The Government’s Plan for Your Retirement Savings
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photo: Don Hankins
The federal government is looking into ways of convincing you to turn some of your 401(k) over to an insurance company. Don’t pick up your pitchfork just yet, though. Let me explain.
The trouble with 401(k)s
Compared to old-school pension plans, 401(k)s have some advantages: they don’t bankrupt companies; they allow workers to make their own investment choices; and they’re relatively portable from one job to the next.
But in other ways, 401(k)s are busted. Workers don’t save enough in their 401(k)s for retirement, and when they do retire, they take all their savings as a lump sum and spend through it long before they die.
Uncle Sam is looking at the second problem. In risk management jargon, we’re talking about “longevity risk”: the risk that you will live longer than your money. And one way to manage longevity risk is with (wait for it) an annuity.
The word “annuity” tends to be met by one of two responses: (1) SNORE. (2) Aren’t those the financial instruments designed to take my money and put it into the pocket of an insurance salesman?
So the Department of Labor has done a little rebranding and is now using the term “lifetime income products.”
Whatever you call it, annuities are really, really unpopular. “In a lot of cases, when given the option, people often take a lump sum versus an annuity-type option,” said Michael Davis, Deputy Assistant Secretary of the Employee Benefits Security Administration (EBSA).
He’s not kidding. About 2% of retirees turn all or part of their 401(k) balance into an annuity, according to a 2009 survey by the Retirement Security Project.
So Davis’s department sent out a survey inviting companies, researchers, and anybody else to respond to 39 questions about annuities–er, sorry, lifetime income products. They got 700 responses. Yes, that’s right, there are at least 700 people in the country who can talk about annuities without falling asleep.
I’m one of them, baby, so let’s do this.
What IS an annuity, anyway?
Here’s how an annuity works, in its simplest form.
Step 1: I take a large sum of money and hand it over to an insurance company.
Step 2: There is no step 2. Kidding! Step 2: The insurance company puts my contribution through a formula and turns it into a monthly payout. You can try this yourself, right now, using an annuity calculator.
The payout lasts until you die, and then if there’s anything left over, the insurance company keeps the rest. But if you live to be 102 and your balance is long-depleted, the company has to keep those payments rolling as long as you do. You can also buy a joint annuity, which covers you and your spouse as long as either of you is alive.
The fact that your leftover money goes to the insurance company rather than your heirs is one reason people don’t like annuities. But there are several other reasons.
One is that insurance companies have an even worse reputation than banks. And there’s no FDIC for annuities. In my state, Washington, annuities are insured up to $500,000, but in most states the insured amount is much lower.
Which brings us to the second objection: even a $500,000 annuity doesn’t look like much. I just ran the numbers for a joint annuity, and that $500,000 turns into $2656/month. I mean, holy crap. You want me to turn half a million bucks into an amount that wouldn’t buy a decent used car? Of course, if you draw down your half-mil at the recommend 4 percent per year in retirement, that’s $1667/month. No wonder people outlive their savings.
Finally, remember how “financial innovation” almost destroyed the world? Annuities have seen more than their share of financial innovation. The simple immediate annuities I described are not evil at all…but they have evil twins, evil cousins, and evil great-aunts. These are the products that have a deserved reputation for lining insurance company pockets at your expense, and they’ve given all annuities a bad name.
The box that rocks
Here’s one solution the government has in mind: put a box on your 401(k) statement showing how much your balance would turn into if you bought an annuity with it at retirement age. It might look something like this:
In fact, a bipartisan Senate bill would mandate this kind of box, which is based on those annual Social Security statements you already receive.
I ran the idea by Robyn Credico, a consultant with Towers Watson, which helps companies manage their retirement plans. I asked her if she knew of any company already using the annuity box. “No, I don’t,” she said. “I also don’t know how you would do it, because it’s very dependent on your assumptions, and so if I make assumptions that make the annuity look very good, and when the person goes to buy an annuity, it looks very different, it’s a big issue.” (Among the assumptions she’s referring to would be one’s age and life expectancy, the prevailing interest rates at the time you annuitize and so forth.)
One way around this is to let 401(k) participants lock in an annuity rate now by buying a deferred annuity: you pay now, but don’t collect until you’re 65.
But this raises all sorts of other issues. What if the insurance company goes bankrupt in the, say, 60 years between now (when you buy the deferred annuity) and when you die? What happens if you switch jobs and your new employer doesn’t offer an annuity with the same company? Once you get into an annuity, you generally can’t check out.
