Dementia Insurance

A recent blog post reported that David Laibson, a talented behavioral economist at Harvard University, cited annuities as a way to help minimize poor financial decisions associated with dementia, a type of “dementia insurance.”  This notion is right on.  The retirement income landscape has changed.  Increasingly, individuals’ well-being in retirement will depend on how much they have in their 401(k) plans.  They will have to figure out how best to protect their assets and allocate that money over 20 to 30 years in retirement.  This challenge is new; with traditional defined benefit plans, the employer provides an income for life and the recipient has no responsibility.

Most analysts of 401(k) plans agree that these plans have not worked as well as one might hope.  On the accumulation side, participants make mistakes at every step along the way.  They fail to join the plan, to contribute as much as they should, to allocate their investments sensibly, to roll over money when they move from one job to another, and to rebalance their investments as they age.  Legislation, such as the Pension Protection Act of 2006, was aimed at making these plans easier and more automatic.  But serious problems remain.  And the accumulation period of a participant’s life is one where cognitive impairment, for the most part, is not a problem.

Now 401(k) plan participants are entering retirement with a pile of money, which they need to use effectively for a secure retirement.  But retirement is a period where cognitive decline is almost inevitable and dementia a possibility.  The data show that over half of people in their 80s have either dementia or cognitive impairment without dementia.  These individuals will not be able to manage their own money.

Moreover, recent data show that financial fraud against older people is on the rise.  With the ability through the internet to contact millions of people with a single stroke, scammers often target gullible older people with the lure of solving their financial problems with too-good-to-be-true investments.  This phenomenon will only get worse as the numbers of older individuals with cash balances and declining cognition increase.

One answer to the challenge of needing to manage money, on the one hand, and declining cognition, on the other, is to purchase an annuity early in retirement.  An annuity transforms 401(k) balances into a stream of lifetime income, which requires further decisions.  As discussed last week, the cheapest way to purchase the best annuity is to delay claiming Social Security benefits.  For those with modest 401(k) balances, the ideal strategy may be to work as long as possible, then use 401(k) assets to pay for living expenses to delay claiming an extra two or three years.  The thing to remember is that the monthly Social Security benefit at age 70 is 75 percent higher than that at age 62.  And the Social Security annuity is indexed for inflation, a product hard to find in the private market. 

The bad news, then, is the potential for calamity as people will increasingly be required to manage their own money in retirement and face the inevitable specter of declining cognition.  This combination opens the door for serious mishandling of funds or falling victim to fraud.  The good news is that this problem has a solution: put as much money as possible into an inflation-indexed annuity by delaying Social Security claiming as long as possible.