As the baby boom generation moves toward retirement, the financial needs and preferences of its members likely will change considerably as their lifestyles change. Key social and demographic trends will shape the retirement years and have implications for how insured institutions can attract and retain these customers. For example, older individuals generally want to move assets into safer, more conservative investments to protect the wealth they have accumulated. In addition, an ongoing shift from traditional defined benefit to defined contribution pension plans presents challenges to aging baby boomers, as they now must accept more responsibility for their own retirement planning. Retirees with substantial equity in their homes may have questions about how to use that equity to help fund their retirement. And finally, baby boomers can expect to live longer than past generations, and they must consider the effect higher health care costs may have on their retirement security. This article focuses on understanding the opportunities these trends may present and how FDIC-insured institutions may offer financial products and services that can help meet the needs of aging baby boomers.

As Baby Boomers Approach Retirement, Their Preference for Lower Risk Financial Products Is Expected to Grow

Studies show that as baby boomers age, their investment strategies tend to become more conservative. For example, older individuals tend to shift out of the stock market about the time they begin receiving annuities or withdrawing some of their financial assets.¹ The results of a recent survey of baby boomers indicate that respondents shifted some portion of their retirement savings from relatively riskier assets, such as accounts invested in stocks and real estate, into safer ones, such as savings accounts.² Forty-two percent said they had put money into regular savings in 1998; by 2003, this number had increased to 50 percent. The shift for older respondents (ages 53 to 57) was slightly higher—an additional 12 percent of them had put money into regular savings by 2003. During the same period, older respondents' contributions to individual retirement accounts (IRAs), 401(k) plans, and other retirement savings accounts, often invested in equities, dropped 6 percent. Certificate of deposit (CD) data show similar results: older people are more likely to hold CDs than younger people, and the median value of their CD holdings exceeds that of younger people (see Chart 1).³

Chart 1

These trends may present opportunities for insured institutions. The ability to offer a range of investment products and services may enable banks to help these individuals hedge against the risk that inflation could deplete the value of their assets.⁴ Inflation-linked

CDs may be particularly attractive to baby boomers because of the enactment of legislation raising deposit insurance coverage of certain retirement accounts to$250,000.⁵

Inflation reduces the purchasing power of fixed payment streams flowing from ordinary bonds and annuities.⁶ However, bonds and annuity products that feature payment streams that adjust for price increases can help mitigate the effects of inflation.⁷ Therefore, financial products that may be appropriate for baby boomers concerned about preserving their accumulated wealth include U.S. Treasury inflation-linked bonds (TIPS), TIPS mutual funds, inflation-linked U.S. savings bonds (I-bonds), or immediate life-escalating annuities (see text below for an explanation of immediate life escalating annuities).⁸

Pension Plan Changes May Create Demand for Financial Planning Services

The trend away from traditional defined benefit pension plans to defined contribution plans is tending to shift responsibility for retirement planning from employers to employees (see "The Shift Away from Defined Benefit Plans"). However, research shows that a significant number of households nearing retirement have done little or no retirement planning.⁹ Fewer than half (41 percent) of the respondents to theVanguard study indicated that they have an asset accumulation goal, and one-quarter did not have an income goal for their "current" standard of living or a "minimally acceptable" standard of living during retirement.¹⁰ Almost 25 percent of the respondents to the AARP baby boomer study said they would benefit from more retirement planning information and advice.¹¹

Some baby boomers will receive retirement income from both Social Security and traditional defined benefit pension plans; however, many may not know how much they can expect to receive from these sources and may need help choosing appropriate investment vehicles to augment that cash flow.¹² In addition, a key issue for many baby boomers, as they look forward to living longer, will be determining an appropriate withdrawal strategy of retirement savings that ensures they will not outlive their financial assets. Penalties for early withdrawals, minimum required distribution requirements, and estate planning issues also must be considered.

These questions are further complicated by the fact that baby boomers' retirement assets are taxed at different rates. For example, some retirement accounts, such as traditional IRAs, are taxed at ordinary marginal tax rates when withdrawn, while other assets are taxed at capital gains or qualified dividend rates. Social Security is either tax-free or taxed at a preferential marginal tax rate, and Roth IRA withdrawals are tax-free.¹³

Obtaining wealth management and financial and tax planning services, therefore, is critical to aging baby boomers.¹⁴ A newsletter for independent banks, Banc Investment Daily, recently reported that banks are beginning to develop long-term strategies as a means of attracting the $200 billion per year that soon will rollover from 401(k) plans when baby boomers retire.15 In fact, Wachovia Corp. recently hired ¹⁵ consultants to provide education, marketing, and sales support for its retirement planning products.¹⁶ Customers approaching retirement increasingly will need rollover products and services; this strategy helped the brokerage house TD Waterhouse significantly increase its rollover deposits.¹⁷

