When the 401(k) was introduced a little over three decades ago, it was intended to supplement monthly checks from Social Security and employer-sponsored pension plans. Today, many pensions are gone, Social Security has a funding problem and the primary responsibility for providing a steady retirement income falls to individuals and their 401(k) accounts. For the thousands of Americans retiring each day, there’s a growing sense that the task of turning their savings into monthly checks is one they either don’t want, or for which they are not well suited. As Jennie Phipps puts it in a December 2016 bankrate.com article:
“It is becoming increasingly clear that getting through retirement by living off investments is too difficult and unpredictable for most of us. This uncomfortable conclusion has been driving the government, employers and particularly insurers to seek out an alternative—something that functions a lot like an old-fashioned defined benefit pension plan.”
This nostalgia for an “old-fashioned defined benefit pension” plan is because it promised a lifetime income for the retiree (and in most instances, a surviving spouse) from a formula based on a worker’s earnings and years of service. In contrast, 401(k)s and other defined contribution plans deliver a lump-sum at retirement (with the amount dependent on contributions and investment performance), then leave distribution to the discretion of the retiree. Many retirees adopt one of two prevalent income-producing strategies for lump-sum accumulations:
- Taking earnings (interest, dividends, capital gains) as income while preserving principal.
- Systematically drawing-down earnings and principal, based on an annually adjusted percentage of assets.
Both approaches require ongoing management by the retiree, and neither has the guarantee of a lifetime income. These shortcomings become greater concerns as one ages; retirees feel less competent about managing their affairs and more troubled by the prospect of running out of money. No surprise that a recent LIMRA survey (Life Insurance and Market Research Association) found eight in 10 U.S. workers favor employers providing direction on how to convert savings into a retirement income—like the pensions they remember their parents receiving.
But as attractive as a pension might seem, there are good reasons for their demise.
Pensions: Too Many Ingredients
Pension plans are like sausage; we may like the taste, but most of us don’t know (or want to know) the ingredients. A pension is a constantly changing mix of past, current and future participants that requires regular reassessments of life expectancies, obligations, projected returns and on-going capital contributions.
These complexities, with their uncertain costs and the attendant liabilities, explain why many employers have jettisoned pensions. And of the pensions still in existence, many are in poor financial condition (including Social Security, the nation’s biggest pension). A Wilshire Consulting report found that “87 percent of the 92 state retirement systems that reported data for the 2014 fiscal year were underfunded.” Historically, the destiny of most pension plans is either suspension or implosion, with the risk that some retirees will not receive what they were promised.
Annuities: Fewer Ingredients, Better Results
A better option for a guaranteed retirement income could be an individual life annuity. In this arrangement, an insurance company promises a lifetime stream of payments in exchange for a lump-sum premium. Annuity contracts offer a range of payment options, but to replicate a pension, an individual would typically select a life and joint survivor format, which guarantees monthly payments for an individual and a surviving beneficiary for as long as one of them is alive.
Similar to a pension plan, a life annuity insures against three significant retirement risks:
- Longevity risk—the risk of outliving one’s assets
- Market risk—the risk that fluctuating asset values might decrease income
- Management risk—the risk that mismanagement, whether due to ignorance or diminishing mental capacity, could result in loss of principal and income
A life annuity is similar to a pension plan in that the insurance company provides lifetime incomes for all participants by averaging out the costs of those who live past life expectancy against those who die early. By pooling resources, everyone’s risk is diminished, and every annuitant can expect a guaranteed income.
You might say the annuity’s ingredients for providing a lifetime income are of better quality. Unlike a pension, the insurance company doesn’t have to plan for an unknown number of future participants; it only provides income for those who buy an annuity. And the plans are fully funded up front; no future payments are required to maintain benefits. Because the mechanics are simpler (and the financial regulation is stricter), insurance companies have a stellar track record for keeping their lifetime income promises. What’s more, in many scenarios, an annuity may provide a higher monthly income than either principal-conserving or draw-down strategies—while guaranteeing it for life.
Pension Ignorance Impacts Annuity Utilization
In consideration of these advantages in both income and guarantees, economists have long recommended annuities as being the optimum instrument for turning accumulated assets into streams of guaranteed income. But retirees have been slow to embrace individual annuities, in large part because of their “mis-remembered” perspective on pension plans.
A decision to buy a life annuity is usually irrevocable. If annuitants die before life expectancy, there is no “refund” of the unused premium; the excess is used to ensure those who live beyond life expectancy will get their checks as promised.
This arrangement is not different than a pension. The difference is a pension is funded by an employer. In theory, the cost of providing a pension comes from a reduction in an employee’s compensation, but this cost is hidden. It’s not a deduction on a pay stub, and it doesn’t show up on a W-2.
With a pension, employees didn’t see how the sausage was made, and psychologically, they didn’t pay for it. With an annuity, retirees see the costs, and perceive a possible “loss” if they die early. Yet this is the same loss they experienced with a pension in exchange for guaranteed lifetime benefits.
Other Ingredients—And Help to Put Them Together
If you are retiring with a lump-sum, your income-generating options are not restricted to choosing between a draw-down schedule or a life annuity. There are almost infinite ways to combine guaranteed insurance products with other financial assets to deliver a mix of reliable income, sufficient liquidity and minimized management responsibility. Every situation is different, but it is worth exploring these options with a financial professional.
This article was prepared by an independent third party. This material is intended for general public use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity.
Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS), 355 Lexington Avenue, 9 Fl., New York, NY 10017, 212-541-8800. Securities products/services and advisory services offered through PAS, a registered broker/dealer and investment adviser. Financial Representative, The Guardian Life Insurance Company of America (Guardian), New York, NY. PAS is an indirect, wholly owned subsidiary of Guardian. Wealth Advisory Group LLC is not an affiliate or subsidiary of PAS or Guardian.
PAS is a member FINRA, SIPC.
Neither Guardian, PAS, Wealth Advisory Group, their affiliates/subsidiaries, nor their representatives render tax or legal advice. Please consult your own independent CPA/accountant/tax adviser and/or your attorney for advice concerning your particular circumstances.
By Elozor Preil
