The New Retirement Challenge

By Jeffrey R. Brown
Assistant Professor of Finance
University of Illinois at Urbana-Champaign

Executive Summary

In the coming decades, 77 million baby boomers will enter into their “golden years” of retirement. Thanks to dramatic advances in life expectancy over the past century, the average new retiree can look forward to nearly two decades of retirement; a large and growing number of retirees will spend three or even four decades in retirement. The fortunate among them will spend these years financially secure, able to concentrate their time and energy on family, friends, travel and other personal interests.

For millions of retirees, however, true financial security in retirement will prove an elusive goal. Even those who have carefully saved and built sizeable retirement nest eggs may find that retirement brings a host of new financial challenges. One of the most important of those challenges is determining how to convert one’s nest egg into a sustainable stream of retirement income, especially in the face of so much uncertainty about how long one will live and what future expenditure needs will be.

In the past, many retirees could rely on defined benefit pension plans to provide guaranteed retirement income even at advanced ages. However, the past several decades have witnessed a steady decline in the relative importance of defined benefit pension plans as employers have increasingly come to rely on defined contribution plans such as the 401(k). This shift in private pension provision has led to increased emphasis on self-reliance in retirement planning. Retirees affected by this shift are in addition to those groups of workers who traditionally have had inadequate or no pension coverage and, therefore, have been responsible for accumulating and managing their retirement resources. The uncertain financial future of Social Security provides an additional reason that traditional solutions may no longer be sufficient to provide sustainable income for life.

Rather, tomorrow’s retirees will need access to an additional, reliable source of guaranteed retirement income. Financial products are available to help ensure that an individual can have adequate income at advanced ages, even if she lives to age 100 and beyond. In particular, life annuities provide a guaranteed source of monthly income that cannot be outlived. By providing insurance against a drop in one’s standard of living at older ages, life annuities ought to play a central role in the portfolios of retirees.

This paper explores the changing retirement landscape in the United States, and discusses how the trends toward self-reliance will require that future retirees grapple with this growing retirement challenge – how to make a nest egg last for a lifetime. In addition to highlighting the importance of life annuities to individual retirees, it discusses the importance of annuitization for reducing the fiscal strain on federal, state and local means-tested programs for the aged. Many individuals, who with proper planning could avoid dependence on these programs, do not fully appreciate the financial implications of living a long life or the value of life annuitization. The paper notes that while public policy has provided tax incentives for households to increase retirement savings, virtually no tax or other policy incentives exist to encourage households to convert their nest eggs into streams of lifetime retirement income.

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