In much of the world, retiring is riskier than it's been since the modern welfare state began to emerge, in the late 19th century. Over the past two decades, the level of retirement-related risk has increased as employers shifted from defined-benefit to defined-contribution retirement plans, life expectancies increased, and health care costs rose. Now, looming public-pension crises mean that many people must plan for retirement without knowing how much support the state will provide.

But help may be on the way in the form of the intense competition emerging among banks, insurance companies, mutual funds, and traditional brokerage houses. As these institutions target the retirement market, innovative, risk-mitigating products and services may start to appear. Not that financial-services breakthroughs, should they occur, will solve all of modern society's retirement ills: those who lack the income or the will to start saving early will still experience financial difficulty later in life. Nor can financial institutions reverse the declining ratio of workers to retirees and its implications for the solvency of public pensions, the pace of capital formation, and economic growth (see "The demographic deficit: How aging will reduce global wealth" and "Can pension plans age gracefully?").

But no matter how policy makers choose to handle such broader issues, financial institutions can play an important role by offering products suited to the needs of retirees for risk management (including protection against catastrophes and unexpected longevity) and for income (as opposed to capital appreciation). Perhaps more significant, these institutions can also improve on the advice they give to retirees and workers by tailoring packages of products and services to the needs of people in particular industries, and at various income levels, who have specific employer- and government-provided benefit packages.

Few financial institutions have stepped up to the challenge yet, partly because many believe that the retirement game still has several decades to play out. In reality, the next seven or eight years represent a rapidly closing window of opportunity. Our research shows that in the United States, people in the preretiree segment (who are five to ten years away from retirement) are three times more likely to seek retirement advice and to consider changing their financial-services providers than are today's retirees, who for better or worse already have their plans in place (Exhibit 1). The preretiree segment's share of investable assets is already large (one-quarter of the US total) and is growing rapidly (to nearly one-third over the next decade). This gives financial institutions an opportunity to build a sustainable lead now.

The market for retirement-oriented products is both big and global. In the United States alone, more than $1 trillion of assets a year will be unleashed over the next decade by maturing defined-benefit and -contribution plans and individual-retirement-account (IRA) rollovers (Exhibit 2). And this is just the beginning. Our analysis suggests that retirement-oriented products—using a broad, customer-centric definition including life insurance, health-related offerings (see sidebar, "Convergence in health care"), and nonqualified investment and deposit accounts—will generate $158 billion a year in pretax earnings for US financial institutions by 2012, up from $66 billion today. Although in absolute terms the opportunity is smaller in other countries, it is bound to grow as risk continues to shift to individuals.

The challenge

Neither individuals nor financial institutions have fully adapted to the dramatic shift of retirement risk from governments and employers to individuals over the past 20 years.

New realities

Around the world, more and more uncertainty surrounds public- and private-sector retirement benefits. In Europe, government-financed pension plans support a large share—up to 85 percent, in Germany—of an average citizen's retirement needs. Although these plans are now solvent, long-run demographic pressures will pose risks for which few people have prepared sufficiently. Early signs of stress, such as pension cuts and a higher retirement age in Italy, are already evident. Similar risks threaten the recently established national pension plans in Asian countries such as Japan and South Korea.

In the United States, the debate over Social Security reform has highlighted the solvency risks of that program, which accounts for a smaller share (less than 50 percent) of the income of retirees than do state-sponsored European plans. Complicating the US situation is the fact that the proportion of the population covered by private defined-benefit plans has fallen by half in two decades, to 20 percent. While most people now have defined-contribution plans intended to take up the slack, few have saved enough for a prosperous retirement. More than half of today's 55-year-olds in the United States have saved less than $50,000 in their defined-contribution plans, and more than 75 percent have less than $100,000.

At the same time, advances in health care have raised life expectancies and therefore the risk that retirees will outlive their savings. Most retirees still expect to survive to an "average" age, but more and more of them will live much longer. A 65-year-old couple in the United States, for example, has a greater than 50 percent chance that one partner will live to be at least 90.

In many countries, health care costs will further squeeze the resources of retirees. In the United States—admittedly an extreme case—these costs have outstripped general inflation for years and have recently been growing at around 10 percent annually. Unfortunately, many people overestimate their health benefits. More than two-thirds of all US citizens, for example, believe that their employer covers the health care expenses of its retirees, but only one-third of US employers actually do. More than two-thirds of all US citizens think that Medicare will provide comprehensive coverage, but it won't. And in countries with state-sponsored health care plans, the same demographic forces creating pension solvency risks also sap the viability of today's generous health benefits.

