from the CFA Institute Wealth Management Conference held in New Orleans on 4 5 March 2015 in partnership with CFA Society Louisiana. to live, on average, 5 years less in retirement than a client who is 35 years old. The older client s expected retirement lifetime is five years less than the younger client, which means that the younger client needs to save for a retirement that is going to last five years longer on average. Asset returns over the next 30 years are unlikely to be the same as the past 100 years, at least in the United States. So, young people today not only have to save in a relatively low-return environment but also have to save for a longer retirement unless they decide to retire at a slightly older age. Today, people need to think about when they should retire and whether retirement means stepping away from the work force entirely. Differences in longevity between men and women were actually the greatest in the mid-1970s, and after that time, everyone began to believe that women were going to outlive men consistently. But the gap is now narrowing. In the past, men tended to be older than women when they got married, but now more women are marrying men of about the same age, and more older women are marrying younger men. This shift has some interesting implications when it comes to such issues as widowhood and joint longevity. Why is the longevity gap between women and men now only two years when it was once four years? Some people think it is because women entered the work force, but it is actually the opposite because there is a strong relationship between income and longevity. Women who have higher incomes tend to live longer. One reason the gap is narrowing is because fewer men are smoking and more women are smoking, so men are actually living longer than in the past. Idiosyncratic longevity risk is a consideration for financial advisers when they are planning a retirement income strategy with a client. It is a type of 48 Third Quarter CFA Institute. All Rights Reserved. cfapubs.org

2 Planning for Retirement Living risk that a pension manager does not have to deal with. Pension managers care about such things as systematic increases in longevity. Their concern is that their entire pool of pensioners will live two years longer than they had expected or that asset returns are not as high as they had anticipated. But financial Figure 1. Years Average Longevity at Age 65 for Females and Males in Various Countries, A. Females planners have to deal with uncertainties about an individual s retirement that could last for 10, 15, 20, or 40 years or maybe even longer. What is the best way to deal with that kind of idiosyncratic longevity risk? I am very product neutral, but when it comes to dealing with any kind of idiosyncratic longevity risk, the most efficient way to do it is by pooling that risk, especially when it comes to later-life risk. Pooling that risk makes a certain amount of sense. Basing decisions on out-of-date US Social Security Administration (SSA) longevity data will lead to the wrong conclusions about expected longevity for most private wealth clients. The population receiving social security includes those who are most likely not private wealth clients. Table 1 shows the probability of a 65-year-old living to 95 based on data from SSA and SOA. According to SSA data, the chance that a male at age 65 would make it to 95 is about 7%. According to 2000 SOA data, 31% of couples who buy a joint annuity are predicted to be receiving payments at age 95. But the data are based on the types of people who bought annuities people who tend to be healthier and have higher incomes. In contrast, the 2012 SOA tables have a survival rate at 43% to age 95, and this rate is only going to go higher. If financial planners are still using the old 30-year time horizon to judge the safety of a retirement income strategy, 43% of their clients are going to live beyond the age-95 threshold. Using out-of-date data is not an appropriate way to assess the safety of a retirement income strategy. Years B. Males Table 1. Probability of a 65-Year-Old Living to Age 95 Based on Different Mortality Tables Male Female Both SSA periodic life 7% 13% 1% 19% 2000 SOA annuity SOA annuity SOA annuity in Note: Final column indicates couple with an annuity Japan France Spain Sweden United Kingdom United States Denmark Source: Based on data from the Human Mortality Database ( The reason longevity is increasing is related to one of the most unusual and interesting trends in longevity. There is an increasing difference in longevity between those who have less than the average social security income and those who have more than the average social security income. That gap was negligible among those who were born in the 1912 cohort, but the gap is now nearly five years, and it does not seem to be decreasing. The widening gap is happening despite the fact that people who earn a lot of money are no different genetically from those who do not earn a lot of money. In fact, men, especially high-income men, have been seeing the biggest gains in longevity. This 2015 CFA Institute. All Rights Reserved. cfapubs.org Third Quarter