Some Baby Boomers May Need to Tap Equity in Their Homes to Fund Retirement

For many older Americans, the value of their home is their most significant financial asset.¹⁸ Many baby boomers may have inadequate savings to fund their retirement years, but may hold significant illiquid equity in their homes.¹⁹ In fact, households headed by individuals 45 to 54 are more likely to own a home than to have a retirement account (77 percent compared with 58 percent).²⁰ As Chart 2 indicates, home-secured debt diminishes for ages above 35 to 44 (the age cohort that includes the youngest baby boomers).²¹

Chart 2

Although aging baby boomers may no longer need a traditional mortgage, some are candidates for other forms of mortgage products. Statistics show that tapping the equity in real estate is becoming an increasingly attractive source of income to fund retirement. For example, retirees who face unexpected expenses (such as medical or home improvement bills) may apply for a home equity loan or a home equity line of credit that may have generally low closing costs and may be appropriate for short-term financial needs. Home equity conversion plans represent another way retirees can supplement their income (see text box). Although terms vary, in general, these plans allow homeowners to remain in their home while turning the equity into an income stream during retirement. The income stream is repaid when the home is sold.

Dealing with the Rising Cost of Health Care

As baby boomers age, they must consider how rising health care costs could affect their retirement security. About half the personal bankruptcy filers interviewed for an article in Health Affairs cited medical expenses as contributing to their decision to declare bankruptcy.²² Furthermore, some aging baby boomers are unclear about the level of protection their health insurance provides. For example, AARP statistics show that 30 percent of baby boomers mistakenly believe Medicare covers long-term nursing home care.²³ Others may overestimate the cost of long-term care insurance policies and decide against purchasing them.²⁴ Although baby boomer income and wealth, on average, are higher than those of previous generations, the distribution is skewed toward higher income brackets.²⁵ Baby boomers in higher income brackets may have the financial resources to cushion against rising health care costs; however, others in lower and middle income brackets may find it difficult to budget for unexpected health care expenses.

Receiving counseling about Medicare and the availability and costs of long-term care insurance, therefore, can help aging baby boomers make key decisions about health insurance products as they near retirement. Choosing a long-term care product is a complex decision that must weigh many variables, including age, current health, family medical history, income, and wealth.²⁶ For example, some younger middle-income baby boomers may benefit from purchasing long-term care insurance. Baby boomers entering retirement may consider an immediate life annuity bundled with long-term care insurance.²⁷ "Bundling" helps a bank offer products and services more affordably because the risks of each product to the bank are offsetting. For example, if a customer is a relatively high risk to the bank in terms of long-term care insurance (because of poor health), this individual likely would be lower risk in terms of an immediate annuity (poor health may suggest shorter longevity).

Retirement Challenges May Create Opportunities for Banks

Banks and thrifts that design and market products and services that respond to the changing financial needs of aging baby boomers may be well positioned to attract and retain these customers. In addition, these institutions have the opportunity to benefit from increasing levels of fee income. Overall, noninterest income is becoming more important as a source of revenue growth for banks of all sizes, as net interest margins continue to tighten in an increasingly competitive marketplace. Although larger banks (with assets greater than $1 billion) consistently have received a greater share of revenue from fee income sources, Chart 3 shows the increasing importance of noninterest income to smaller institutions (with assets less than $1 billion).

Chart 3

Larger institutions historically have offered product lines not readily available to smaller institutions, such as investment banking services and capital markets products. However, recent advances in technology and affiliations with other financial institutions are helping to bridge that gap. Increasingly, smaller community banks may find opportunities for growing fee income through the sale of wealth management products and financial planning services, as well as fees associated with electronic banking services. As baby boomers age toward retirement and their investment strategies become more conservative, banks of all sizes may be able to benefit by offering products and services that meet their financial needs.

Heather Gratton
Senior Financial Analyst

Footnotes

¹ Ameriks, John, and Stephen P. Zeldes. September 2004. How Do Household Portfolio Shares Vary With Age? (draft). http://bear.cba.ufl.edu/karceski/fin6930/lecture%20notes/Ameriks_Zeldes.pdf.

² Baby Boomers Envision Retirement II, prepared for AARP by Roper ASW, May 2004. The 1998 respondents were between ages 33 and 52, and the 2003 respondents were between ages 38 and 57. Riskier assets are defined here as assets with greater return volatility than short-term, highly liquid, relatively low-risk debt instruments such as Treasury bills. http://assets.aarp.org/rgcenter/econ/boomers_envision.pdf.

³ Bucks, Brian K., Arthur B. Kennickell, and Kevin B. Moore. 2006. Recent Changes in U.S. Family Finances: Evidence from the 2001 and 2004 Survey of Consumer Finances. Federal Reserve Bulletin. www.federalreserve.gov/pubs/bulletin/2006/financesurvey.pdf. The number of families interviewed for the 2004 survey was 4,522.

