The Illusion of Wealth

by George Sisti

It’s been my experience that new retirees who have enough financial assets to sustain their retirement lifestyle often experience anxiety about running out of money. Another left-brained, number crunching analysis won’t remedy this malady so I’ve had to develop a different strategy. I’ll ask them to close their eyes, hold their hands out palms upward and imagine the weight of $1,000 in their hands; what $1,000 “feels” like. Then I ask them to imagine what $5,000 “feels” like. So far, so good. But when I ask them to imagine what $1 million or $2 million “feels” like, the exercise ends because no one can “feel” that much money. Most people are more sensitive to (they can “feel”) wealth expressed as a monthly income because they can relate it to their monthly financial obligations. Few people know, or know how to determine, if their portfolio’s “weight” (lump sum) will support their monthly cash flow throughout retirement.

Recently, there have been numerous articles in the financial media about the benefit of annuitizing the lump sum balance of a defined contribution plan (i.e. 401(k) or 403(b)). A new retiree transfers the lump sum to an insurance company in exchange for a guaranteed monthly payment, creating a personal defined benefit pension. Alternatively, retirees can rollover the account balance of their defined contribution plan into their own IRA. So, how can a new retiree know which is the better option?

For this discussion, we will assume that you are a 65-year-old retiree with $1 million in your 401(k). We assume that inflation will average 2.5% during your 25-year retirement and that the discount rate (the interest paid by safe fixed- income investments) is 3.5%. Would you prefer to receive the $1 million as a lump sum rollover into your IRA or would you rather annuitize the lump sum and receive $5,000 every month for the rest of your life? Using our assumptions, these two options are financially equivalent.

The academic paper: “The Illusion of Wealth and Its Reversal” uses these assumptions in dealing with the question of how people perceive wealth when presented as a choice between a lump sum payout or an annuitized monthly payment for life. The researchers discovered that for lower lump sum values (i.e. $100,000 and the annuitized equivalent of $500 per month) the study’s participants were more likely to prefer the lump sum over the monthly check because it seems to represent more wealth than the annuitized payment. At higher wealth levels (i.e. $1 million) the illusion of wealth “reverses”. The study’s participants were more likely to prefer an annuitized payment of $5,000 per month over the lump sum $1 million payout. Both group’s choices are based on faulty illusions of relative wealth, since in both cases the lump- sum and annuitized options are mathematically equivalent.

The authors of the paper concluded that the relative attractiveness of annuities vs. lump sum payouts depends on underlying wealth levels. The larger the lump sum, the more likely it was that the study’s participants favored the annuitized payout – because the monthly payments were larger and gave the “feel” of more wealth. But the larger the lump sum, the less likely it is that our new retiree needs a guaranteed monthly income to avoid running out of money in retirement. A conservative portfolio allocation will likely generate a sufficient income stream to fund their spending needs and still leave a meaningful legacy.

There is one huge downside to the annuitization option. Annuitized payments are unlikely to be inflation-adjusted. With 2.5% annual inflation, the $5,000 monthly payment will spend like $3,050 twenty years from now. The safety of fixed, annuitized income payments is illusory in an inflationary environment. This is why annuitizing a defined contribution plan’s lump sum balance at retirement has never appealed to me. A retiree who chooses the annuitization option is essentially converting their retirement plan to a 100% fixed income portfolio –– one that over several decades will likely be ravaged by inflation. But few affluent retirees factor in inflation when they are presented with the option of receiving what, today, is a relatively large guaranteed monthly payment.

The findings of this study add to my conviction that the average person has absolutely no clue how to finance a multi- decade retirement. The subject material isn’t easy to understand and the math can be confusing. Whether to annuitize the lump sum of your defined contribution plan is probably the most important financial decision you’ll make in retirement. It’s also a decision that few new retirees can make on their own. Before making the decision, I recommend that you seek advice from at least two financial advisors who have no financial interest in your decision. Don’t do business with any financial professional who promotes annuitization but doesn’t mention the long-term impact of inflation.

Disclaimer – The information in this article is educational in nature and should not be considered as personal investment, tax or legal advice. Each reader must determine how the content of this newsletter should be applied to their investment portfolio. This newsletter is not a solicitation to sell investment advisory services where such an offer would not be legal. Investing in stocks and mutual funds involves risk and the potential loss of principal. Historical data is from sources believed to be reliable. Past performance is not a guarantee of future returns.