Kitces: A new hierarchy of retirement needs

Even though money itself is fungible, how we — and our clients — think about assets is not. Instead, we mentally deposit money in buckets of current income, current assets and future income. This instinctive categorization explains the popularity of so-called bucketing strategies for retirement income, whether segmented by time (short, intermediate and long-term needs) or type of spending (essential vs. discretionary).

And just as Abraham Maslow in the 1940s ranked humans’ fundamental needs ranging from the physiological to the psychological, we do the same with our money. First, we pay current expenses (groceries), then fund short-term financial reserves (checking accounts), and finally put savings toward future income (investment retirement accounts). This hierarchy helps explain why some types of retirement income strategies — annuitization among them—are unpopular, despite retirees routinely stating that their biggest fear is outliving their retirement assets.

The biggest caveat to this hierarchy is that clients often feel compelled to save more for retirement than they actually need. Research finds that the amount of liquid bank holdings a person has directly and positively relates to their well-being and life satisfaction.

And if clients can’t achieve their needs for future income until they meet their need for current assets, they may continue to feel cash-strapped and/or choose retirement income solutions that are mechanically inferior but psychologically more satisfying.

MENTAL ACCOUNTING BUCKETS
Bucketing strategies are hugely popular in the financial planning space. The classic time segmentation strategy typically divides retirement assets into three buckets: a short-term bucket to cover the next few years of spending, kept in cash; an intermediate-term bucket to cover the subsequent 5-10 years of spending, invested in bonds; and a long-term bucket to cover spending beyond a 10-year horizon, invested in equities. Notably, such bucketing strategies don’t necessarily produce a materially different asset allocation than a classic diversified balanced portfolio. Nonetheless, for an investor who might have a 60/30/10 stock/bond/cash portfolio anyway, it seems to be far easier for most retirees to conceptualize.

An alternative version of bucketing is dividing long-term expenditures into essentials — consisting of the food/clothing/shelter variety of expenses you really can’t afford to outlive — and discretionary expenses, i.e., the ones you want but don’t need to survive.

Once expenses have been separated, assets can be allocated to appropriately match the buckets. For instance, essentials might be paired with Social Security and lifetime immediate annuitization, while discretionary expenses can be funded with a diversified portfolio.

In a planning context, these bucketing strategies are often used as a means to help retirees acclimate to the impact of market volatility on retirement assets.

More generally, though, these strategies appear to work because they align reasonably well with how our brains do accounting, turning otherwise fungible assets into separately accounted buckets.

This accounting, however, doesn’t always tie buckets directly to particular goals. Looking at the available research, Shefrin and Thaler found that consumers most typically account for their wealth in three separate buckets: current income, current assets and assets to support future income.

These mental buckets matter. Even if the actual investment accounts are otherwise similar and the money is fungible, consumers react differently depending on where they feel the squeeze as their situation changes over time. Thus, a household that feels less wealthy is most likely to constrain its current income to get back on track — and focus blame for its shortfall on its latest expenditures. Meanwhile, a household wealthy in net worth terms may still feel poor and unhappy if it doesn’t have a reasonable amount of liquid cash on hand.

Perhaps the most significant implication of these buckets, though, is their implicit prioritization. When current income matters more than current assets — which in turn matters more than future income — it’s difficult to be satisfied with the status of the longer-term buckets until the nearer-term ones are satisfied.

Viewed another way, just as Maslow found that people have a motivational hierarchy of needs that must be satisfied in a certain order, so too does the retiree appear to have a rigid hierarchy of retirement needs.

CASH VS. ANNUITIZATION
A prospective retiree’s #1 concern is that he/she won’t afford retirement and/or will outlive available retirement assets. In essence, it’s the fear that the future income bucket in the hierarchy won’t be satisfied. Yet the most straightforward solution to this fear — buying a lifetime immediate annuity at retirement — is rarely implemented, with immediate annuity sales continuing to hover at barely $2 billion every quarter: a miniscule proportion of total invested retirement assets.

Yet this is easily explained. Even if we fear a shortfall of future income, we’re not willing to give up the liquidity of current assets to secure it because having sufficient current assets is a required foundation first. In other words, even if immediate annuitization solves the future income need — and even if we can afford to do it — we’re still not willing to undermine the lower levels of the pyramid to satisfy the top. Viewed another way, it’s not actually a fear of outliving money but a fear of outliving money available after having enough liquid cash on hand to meet current expenses.

Accordingly, it’s no surprise that to the extent retirees choose annuitization, they strongly prefer partial annuitization options to all-or-nothing strategies because it has less of an impact on the current assets tier of the hierarchy.

Similarly, the hierarchy helps explain the popularity of variable annuities with guaranteed living withdrawal benefits as well. Generally, the actual future-income guarantee is far superior with a pure immediate annuity than with a GLWB, but the variable-annuity-with-GLWB strategy is a more liquid version, helping satisfy the desire for current assets.

This suggests that even within the future income tier of the hierarchy, consumers distinguish between allocations to liquid future-income sources and illiquid versions that — while more guaranteed — come at the cost of liquidity.

THE GUARANTEES TRAP
Another challenge emerging in this research is that ultimately, retirees don’t just want to have future income in retirement to satisfy their needs. Indeed, they want the potential for an increasing standard of living over time too.

Consequently, it’s not enough to say, “Here’s a strategy to guarantee your retirement income” if it’s implicitly paired with the qualifier: “but this is as good as it gets.” This is distinct from a retiree who may have an explicit legacy goal to leave assets to heirs. In fact, even those who don’t want to leave assets may still refuse to annuitize their assets because of the lack of personal upside potential.

The most straightforward way to resolve this issue, of course, is to purchase a rising stream of guaranteed income, such as an inflation-adjusting immediate annuity. Yet in practice, these products are even less popular than traditional fixed immediate annuities.

This too makes sense. Because most households have limited assets, spending the same available dollar amount on an inflation-adjusted immediate annuity will result in a lower starting payment — but the requirement to take a lower starting payment now causes a deficit in the tier of current income needs.

On the other hand, this again helps explain the popularity of the GLWB annuity — or more generally various so-called floor-with-upside retirement income strategies — because the floor helps secure current and future income. The upside, meanwhile, satisfies “as good as it gets” syndrome, and the liquidity, which is usually associated with the investments that produce the upside potential, satisfies the need for current assets — even if, ironically, the cumulative outcome may be an inferior retirement income guarantee.

BEHAVIORAL BIASES
As we’ve seen here, retirees may have a demand for more retirement income and assets than they actually need. As planners, how do we reconcile that?

In theory, retirement income needs can be fully satisfied with some allocation to current and future income needs. However, research suggests that people typically have a current assets bucket as well, and they may not be happy if it is depleted — even if it is not needed. One study found that having cash on hand — e.g., a liquid checking/savings account balance — was directly correlated with life satisfaction even after controlling for investments, total spending and indebtedness. It wasn’t about the need for cash, but simply the satisfaction of having it on hand.

Yet if retirees want everything they need as well as additional liquid assets, they obviously want more than they actually need. The situation is further exacerbated by “as good as it gets” syndrome, and the desire not only to secure future income in retirement, but to have rising future income. This comes even though research suggests retiree spending actually declines with age.

In other words, while we probably need less in assets to cover declining future income needs, we want even more to satisfy a desire for upside potential even if we won’t likely end up needing or using the proceeds.