3 CFA Institute Conference Proceedings Quarterly shift suggests that longevity is something that can be changed. People can make choices in their lives that allow them to have a longer retirement period as well as a better retirement period. In economics, it is called the endogeneity of the retirement life cycle. To some extent, it means that people can choose how long they are going to live by doing such things as watching what they eat and exercising. The data indicate that there is a correlation between income and education and healthy diets and exercise, but increasingly, society is getting more stratified by socioeconomic and educational status. Changes in longevity, especially between the early 1990s and the 2000s, appear to be particularly negative among women in the southern United States. What Happens When We Reach Our 80s? The chance that people will live to age 90 once they get to age 80 has increased from 15% to 32% for women and from 12% to 25% for men between 1950 and One of the reasons we are concerned about longevity is because we change as we get older. There are clearly different stages of the retirement life cycle. If there is a very high chance that once people reach age 80 that they are going to reach age 90, it has interesting implications for planning because a 90-year-old is not the same as an 80-year-old. So, for women who are likely to be clients, about one in three will live to be 90 years old, up from about one in seven in For men, one in four will live to be 90 years old. There is also some evidence that people are getting healthier in old age. For example, the percentage of people aged who can walk a half mile has been going up over time from about 72% in 1978 to more than 84% in It is known that mobility declines with age, but the frequency of geriatric conditions goes down with higher income. Again, the message is that the decisions people make affect their mobility and susceptibility to frailty in old age. People can make investments in their health that allow them to have a different lifestyle in retirement. When considering a retirement income strategy, it is often assumed that people will be spending the exact same amount every year after they retire. The reality is that people do not do that. Even people who have plenty of money tend to reduce their spending over time. It becomes more and more difficult to go on vacations. Greater physical limitations become part of life, and the drive to spend as much money declines, so total spending tends to decrease over time. In later life, people start to have increases in health expenditures. That type of expenditure is again an idiosyncratic risk. There are some retirees who are going to have huge expenses later in life, and there are other retirees who are not going to see those expenses. So, it is not efficient for retirees to save enough money to cover all of their potential long-term health expenses in retirement. If only 20% are going to have really large expenses, then that is one of those risks that is most efficiently dealt with through pooling. Everybody has different opinions about long-term care insurance. In the private market, it is not a perfect product, but there needs to be a way to address the idiosyncratic risk of health expenditures later in life. Otherwise, many retirees will be exposed to the possibility of running out of money, or many retirees will save up a lot of money that they will not spend. Either way, neither group will get the most out of retirement. Longevity Implications and Retirement Living The first implication of longevity trends is that people will probably live longer. The second implication is that people have some control over how long they are going to live and how well they are going to live in retirement. In particular, joint longevity is very long. So, planning for a 30-year time horizon is no longer appropriate. Being healthy in retirement is good because it means being more mobile, but a healthier, more mobile retirement means most likely spending more later in life. Thus, consider the following questions: What do people do with their capital at retirement? How do people plan for life in retirement? What is it that makes people happy? The University of Michigan Health and Retirement Study (HRS) regularly surveys about 20,000 individuals over the age of 55 and uses research techniques that measure global life satisfaction. The research uses a battery of questions to assess whether someone is satisfied with his or her life so-called global life satisfaction. One of the first questions we asked when studying predictors of satisfaction is whether money makes people happier in retirement. The answer was yes in fact, quite a bit happier and it seems to be a relatively linear effect. More money means a better retirement but only up to a point. At about $3.5 million of investable assets, there is an inflection point. It is not as if someone who has $5 million is going to be unhappy, but once an individual has saved up more money than he or she could realistically spend in retirement, then at that point the person becomes a wealth manager in addition to being a retiree. Of course, everyone would like to be in that situation. Why are people who have more money happier? Is it because they spend more? The results of the spending module in the HRS indicate that wealthy 50 Third Quarter CFA Institute. 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4 Planning for Retirement Living people do spend more, but they do not actually spend that much more. They spend about two times as much as people who are in the lowest wealth quintile and living on social security. Essentially, wealthy people have a lot more money that they could spend in retirement, but they only spend about an extra $20,000 each year. One of the reasons is because they do not spend their income. Wealthy people often have multiple sources of income, and in retirement, they tend to not spend all of their income, which means they accumulate wealth in retirement. When asked whether it is important to them to give money to their children, most of them say no. In an interesting exercise, one of my graduate students used Monte Carlo simulations for different types of asset allocations with a 99% confidence level of not running out of money to determine how much money could be spent in retirement and how much money is currently being spent. The difference between the two could be called the spending gap. That spending gap is really the difference between how much money an individual is spending right now and how much money he or she could safely spend without worrying about running out of money. To make it more realistic, we assumed