Do you convert retirement saving to retirement income?

There is some interesting news out of South Africa, which relates to how people make monetary decisions when they have to convert retirement saving to retirement income. In Canada those who have money in their Registered Retirement Savings Plan, must convert these to a Registered Retirement Income Fund in the year the person turns 71. Many other countries have plans when at retirement, individuals must convert their accumulated savings into income.

According to Economics the optimal strategy for retirees is to try and secure a guaranteed income for life using life annuities.

A survey conducted by Just Retirement South Africa in 2016 revealed that 86% of people surveyed, between the ages of 55 and 85, preferred a guaranteed income for life in retirement. The 2015 Sanlam Benchmark survey showed a similar result, with 87% of people surveyed wanting certainty of income for life. But the reality is much different, the Association for Savings & Investment SA (ASISA) statistics reveal that 90% of 2015 annuity sales were of living annuities, which provide no explicit long term protection.

This observation has become known across the world as ‘the annuity puzzle’. Economists describe the annuity puzzle as a problem of maximizing lifetime expected utility.

It can be explained by recognizing that in the real world people do not make decisions by taking into account all costs and benefits. Instead, people are influenced by psychological factors and what’s considered socially acceptable or popular, and their preferences depend on how information and choices are presented to them.

The World Development Report (2015), ‘Mind, Society and Behaviour’, summarises hundreds of studies and behavioural finance research into one framework. The framework rests on three principles of human decision-making: thinking socially, thinking with mental models and thinking automatically.

These factors help to explain why when faced with this decision retirees currently convert their savings into income using living annuities:

·       Thinking socially. We have become accustomed to high real returns. Hence, investing (rather than annuitising) at retirement has become popular, with much marketing in the industry focussed on providing long-term returns, and not on how individuals can convert savings into income.

·       Thinking with mental models. When Investment framing is used at retirement instead of consumption framing research in the US and the Netherlands has shown that this has a significant impact on an individual’s ultimate decision. If investment framing is popular, instead of converting those savings into income, people will want to invest those savings. There is very limited evidence of individuals being presented with a comprehensive framework (and hence mental models) with which to understand the trade-off between living and life annuities, given their circumstances.

·       Thinking automatically. The benefits and risks of the available annuity options at retirement are complex areas to navigate. In the face of such complexity, people end up thinking automatically when faced with the decision of how to convert their savings into income – based on what they have heard from others (thinking socially) and using the rules of thumb available in the industry (mental models created over the years, founded on how to invest rather than how to convert capital into income).

One of the solutions put forward in South Africa, was for retirement funds to adopt default annuity strategies. Many retirement funds, especially umbrella funds, have started adopting default annuity strategies by making arrangements available for individuals to retire within the fund. It’s been shown that introducing defaults in other areas of finance can improve the ultimate decision making by individuals. It’s anticipated that default annuity strategies would be similarly successful.

In the financial planning industry, advisers can assist to improve their clients’ decisions on how to convert savings into an income at retirement. They can do so by introducing a ‘consumption framing’ approach, whereby appropriate mental models are created to enable an individual to trade-off between the main objectives at retirement (e.g. providing for lifetime spending needs and liquidity or an inheritance). 

Based on an individual’s circumstances, including their main retirement objectives, the most optimal investment strategy at retirement can be recommended. This includes the proportions between living annuities and life annuities and the asset allocation for the living annuity component.

All these interventions capitalize on behavioural finance techniques; it is believed that by making use of these techniques, individuals’ decisions about how to convert accumulated savings into an income can be improved, ultimately leading to pensioners securing more sustainable incomes into retirement.