Personal Retirement Challenges

November 1, 2013
Zvi Bodie of Boston University and Andrew Lo and Robert Merton both of MIT, Organizers
Sponsored by the TIAA-CREF Institute

John Beshears, David Laibson, and Brigitte Madrian, Harvard University and NBER; James Choi, Yale University and NBER; and Stephen Zeldes, Columbia University and NBER

What Makes Annuitization More Appealing (NBER Working Paper 18575)

Beshears, Choi, Laibson, Madrian, and Zeldes conduct and analyze two large surveys of hypothetical annuitization choices. They find that allowing individuals to annuitize a fraction of their wealth increases annuitization relative to a situation where annuitization is an "all or nothing" decision. Very few respondents choose declining real payout streams over flat or increasing real payout streams of equivalent expected present value. Highlighting the effects of inflation increases demand for cost-of-living adjustments. Frames that highlight flexibility, control, and investment significantly reduce annuitization. A majority of respondents prefer to receive an extra “bonus” payment during one month of the year that is funded by slightly lower payments in the remaining months. Concerns about later life income, spending flexibility, and counterparty risk are the most important self-reported motives that influence the annuitization decision.

Robert Novy-Marx, University of Rochester and NBER, and Joshua Rauh, Stanford University and NBER

Funding Soft Liabilities

Novy-Marx and Rauh examine the consequences of alternative funding strategies for liabilities such as post-retirement health benefits for U.S. state and local government employees. They begin with the observation that although many state and local governments provide subsidized health insurance to retired public employees, the legal protections that apply to state and local pension liabilities generally do not apply to these other post-employment benefits. Under current government accounting rules that give a role to expected returns on assets in the choice of discount rates, states and local governments use discount rates that increase with the extent to which they have pre-funded their retiree health benefit liabilities. Financial economics, in contrast, implies that viewed from the perspective of taxpayers, cash flows should be discounted at rates that reflect their risk, and that do not depend on funding status. The authors estimate retirement health insurance liabilities from a taxpayer perspective for the state of California under different assumptions about the extent to which the state could default on the benefits. They then analyze optimal funding strategy in a model in which risk-averse workers who otherwise lack market exposure demand wage premiums to compensate for the possibility of default on retiree medical benefits. The analysis suggests that more aggressive pre-funding reduces the option value of default, but also can reduce the wage premium that must be paid to workers.

Lans Bovenberg, Theo Nijman, and Bas Werker, Tilburg University, and Roel Mehlkopf, Ministery of Social Affairs

Variable Annuities in Collective Pension Schemes with Risk Sharing: Valuation, Investment and Communication

Bovenberg and Mehlkopf explore pension schemes that provide (deferred) variable annuities by sharing risks among current participants on the basis of complete contracts. Annuities are adjusted gradually after an unexpected shock. This is consistent with habit formation and leads to life-cycle investment. The authors show how these variable annuities can be valued in a market-consistent fashion and discuss how investment policy of a pension fund can be determined endogenously on the basis of the desired risk profiles of the (deferred) variable annuities.

Veronika Pool and Irina Stefanescu, Indiana University, and Clemens Sialm, University of Texas, Austin and NBER

It Pays to Set the Menu: Mutual Fund Investment Options in 401(K) Plans (NBER Working Paper 18764)

Pool, Sialm, and Stefanescu investigate whether mutual fund families acting as trustees of 401(k) plans display favoritism toward their own funds. Using a hand-collected dataset on retirement investment options, the authors show that poorly-performing funds are less likely to be removed from and more likely to be added to a 401(k) menu if they are affiliated with the plan trustee. They find no evidence that plan participants undo this affiliation bias through their investment choices. Finally, the subsequent performance of poorly-performing affiliated funds indicates that these trustee decisions are not information-driven and are costly to retirement savers.

Ralph Koijen, London Business School and NBER; Stijn Van Nieuwerburgh, New York University and NBER; and Motohiro Yogo, Federal Reserve Bank of Minneapolis

Health and Mortality Delta: Assessing the Welfare Cost of Household Insurance Choice (NBER Working Paper 17325)

Koijen, Van Nieuwerburgh, and Yogo develop a pair of risk measures for the universe of life and health insurance products. Health delta measures the differential payoff that a product delivers in poor health, while mortality delta measures the differential payoff that a product delivers at death. A life-cycle model of insurance choice simplifies to replicating the optimal health and mortality delta through a portfolio of insurance products. For each household in the Health and Retirement Study, the authors calculate the health and mortality delta implied by its ownership of life insurance, annuities including private pensions, and long-term care insurance. They compare them to the optimal health and mortality delta implied by the life-cycle model. For the median household aged 51 to 57, the lifetime welfare cost of market incompleteness and suboptimal choice is 4 percent of total wealth. Both observed household characteristics and unobserved preference heterogeneity fail to explain this welfare cost.

Rik Dillingh and Henriette Prast, University of Tilburg; Mariacristina Rossi, University of Turin, CeRP - Collegio Carlo Alberto; and Maria Cesira Urzi Brancati, Universita di Roma tor Vergata, CeRP-Collegio Carlo Alberto

Psychology and Economics in the Reverse Mortgages

Dillingh, Prast, Rossi, and Brancati present results from a survey on the attitudes toward reverse mortgages in the Netherlands. They find there is substantial potential interest in reverse mortgages, especially for the purpose of being able to live more comfortably and not worry about money until death, or to be able to spend a large sum of money upon retirement on hobbies, home improvements or traveling. A similar study was done for Italy, the results of which differ from those for the Netherlands. For Italian households a reverse mortgage is primarily seen as a last resort. The authors use two different frames for suggestions on the use of the loan - own consumption versus bequest - and find that the latter significantly raises interest in reverse mortgages of people with a bequest wish. They interpret this as evidence that people are unaware of the potential of reverse mortgages to optimize the timing of bequests. Demand is highest among those around retirement age, depends positively on the ratio of housing wealth over income and on the perceived riskiness of future pensions, and negatively on the expected replacement ratio. The authors find a counterintuitive result for bequest timing, with people being more interested if the age difference with the oldest child is larger. Self-assessed financial literacy does not play a role, and women are less interested.

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