that 40% of the money was set aside for children and/or to save for health care. Running the simulations again showed that the gap was still there, albeit not as big as the first simulation. The results indicate that people in the highest wealth quintile could be spending a lot more every year but they are not. I have a theory about why they are not spending, but first I want to share the story of the grasshopper and the ant. During the summer, the ant carefully collects food for the winter, and the grasshopper just dances around and watches the ant. By the time winter comes, the grasshopper starts getting hungry, so he asks the ant for some food. The ant refuses and tells the grasshopper to dance through the winter. My theory is that the ants (the wealthy), who have become used to saving money their entire lives, do not turn into grasshoppers (spenders). They have a lot of money saved, but they cannot change their non-spending ways. We are looking more closely at identifying grasshoppers for example, those who have had a windfall later in life. We are interested in the grasshoppers who received an inheritance, sold a business, accumulated wealth through illiquidity, or perhaps were just lucky, such as having bought a house in California and having sold it at the right time. We have asked whether those grasshopper types spend money faster than the ants. The reality is that they do. Most people probably know someone who is like a grasshopper and someone like an ant. I know someone who is very much an ant and has to be talked into spending her entire pension. She always feels guilty about occasionally dipping into savings, which she does very infrequently. I know someone else who is a grasshopper. He has accumulated some money in his 401(k), but I have convinced him that he will be in trouble with the IRS if he takes out more than his required minimum distribution from the 401(k). It is a scare tactic, but otherwise, someone would have to take care of him when he is older. There are different types of personalities when it comes to spending in retirement. In general, everybody tends to spend a little less each year, but there are people who are very vulnerable to spending down their assets too soon in retirement. Many believe that people are happier as they get older. When we conduct the analysis for this aspect of retirement, we use a multivariate analysis, which means that we control for everything that could possibly affect happiness. We control for income, wealth, education, and gender all in the same model so that when there is an effect, it is independent of everything else that is in the model. For example, when looking at just age, people aged score the highest in satisfaction with their lives. It is very difficult to figure out when to retire. Retirement is all about leisure. People are likely to get the most out of their leisure time when they are healthy enough to enjoy it. The trade-off is between potentially running out of money and doing what makes people happy. Some people, for example, derive more satisfaction from their jobs and some derive less. Your spouse is another factor that can affect satisfaction in retirement. When people retire, they tend to lose the social contacts that exist in the working environment, which means the relationship they have with their spouse becomes more important and has a bigger impact on life satisfaction. If couples have relationship issues, part of investing for retirement should involve marital counseling about retirement. A financial adviser whose firm has multiple life coaches on staff told me that they tell couples to save up all the vacation time they can and then take one month off and stay at home. Pretend for a month that they are retired and see what happens. The adviser said the couples may not realize that they can benefit from marital counseling before they start, but what often happens is that couples discover that the wife has a larger social network than the husband. Frequently, when men retire, they have to rely on their wives more to be their primary source of social support. The spouse with a social network beyond work often will like to spend a certain amount of time with those friends, which can create some marital strife. I am convinced that marital counseling is an 2015 CFA Institute. All Rights Reserved. cfapubs.org Third Quarter

5 CFA Institute Conference Proceedings Quarterly important part of the investment that people can make to get the most out of retirement. There are good arguments to plan for coordinating retirement between spouses because if one spouse is working and the other is not, the one who is not working is significantly less happy in retirement. Positive relationships between spouses and with children become very important after retirement. If people have a positive relationship with their spouse, then they are happier in retirement; but if the relationship is negative, they are more unhappy in retirement. The same correlation also applies to relationships with children. Having children usually makes retirees a little bit happier, but living within 10 miles of the children is not a good idea. Some may disagree, but my opinion is based on our research of 20,000 retirees. We have found that if people s retirement plan is to move out of their current home and move closer to their children, it does not seem to work out very well and greatly affects satisfaction. Planning for Later in Life Social time seems to be another strong predictor of satisfaction in retirement. A study by Axel Börsch-Supan and Morten Schuth compared retirees who retired early (in their early 60s) with those who retired later (late 60s to 70). 1 Their hypothesis was that those who retire later are better able to maintain their social contacts. But they found that it does not matter when people retire because after they finish working, they lose their social network over time. A study conducted by Russell James, one of my colleagues at Texas Tech University, looked at the amount of life satisfaction that was provided by different types of living environments. 