As employers watch a growing number of workers retire with no dependable source of monthly income beyond a meager Social Security benefit, the need grows for a simple, economical conversion of an account balance to a reliable monthly benefit. With the decline in the availability of defined benefit pension plans, once a mainstay of retirement security, and the expanded prevalence of 401(k) and similar defined contribution plans, employers are seeing more and more people facing retirement with a fist full of cash and uncertainty about how to make it last.
Some employers may get the question from employees nearing retirement, “Now what do I do?” Employers generally feel the added cost related to providing post-retirement financial planning solutions makes their adoption cost-prohibitive. Further, many employers are rightfully concerned about the fiduciary risk that accompanies the promotion of specific annuity solutions. Thus retirees are generally on their own.
This article summarizes some of the approaches commonly used by retirees to convert their lump-sum distribution into a lifetime of retirement income, including:
- Payments over life expectancy
- Adjusted payments, recalculated annually using the remaining life expectancy
- 4% of the beginning account balance, adjusted by the Consumer Price Index (CPI)
- Immediate annuity
- Longevity annuity
- Work longer/defer retirement
- Do your best, hope it works
- Individuals may find themselves adopting more than one approach.
Payments over life expectancy. Two common “life expectancy” approaches are the remaining expectancy strategy and the 4% rule.
- The remaining expectancy might be seen more often when a retiree is working with a financial planner. This approach involves determining the remaining life expectancy each year and dividing the available assets by this amount. The IRS publishes several life expectancy tables that may be used. One popular table is known as the 70 ½ table, used to determine minimum distributions from IRAs and employer retirement plans starting at age 70 ½. (The table includes factors for ages younger than 70 ½.) Each year’s factor takes into account the expected remaining lifetime.
The primary advantage of this approach is its simplicity and the relative assurance that assets will remain for as long as the individual lives. However, the specified distribution may vary significantly from year to year depending on investment return volatility. Also, many retirees have higher expenses in the early years of retirement while travel and other recreation is more feasible; the initial distributions under the life expectancy strategy are generally smaller than in later years.
- The 4% rule is something a retiree is more likely to manage on their own. Under this approach, the retiree is allowed to spend 4% of their total retirement assets in the first year of retirement. The dollar amount they spend in each following year is the prior year’s dollar amount adjusted by CPI. In theory, annual withdrawals at this level will result in an income stream that lasts until sometime around age 100.
As with the remaining expectancy approach, the 4% rule has low administrative costs. Most people are able to determine the amount available to spend in the first year on their own without expensive help from an adviser. Many can follow the news about CPI increases and adjust the annual payments correctly, at least in the early years of retirement.
Both of these approaches have several advantages, including:
- Acknowledgement of the potential for a long retirement. These approaches were developed based on modeling of investment returns and longevity scenarios. The calculations take into account the fact that many retirees will live well past age 90 and will prefer that their retirement income continues for as long as they live. Strategies that do not take this into account can have catastrophic consequences for those who experience extended lifetimes.
- Flexibility. In the event major unexpected expenses are encountered, the retiree has access to the retirement assets and is able to choose to reduce future income to meet the amount currently needed.
- Heirs. In many cases, the retiree will leave assets to heirs.
On the other hand, the life expectancy approaches do have disadvantages:
- Discipline (or the lack thereof). Many retirees lack the fiscal discipline needed to successfully operate under the rules. The availability of a large retirement accumulation pool coupled with the knowledge that it might not all be needed may create an undeniable temptation. The result may be a reduction in future income that turns out to be disastrous.
- Investment losses in early years. Both approaches, and especially the 4% rule, are designed to function in a wide variety of investment scenarios. In general, investment shortfalls in a few years should be offset by gains in other years. However, withdrawals in early years, if there are disappointing returns in those early years, will result in a smaller account balance and the application of favorable investment gains on this smaller account balance might not be enough to recover the losses. This was a growing concern as markets experienced consistently low returns for an extended period through the fall of 2016, illustrating the potential riskiness of this approach.
- Unanticipated withdrawals. It is critical that aficionados of these designs understand that an extra withdrawal in a year must be offset in a later year by an adjustment of not just the amount withdrawn but also by investment earnings on that extra withdrawal.
- Mental acuity decline. While many retirees feel when they retire that they are well equipped to manage a pool of retirement assets, this may no longer be the case later in life. Energy levels, ability to concentrate, and ability to make timely decisions all decline with age. For many, this may include dementia. Carrying out financial decisions may become impossible.
- Low initial withdrawals. Because both of these strategies rely solely on the individual’s assets to provide for a high level of certainty that assets will remain to provide income should the lifetime be extended for many years, the amounts designed for withdrawal in the early years are necessarily small.
Immediate annuity. An immediate annuity is a contract with an insurance company that provides a monthly income starting now (immediately) and continuing for as long as the retiree lives. This may be an attractive option for many retirees.
Advantages of immediate annuities
- Certainty. An annuity provides a known level of retirement income for as long as the retiree lives. Anxiety about living too long and running out of assets is significantly reduced.
- Protection against undisciplined decisions. An annuity can minimize the risk of undisciplined expenditures that reduce resources (and income) later in life.
