Unfortunately, from all evidence, individual investors are not very well equipped, and certainly not very effective, in managing their own investments, or in making other key financial decisions.
U.S. 401(k) accounts, and their equivalents elsewhere, are a particular problem. According to the 2014 DALBAR report, over the past 20 years the average "equity fund" investor achieved an average 5.02% annualized return, which is 4.2% less than the 9.22% than he/she could have achieved by simply investing funds in an S&P500 index-tracking fund. Investors in "fixed income funds" did more poorly still -- their average return was an abysmal 0.71%.
Given the disappointing performance of most 401(k) accounts, the Pension Research Council estimates that more than half of U.S. retirees will rely on Social Security for more than 50 percent of their total income. Many will be left with the painful choice of either a large drop in living standards, or else risking prematurely exhausting savings and being at the mercy of children or relatives. Perhaps many prospective retirees should lower their expectations for life after retirement, but there is little evidence that many are doing this.
An international problem
Other nations are facing similar challenges, leaving both investment advisors and government officials worldwide fretting that many retirees in the coming years will suffer financially.
The Canadian equivalent of the U.S. 401(k) is called the Registered Retirement Savings Plan (RRSP). Contributions to RRSP can be made pre-tax while working, but most withdrawals are subject to tax, in the same way as a U.S. 401(k). The Canada Pension Plan (CPP), which is the equivalent of the U.S. Social Security, is significantly less generous than in the U.S., and recipients with more than CDN$67,668 total income must currently pay a 15% tax on CPP benefits.
Australia has an Age Pension system, but the payments are relatively modest, and are means tested. For example, if a retired couple's combined fortnightly income exceeds AUD$2,877, their Age Pension payment drops to zero. Fortunately, Australia has a "superannuation fund, analogous to a U.S. 401(k) account, to which almost all employers contribute (currently at least 9%, but rising to 12%; some large employers, such as universities, contribute 17%). Australia superannuation funds are not taxed provided they are withdrawn as annuities.
The U.K. has a State Pension system, with benefits depending of the number of years of National Insurance contributions. In some respects, it is almost as complicated as the U.S. Social Security system. In some European nations, mandatory retirement rules still exist, but for most in the English-speaking world, such rules have been mercifully laid to rest.
Complexities of the U.S. Social Security system
So what is involved in collecting Social Security in the U.S.? Just head to the nearest Social Security office when one turns 62? Not so fast. Most retirees would be much better off waiting until at least 66 (the current full retirement age), or even 70 if their financial circumstances permit, as indicated by this table:
But even this isn't the full story -- it is often considerably more complicated, depending on the circumstances of the prospective retiree and his/her spouse.
Here is an analysis of four scenarios proposed by one of the present authors, together with an analysis and recommended strategy for each provided by Chris Hughes of the Del Monte Group. Here "PIA" means the Primary Insurance Amount, or the monthly Social Security benefit that would normally be paid at full retirement age (currently 66). One can find one's current PIA by contacting the Social Security Administration, or by logging into one's SSA account.
- Assumptions: Nick: 65, Amy: 62; married; Nick's PIA: $2,000, Amy's PIA: $1,700. Assuming the couple is relatively healthy and have some savings, they should both delay collecting benefits as long as possible. Nick should either begin his benefits or "file and suspend benefits" by age 69. This will enable Amy to collect spousal benefits (50% of Nick's PIA) when she turns 66. Amy should collect the spousal benefit for four years, until she reaches age 70, at which time she should switch to her own benefit. She would receive 132% of her full retirement benefit, or $2,244. The life expectancy for men aged 65 is roughly 83, while the life expectancy for women aged 62 is about 85. Assuming they live to their respective life expectancies, employing the above strategy will yield them at least $110,000 more in cumulative lifetime benefits compared with starting to collect now.