2 Generally, people who live in their own home are happier throughout the majority of their life until about age 80. There is a big change in the retirement life cycle that seems to occur around age 80 that makes living in your own home less preferable to living in a place where everything is taken care of. And even more important, there are more frequent social interactions with other people at a time when people tend to become less mobile. In my opinion, everyone s retirement plan should include a plan for a living environment. At some point in retirees life cycles, they should transition from their home into a living environment 1 Axel Börsch-Supan and Morten Schuth, Early Retirement, Mental Health, and Social Networks, in Discoveries in the Economics of Aging, edited by David A. Wise (Chicago: University of Chicago Press, 2014): Russell N. James III, Multifamily Housing Characteristics and Tenant Satisfaction, Journal of Performance of Constructed Facilities, vol. 21, no. 6 (December 2007): that tends to make people in their 80s or 90s more satisfied. The best time to make the move is before 80 because if people wait, then the natural response is to worry about losing independence. If they move earlier in retirement and acknowledge and plan the transition, such as spending time choosing the kind of place that they want to live in, then it seems like a natural transition and it becomes a positive change instead of a negative one. Planning about transitioning living arrangements later in life is the best way to move people into a living environment that is better suited for them. The wealthy tend to have more frequent social contact in retirement. One of the reasons that wealthy people are happier in retirement is because they engage in different types of activities. My colleague Charlene Kalenkoski and I have been looking at how people spend time in retirement, especially between higher income and lower income groups. One of the biggest differences between people in these groups is that those with more money engage in a wider variety of activities, which increases the likelihood that they are going to be interacting with other people. They go out more often. They travel more often. Recently, we looked at how often US retirees travel outside of the state that they live in; we found that wealthier people spend more time outside of their current living environment. Essentially, their wealth allows them to do more things, and the more things people do, the happier they seem to be. Getting Older On a slightly sadder note, our bodies and our minds deteriorate as we get older. The healthiest people in the world will still see a decline in old age. For example, a man in his 60s may be able to complete a half marathon in minutes. But by the time men are in their 80s, it takes minutes. People begin to steadily decline in physical ability starting around age 60 through their 70s and especially in their 80s. For people in their 80s and 90s, the decline manifests itself in much greater susceptibility to different types of diseases, such as cardiovascular disease and Alzheimer s disease. In general, for people in their 80s and 90s, physical and mental processes tend to decline by about 1 2 percentage points per year. But there are things that can be done to mediate that rate of decline, such as replacing joints. An adviser I know shared that because of the artificial hip, one of his clients who had a debilitating hip disease can now do much more in retirement than before. Before this type of discovery, retirement was much less pleasant, but now opportunities have been created by medical technology. Although medical advances allow people to replace a declining part of the body, there is only so much people can do to improve cognitive function in old age. 52 Third Quarter CFA Institute. All Rights Reserved. cfapubs.org

6 Planning for Retirement Living Cognitive abilities tend to decline over time, which is a fact that people need to prepare for. Figure 2 illustrates cognitive theory. The easiest way to describe the human brain is that it is a combination of a processor and a hard drive. The processor part of the brain identifies a stimulus and immediately finds context by looking quickly into the hard drive and then providing a response to the stimulus. The quickness at which people can process a stimulus actually peaks when they are in their mid-20s. Albert Einstein, for example, had his magic year, in which he transformed the field of physics, when he was 26. Figure 2. Cognitive Theory 53 Crystallized Intelligence Performance Fluid Intelligence Age Source: David Laibson, Aging and Investing: The Risk of Cognitive Impairment, AAII Journal (September 2011). Wealth managers are in a profession that requires not only processing ability but also a strong hard drive. In general, the more knowledge that they have, the better they are at making decisions. A number of studies have found that decision-making quality tends to peak when people are in their mid-50s and then begins to gradually decline as the ability to efficiently process complex information begins to decline. At this point, how many of those 10 words I gave at the beginning can you remember? Figure 3 shows that people go from being able to remember about five and a half words in their early 60s down to maybe three words by the time they are in their 90s. Word recall ability tends to fall at a linear rate. Similarly, it is fascinating that numeracy also tends to decline at a relatively linear rate. The HRS includes the following question: If five people all have the winning numbers in the lottery and the prize is $2 million, how much will each of them get? More than 50% of respondents in their 50s correctly answered $400,000. That percentage