⁴ Bodie, Zvi, and Michael J. Clowes. 2003. Worry-Free Investing. Financial Times Prentice Hall, pp. 17–21.

⁵ For more information on one example of an inflation-linked CD offered by LaSalle Bank, see www.lasallecdips.com. Deposits (including CDs) are FDIC-insured. Legislation signed on February 8, 2006, will increase the $100,000 insurance limit to $250,000 for certain retirement accounts. This higher limit could attract nearly $30 billion of new deposits in IRA/Keogh accounts at FDIC-insured institutions. January 31, 2006, update to a revised FDIC September 7, 2001, memorandum, "Potential Effects of Certain Cover Limit Changes on FDIC Insurance Funds Reserves."

⁶ Swensen, David F. 2005. Unconventional Success—A Fundamental Approach to Personal Investment. New York: Free Press, 51.

⁷ Banks that offer inflation-linked products can purchase and hold Treasury inflation-linked bonds in their own investment portfolios to hedge the inflation risk.

⁸ U.S. Treasury inflation-linked bonds are called TIPS—Treasury Inflation Protection Securities. Banks, brokers and other investors purchase TIPS for their customers through the U.S. Treasury's Commercial Book-Entry System. Inflation-linked CDs feature less duration risk than TIPS, but higher before-tax interest rates than I-bonds.

⁹ Lusardi, Annamaria. December 2003. Planning and Saving for Retirement. Dartmouth College. The 4,489 respondents who were asked how much they thought about retirement were approximately 51–61 years of age when interviewed. www.dartmouth.edu/~alusardi/ Lusardi_pdf.pdf.

¹⁰ As noted in the Vanguard study, a target goal for asset accumulation is the dollar amount in financial assets a person plans to accumulate by retirement age to augment income flows from Social Security and traditional defined benefit pension plans.

¹¹ See note 2.

¹² In 2005, real lifetime benefits for an average-income couple from Social Security were $439,000. Data are from testimony of C. Eugene Steuerle, The Urban Institute, before the Subcommittee on Social Security of the House Committee on Ways and Means on June 14. 2005, http://waysandmeans.house.gov/hearings.asp?formmode= printfriendly&id=2774.

¹³ These issues are complex. For example, federal tax regulations vary regarding distributions for an IRA in the retiree's own name or one that is inherited. Refer to the Internal Revenue Service website at www.irs.gov.

¹⁴ Ten percent of the investment management services in the United States are provided by banks or thrifts. Investment Company Institute, 2005 Investment Company Fact Book, 45th edition, March 2005.

¹⁵ Banc Investment Group, LLC. April 28, 2005. Boomer Puzzle. Bank Investment Daily.

¹⁶ American Banker Online. February 7, 2006. "In Brief: Wachovia Deploys 15 Retirement Aides."

¹⁷ Dente, Thomas, and Christine Detrick. January 28, 2005. How to Keep Retirees' Savings In the Bank. American Banker Online.

¹⁸ Rich, Motoko, and Eduardo Porter. February 24, 2006. "Increasingly, the Home is Paying for Retirement." The New York Times.

¹⁹ See "Are Baby Boomers Financially Prepared for Retirement?" in this issue, for more information on sources of retirement income.

²⁰ See note 3, pp. 13 and 22.

²¹ See note 3, p. 29.

²² Himmelstein, David U., Elizabeth Warren, Deborah Thorne, and Steffie Woolhandler. February 2, 2005. MarketWatch: Illness and Injury as Contributors to Bankruptcy. Health Affairs. http://content.healthaffairs.org/cgi/content/full/hlthaff.w5.63/DC1.

²³ See note 2.

²⁴ "Baby Boomers Get an 'F' in Planning for Old Age." SeniorJournal.com, July 2, 2001. www.seniorjournal.com/NEWS/ Retirement/07-02-1BoomerF.htm. A study conducted by the Center for Aging Research and Education and sponsored by the GE Center for Financial Learning found that 75percent of the respondents had no idea how much long-term care policies cost, with most overestimating the cost of long-term care insurance premiums by more than 300 percent.

²⁵ For example, the U.S. Census Bureau Historical Income Tables show the mean inflation-adjusted household income for households with the highest incomes (top 20 percent) had a mean increase of 50percent between 1980 and 2004. The next 20 percent had a mean increase of 24 percent, while income for the remaining 60 percent of households grew only 13 percent.

²⁶ Driscoll, Marilee. 2003. Long-Term Care Planning. Penguin Group (USA) Inc.

²⁷ Merton, Robert C. January/February 2003. Thoughts on the Future: Theory and Practice in Theory Management. Financial Analysts Journal, Volume 59, Number 1. http://students.washington.edu/ wcy/424/merton03.pdf.