- Assumptions: Nick: 65, Amy: 62; married; Nick's PIA: $2,600, Amy's PIA: $0; Nick's life expectancy (due to a medical condition): 70. With Nick only expected to live for another five years or so, it may appear that he should file for benefits immediately. But instead he should wait until he is 66, then "file and suspend" his benefits. This will trigger spousal benefits for Amy (37.5% of Nick's PIA, or $975). So when should Nick collect, knowing that he has a terminal illness? Since Amy will receive his benefit upon his passing, Nick's decision will affect her cumulative lifetime benefits. Each year he delays beyond age 66, he will earn an 8% delayed retirement credit. Even if he dies before collecting a penny, Amy, as his widow, can then switch from spousal benefits to survivor benefits and collect what he would have collected at age 70. Assuming she lives to 85 (which is the life expectancy for a woman age 62), this strategy will yield Amy at least $75,000 more during her lifetime than if Nick elected to collect his benefits at age 65.
- Assumptions: Nick: 62, Amy: 62; married; Nick's PIA: $1,800, Amy's PIA: $2,500. In this case, because Amy has the higher benefit, it make sense for her to defer her benefits as long as possible -- ideally until age 70. When she reaches age 66, she should "file and suspend" benefits, triggering spousal benefits for Nick (50% of her PIA). When they reach 70, Amy should turn on her benefits, and Nick would switch from spousal benefits to his own benefit. Again, using mortality tables to project life expectancy, a 62 year old male, on average, will live to 83, and a 62 year old female, on average, will live to 85. Thus, in this case, delaying both of their benefits until age 70 will yield them a whopping $180,000 more in cumulative lifetime benefits, compared to collecting at 62.
- Assumptions: Nick: 65, Amy: 62; married; Nick's PIA: $2,400, Amy's PIA: $700. In this particular case, the best strategy is a three-step process: As the lower wage earner, Amy should file for benefits immediately. Then when Nick reaches 66, he should file a restricted application for spousal benefits (50% of Amy's PIA). Then when Nick turns 70, he should file for his own benefits, collecting benefits based on his own earnings. This will then allow Amy to file for spousal benefits, collecting a little less than half of Nick's PIA.
The above examples were all for long-time married couples. In the case of divorce or remarriage, additional complications arise.
Needless to say, very few American workers are even aware of these complexities, or the ramifications of not selecting the best strategy. And one even wonders whether the agents working for the Social Security Administration fully appreciate all of these issues. For example, in a real-life case similar to item 2 above, "Nick" was told to start collecting benefits immediately, because he only had five years to live.
A useful discussion of some these complexities, in the form of a chat between Paul Solman of the PBS News Hour and Laurence Kotlikoff of Boston University, is available at the PBS website. See also this discussion between Kotlikoff and Steve Forbes.
Consequences of financial illiteracy and innumeracy
All of this underscores the relatively poor level of financial literacy, both in the U.S. and elsewhere. The Securities and Exchange Commission recently concluded:
[I]nvestors have a weak grasp of elementary financial concepts and lack critical knowledge of ways to avoid investment fraud. ... Certain subgroups, including women, African-Americans, Hispanics, the oldest segment of the elderly population, and those who are poorly educated, have an even greater lack of investment knowledge than the average general population.
What's more, one could argue that the increasing complexity of today's financial world requires much more of investors than in past years, whether they be professional investors working for large firms or individual investors managing their 401(k) and government benefits. As a single example, statistical overfitting of stock market data is rampant in the financial field, and thus investors can easily be led astray into investments that may look good on paper, based on impressive backtest results, but fall flat in practice.
One key problem, which is evident just by considering the scenarios above, is that financial literacy is inextricably linked to mathematical literacy. In this regard, the latest results of the U.S. National Assessment of Educational Progress (NAEP) test are not encouraging. The 12th grade overall score of 153 in mathematics was identical to the 2009 score, and only slightly higher than the 2005 score, in spite of years of effort and billions of dollars spent to improve K-12 education.
In any event, many investors, young and old, need additional training in the financial arena. As a colleague of ours with a Ph.D. and 35 years' experience in the financial field confided to one of us recently, "I barely feel qualified to manage my own investments."