In short, more than ever before, retirees will be subject to variables beyond their control, including health care costs, the performance of financial markets, and policy shifts by governments.

Inadequate responses

On the whole, financial institutions understand what is happening, but many have responded slowly, and few have internalized the magnitude of the change that lies ahead. They still operate under the old definition of retirement, with one set of financial options for employed workers (who focus on accumulation) and another for retirees. Meanwhile, individuals are coping with the risks by changing the nature of retirement itself. Once defined as a single point in time, punctuated by a party and a gold watch, it is becoming a multiyear transition in which full-time work gives way to part-time work generating income that is supplemented by money from defined-contribution plans and public-pension support. The new definition of retirement raises the bar substantially for advisers by complicating the needs of retirees and of people who are still employed.

Paradoxically, at a time when it has never been more important for advisers to change their ways, many of them are complacent. In a McKinsey study, more than 85 percent of those we surveyed said that they were "well prepared" to meet their clients' retirement needs.¹ Yet a majority of the consumers McKinsey surveyed didn't agree.² We suspect that this growing disconnect between advisers and clients results from the natural difficulty advisers have changing from the asset accumulation strategies that made them successful during the long bull market of the 1980s and 1990s. The disconnect is particularly acute for some experienced brokers who have little incentive to shift focus from accumulation to income and risk management, because their client portfolios already generate sizable management fees.

What financial institutions can do

As painful as the transition may be, companies that have spent two decades cultivating expertise in asset accumulation must now help clients bear a greater retirement burden by marketing new, risk-mitigating products and advisory services. Institutions will have to become more distinctive in areas—generating income, preserving assets, and offering protection against catastrophes—that in many cases aren't their natural strengths. And despite the complexity of these products, financial institutions should keep their advisory services, distribution, and product packaging simple.

Develop products focused on income and risks

Financial institutions understand the fundamentals of risk mitigation, such as how to hedge portfolios and provide guaranteed income. Still, applying this knowledge to retirement-oriented products is tricky because many of the needs of retirees cut across the traditional silos of life insurance, investments, banking, and even health benefits. Variations on traditional products such as annuities may work, but other needs call for newer offerings, including longevity insurance and asset preservation products, which are just entering the mainstream. Promising ones include the following:

• Longevity insurance. Lump-sum premiums guarantee a future income stream, starting at a specified future age, for the rest of the retiree's life. Longevity insurance differs from traditional annuities in its cost: a 65-year-old man buying it could get a $1,000-a-month income stream, starting at age 85, for about 10 percent of the cost of an identical income stream that began at age 65. Financial advisers, of course, like the fact that the remaining 90 percent might be available for investment (potentially generating fees).
• Asset preservation. Financial institutions can also assume a degree of investment risk for consumers who don't want or can't afford to bear it themselves as they age. Principal-protection products, for example, preserve a customer's original investment and offer a minimal return even in the worst bear markets. In exchange, the consumer agrees to share the benefits of rising markets—accepting, say, just 80 percent of the upside, with the provider keeping the rest. These products should be popular with people in Asia who have been made cautious by the region's financial crises; 80 percent of the South Korean consumers in a McKinsey survey, for example, described principal guarantees as a required feature of any retirement products they might buy.³
• Synthetic defined-benefit plans. Some life insurance companies are innovating by creating personal defined-benefit plans that can be held inside 401(k) plans. These synthetic plans offer consumers the peace of mind of a defined income stream in retirement, the discipline of regular tax-exempt savings, and protection against the risk that interest rates (and therefore income) will be at a cyclical low at the time of retirement.
• Capturing home equity. In Japan and the United Kingdom, financial institutions are helping retirees to increase their income through reverse mortgages that tap into home equity while preserving the right of residence during their lifetimes. These products have traditionally been less successful in the United States, but they are gaining momentum, which we believe will grow over time because for many people there, homes represent too large a share of total assets to ignore in retirement planning.

Packaging and marketing products like these in simple ways that appeal to a variety of client segments will represent a major challenge for financial institutions, which have long stressed consumer choice and differentiated themselves by offering large numbers of features. (Many issuers, for example, offer more than 20 variations on their basic annuity plan.) The result has been literally thousands of options and confusion among consumers and advisers.