declines to less than 40% for those in their 70s, and by 90 years old, it is only 10%. (By the way, even when people are at their cognitive peak, about half of them cannot divide 20 by 5.) Most people assume that everyone has the numeracy skills to be able to handle complex problem solving, especially those who work in public policy. The main point is that there is a decline in numerical ability with age over time, which has many interesting implications because as people get older, they have to deal with a lot of complicated paperwork and must continue to manage their assets. Some colleagues and I conducted a financial literacy survey that was the largest financial literacy test that anyone had ever done. As shown in Figure 4, we found that the peak of financial literacy occurs at about age 50 and then begins to decline. The rate of decline in financial literacy tends to mirror the rate of decline in numeracy and word recall, but when we asked people how confident they were in their ability to make financial decisions, we did not see that same decline. In fact, we saw people reporting a bit of an uptick in ability later in life, which indicates that people do not want to believe they get worse at making financial decisions with age. Anyone who has had a parent or a grandparent who has been driving into their 80s and 90s can confirm that when asked if they are having any trouble driving, they will probably say no. But the reality is that they are not driving quite as well as they used to. As part of the retirement planning process, people need to acknowledge the objective evidence that as they get older, their ability to make complex financial decisions is going to decline. So, plan for that. Decisions need to be made that reduce the potential loss from that decline occurring. Rates of dementia double every five years in retirement to the point that by the age of 85, 30% are experiencing clinical dementia. Clinical dementia is seriously impaired cognitive decision making. If anyone has seen videos of people who are experiencing clinical dementia trying to make basic financial decisions, it is clear that they should not be managing their own financial affairs. As people age, the rate of dementia or cognitive impairment increases, so that by 90 years of age, 78% are either experiencing clinical dementia or some kind of serious cognitive impairment. In the HRS, researchers ask respondents two questions: (1) Have you taken a test to assess whether you are experiencing clinical dementia? (2) Are you managing your own money? The researchers found that 60% of those who are experiencing clinical dementia are still managing their money, and another 10% said they are managing their money but having some trouble doing so. The remainder (about 30%) are delegating money management to somebody else CFA Institute. All Rights Reserved. cfapubs.org Third Quarter

7 CFA Institute Conference Proceedings Quarterly The lesson is that those who are experiencing clinical dementia should not be managing their money without assistance. Of those who are receiving assistance, who is assisting them? Did they make a plan early in retirement to appoint a fiduciary who is able to make financial decisions on their behalf? Is the fiduciary the person they trust the most during the time when they are experiencing clinical dementia? What we see are grave potential problems that show up in the data. Those who experience a large decline in cognitive ability often have a commensurate decline in wealth. In fact, it may not be that the biggest risk to a retiree s portfolio is a bear market; it may be that the biggest risk to a retiree s portfolio is a decline in cognitive ability without a plan and without awareness that it is occurring. Studying those who have experienced cognitive decline, we found that they were far more likely to shift all of their assets from equities into safe assets during the financial crisis. Those who are starting to lose their cognitive abilities have an instinct to do everything that they can to avoid losing Figure 3. Immediate and Delayed Average Score on the Word Recall Test in the 2010 HRS Number of Words Episodic Memory Age Source: Based on data from the 2010 HRS and the author s calculations. Figure 4. Objective Financial Literacy Score by Age Peak at Age Actual Predicted Five Year Predicted Source: Michael Finke, John S. Howe, and Sandra J. Huston, Old Age and the Decline in Financial Literacy, Management Science (Forthcoming 2015). 54 Third Quarter CFA Institute. All Rights Reserved. cfapubs.org

8 Planning for Retirement Living money. When they saw that their investment portfolio had lost money, their initial reaction generally was to not take any risks that could lead to another bad decision. But that right decision in their brain is not the right decision in reality. All of those people who moved out of equities in early 2009 lost out financially. So, another risk of declining cognition is an inability to accept investment risk. Conclusion Planning for retirement needs to include a plan for handling aging. People need to accept that they will decline physically and mentally and develop a plan before it happens to address what they will do when it occurs. Another part of the process is planning for a living environment. People need to ask themselves whether their home is the best place to spend retirement, and if not, to determine at what age they should move out. Finally, people need to plan for managing their income. This part of the plan includes developing a retirement spending plan, thinking about paying for long-term care, and determining whether guaranteed income is important. The final step is taking care of legal matters, such as deciding who to grant power of attorney to, stipulating medical directives, and identifying an elder-care attorney. CE Qualified Activity 0.5 CE credit 2015 CFA Institute. All Rights Reserved. cfapubs.org Third Quarter