- Decline in mental acuity. Annuities reduce the risk of elderly decision-making error.
- Cost. Insurance companies and their sales force are in business to make a profit. Annuity prices must be high enough to provide a profit after ensuring the insurance company will have enough in reserves to pay all of the benefits, even after age 100, and also cover the cost of the sales process, payment distribution costs, customer contact costs, etc.
- Low interest rates. Interest rates have been low for many years. Lower interest rates mean the insurance company issuing the annuity is assuming returns on its investments will be low. The price of the annuity is set on this basis, resulting in higher prices in times of low interest rates.
- Inflation. Fixed annuities pay a monthly benefit that does not change over the lifetime of the retiree. Because the U.S. economy generally experiences at least some inflation in most years, the spending power of fixed annuities declines over time. This can be mitigated to some extent by a variable annuity. Variable annuities produce a payment stream that is generally expected to increase over time. The cost of a variable annuity is generally higher in reflection of the additional amounts estimated to be paid by the insurance company.
- Loss of principal. One component of an annuity is insurance against the cost of living too long. Just as fire insurance premiums may be perceived as a waste of money for those who don’t have a fire and those without accidents may feel their car insurance premiums were squandered, many people feel that the loss of the principal, the loss of the pool of assets used to purchase the annuity, is emotionally untenable. They worry they might experience a short lifespan and not benefit from the policy’s longevity protection.
- Security. Insurance companies do fail on rare occasions and are thus unable to make all promised payments. However, states have rules that provide at least minimal protection in this event, in many cases funded by other insurance companies. The level of protection varies from state to state.
Longevity annuity. A longevity annuity is an annuity with payments that do not start until a future time, such as age 80 or age 85. The longevity annuity addresses several retirement issues. Typically, a retiree will dedicate only a portion of their retirement assets to the purchase of the longevity annuity. The balance is used to cover expenses during the first 15 to 25 years of retirement and, if all goes well, provide a supplement in later years. The goal of the longevity annuity is to protect the retiree from out-living their assets, provide certainty regarding income in later years of life, and mitigate the consequences of mental decline which might affect and/or impair their ability to make wise decisions regarding income and expenses in later years.
The monthly income from a longevity annuity is much larger than the monthly benefit paid by an immediate annuity. The insurance company does not need to make payments in the early years and is able to benefit from investment earnings during the deferral period. Also, not everyone who purchases a longevity annuity lives to collect a benefit; the insurance company uses the anticipation of these deaths to reduce the cost of the longevity annuity.
The advantages of an immediate annuity (certainty and protection) and the disadvantages of an immediate annuity (cost, risk of inflation, and concerns about loss of principal) also apply to a longevity annuity.
In an effort to promote the use of longevity annuities, IRS regulations were issued that provide relief from the requirement that retirees begin distribution from retirement plans and IRAs no later than age 70 ½. Under these rules, an employee or retiree could elect to transfer the lesser of $125,000 or 25% of their account to an annuity contract providing for payment that would begin no later than age 85, also known as a Qualified Longevity Annuity Contract (QLAC). However, very few plan sponsors have made this option available to retirees due to uncertainty regarding fiduciary liability for the plan sponsor and a perception that few retirees would elect this option. Further, purchasing these annuities from other assets (outside of retirement or IRA plans) may have better tax advantages for some retirees.
Work longer/Defer retirement. Studies show more Americans are adopting this strategy. Working longer reduces or eliminates the drain on available retirement assets during working years. Deferring retirement increases the amount paid by Social Security. Health insurance costs before Medicare eligibility (generally age 65) are extremely high, so continued employment in a position providing health insurance, especially in the years before Medicare, significantly reduces this drain on retirement assets.
Additional years of employment may also provide for the accumulation of additional assets for retirement, increasing retirement income in later years.
Do your best, hope it works. There are no known serious academic studies regarding the relative success of this strategy. Those with shorter lifespans who adopt this approach might possibly leave larger amounts to their heirs. Retirees with longer lifespans may find themselves taking on additional employment or seeking other assistance to supplement their income in retirement. Unanticipated favorable or unfavorable adjustments in spending habits and lifestyle may affect these individuals to a greater extent.
Individuals using this strategy may find value in developing and maintaining a strong support system. Typically, a close-knit family environment will increase the efficacy of this approach. Life’s twists and turns may bring unexpected expenses, changes in living costs, unanticipated medical or care needs, etc. On the other hand, unexpected monetary or other windfalls may also occur.
Caveat regarding taxes. This article does not address the tax implications and consequences of these various options. For retirees in a high tax bracket, these concerns may be significant to the extent that certain approaches will be less attractive, depending on the circumstances. Retirees should consult a qualified tax adviser before committing to a specific strategy.
Summary. While employers may want to provide better options to their employees, the fiduciary, financial, and administrative hurdles are steep. Will new low-volatility designs produce a resurgence for defined benefit plans? Will new technology or other efficiencies make trustworthy personal advice available beyond the high-net-worth market? It would come as no surprise if companies are currently developing products that could provide additional alternatives to retirees. The market need is clear: As more retirees are living to 100 and beyond, new and better solutions are necessary.