Tomorrow's leaders, we believe, will assemble a number of these products—together with traditional brokerage, mutual-fund, and cash-management services—in a single "retirement wrap" that is easy to understand, buy, and sell, though the underlying products are diverse and complex. Such wraps would combine risky and risk-free investments and insurance features while guaranteeing a base lifetime income stream. At most financial institutions, developing successful wraps and other appealing packages will require more collaboration than currently exists among product developers, actuaries, marketers who understand different customer segments, and distributors.

Offer better advice

Since innovative, risk-mitigating products are highly replicable, strong advisory services and distribution capabilities will become increasingly important competitive differentiators. Most advisers today, whether independent or affiliated with a provider of financial products, have greater experience selling the latest hit mutual fund than asking clients how much income they will need in retirement. Successful advisers will change that approach—becoming more sophisticated and specialized while keeping things simple.

Too many of the financial-planning models that advisers use to develop strategies for clients are still rooted in an accumulation-oriented framework. These advisers will need better tools for discussing the issues most important to retirees: tax-efficient income management, longevity risks, and catastrophic health risks. A few emerging leaders are starting to embrace a more income-oriented planning model that also helps clients plan for risks such as health care costs, inflation, longevity, and market downturns. We expect such tools to be just the first in a series of planning advances.

Despite better planning tools, the magnitude and complexity of present and future retirement risks make many people—even affluent ones—extremely anxious (Exhibit 3). Increasingly, they want their financial advisers to understand their industry, company benefits package, and specific financial situation. As a result, a number of the next-generation advisers we interviewed specialize: one serves airline pilots, for example, while another serves clients at just a single oil company.

One implication of this increasing specialization is that for financial institutions, the workplace should become the most promising new distribution channel. Our consumer research has uncovered strong latent demand for advice there, and given the growing complexity of current plans, employers too are more sensitive to the need for good advice. The convenience of Web-based, plan-specific information ought to help financial institutions get their messages out, and legislation such as the National Employee Savings and Trust Equity Guarantee (NESTEG) bill, currently pending before the US Congress, should if enacted make it easier for financial institutions to offer advice in the places where people work. As this approach to distribution becomes more popular, product providers will have to cultivate strong relationships with independent advisers, who are likely to play a significant role.

A second implication is that more advisers will be working in teams. In view of the complexity of retirement issues and the range of expertise they require, teams often provide more effective service than can individual advisers, whose expertise is necessarily limited. Although only 16 percent of the advisers we surveyed had fully embraced the idea of teams, many independent advisers use them, and most were open to some form of collaboration. Leading financial-services firms increasingly tend to build teams with complementary product and functional expertise. To ensure their continuity, they include people of varying ages.

Sophistication and specialization should allow financial institutions to thrive while they meet the needs of their clients. One next-generation adviser, for instance, used a model centered on rollovers and annuities to build a practice primarily serving 50- to 60-year-old mass-affluent employees of a large local employer. Segment-specific specialization allowed the adviser to serve nearly 50 percent more clients than the industry average and to achieve well over $1 million in production.

This approach can be replicated in many industries, client segments, and geographies. The need for better financial advice is particularly acute in Europe and Asia, where winning the trust of clients and potential clients is a key challenge, on top of educating them about their retirement needs. In Europe, well-publicized problems (such as the high commissions some financial institutions charge holders of privatized pension accounts in the United Kingdom) have dampened the enthusiasm of many consumers for private-pension products. In Asia, the memory of recent financial crises looms large. Consider South Korea, where 60 percent of the people we surveyed fear that they are not planning properly for retirement but mistrust product-pushing financial advisers: more than half of the consumers in the survey receive no financial counseling whatsoever. By assembling teams of knowledgeable advisers, financial institutions will inspire trust, help their clients, and differentiate themselves in the years ahead.

Financial institutions can't solve the macroeconomic problems posed by the aging of the world's population but can mitigate risks for retirees and help them enjoy their golden years. Stepping up to this challenge will benefit people and society as a whole regardless of what policy makers do, as well as provide rich rewards for the institutions that innovate first and best in their retirement products, advice, and distribution. The winners will succeed in reorienting themselves—away from an asset accumulation, product-centric mind-set and toward meeting the specialized needs of retirees by generating income, reducing risk, and simplifying products, and improving advisory services.