Furthermore, companies worry that if they sell you a deferred annuity, they’ll get sued. “A lot of employers don’t know if they have safe harbor to offer those options,” said the Labor Department’s Davis. In other words, the government allows certain default options for 401(k) investments; annuities are not one of them. And when annuities aren’t the default, we’re back to the original problem: people don’t use them.
“A lot of people are interested in talking about them,” said Credico, “but certainly for the options that are in the plan, we have seen very few large companies actually do that.”
Some of the risks of deferred annuities could be regulated away, but for now, they generally make retirement planning more complicated, not less.
What’s next
The Senate Special Committee on Aging is holding a hearing on June 16, where the Department of Labor will present the results of their survey. Chair Herb Kohl (D-WI) is one of the sponsors of the bill that would put a box on your 401(k) statement. (I wonder how the 75-year-old Kohl feels about being referred to as “Aging Chairman” on his own press materials.)
As for you: regardless of what the government does, don’t be a chump. Turning some of your retirement savings into an annuity at retirement is a good move for nearly every retiree. Those who don’t are doomed to rely solely on the annuity we all share: Social Security.
What if you don’t have enough money in your 401(k) to even think about retiring, let alone “lifetime income”? Reformers are looking at that problem, too, and in a future column I’ll talk about what major retirement reform might look like. Bring your pitchfork, just in case.
Matthew Amster-Burton, author of the book Hungry Monkey, writes on food and finance from his home in Seattle.
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8 Comments so far
leave a commentArgentina showed the way in 2008, as we noted here, by nationalizing private retirement funds on the ground that “the private system never achieved what was needed.”
Now, the Democrats may be poised to imitate Argentina’s theft. Investor’s Business Daily reports:
You did the responsible thing. You saved in your IRA or 401(k) to support your retirement, when you could have spent that money on another vacation, or an upscale car, or fancier clothes and jewelry. But now Washington is developing plans for your retirement savings.
BusinessWeek reports that the Treasury and Labor departments are asking for public comment on “the conversion of 401(k) savings and Individual Retirement Accounts into annuities or other steady payment streams.”
In plain English, the idea is for the government to take your retirement savings in return for a promise to pay you some monthly benefit in your retirement years.
They will tell you that you are “investing” your money in U.S. Treasury bonds. But they will use your money immediately to pay for their unprecedented trillion-dollar budget deficits, leaving nothing to back up their political promises, just as they have raided the Social Security trust funds.
In other words, the government will allow you the “opportunity” to give Washington your savings, in return for which the government will give you unmarketable T-bills or other unreliable promises to pay some minimal rate of return. The program likely will be “voluntary” to begin with, but that makes no sense–you can buy T-bills in your retirement account any time you want. So the only possible point is to make the exchange mandatory. The government steals your savings in exchange for an IOU.
from: http://www.powerlineblog.com/archives/2010/02/025646.php
One very important thing that the author is missing, based on this quote:
“Of course, if you draw down your half-mil at the recommend 4 percent per year in retirement, that’s $1667/month. No wonder people outlive their savings.”
Unless your retirement money is sitting in a checking account, this is simply not true. In a very conservative bond portfolio, 4% isnt an unreasonable expected rate of return …so that $1667 a month is basically indefinite. And 4% is fairly conservative. The exact math is a bit beyond me, but assuming that rate of return, and withdrawing that $2600 instead each month (thus lowering your nest egg by about ~ 1000 extra a month, 12k a year) you could almost certainly last several decades on the amount given by the annuity, and not have to fork over your life savings to the insurance company.
So why again is buying the annuity a good idea? Assuming one had the most basic financial discipline not to overdraw their fund, it seems like the only person that would benefit from that situation if you had any sort of normal lifespan is the insurance company, rather than your heirs.
Lots of inaccuracies, half truths, and hype here. You can shop rates. You can buy protection for your lump sum in order for your heirs to get the remainder in case of your untimely death. You can protect against outliving your lump sum–and just try living on another 40% decline in the market or an extended downturn in the market (say, of the order of 1929-1952). You’d better have a guaranteed income to cover your necessities for as long as you live plus some inflation protection, or you’re going to be one sad, old, hungry puppy. An annuity–and that need only be a portion of your pot–gives you that guarantee in a way that nothing else does. Just do due diligence and get a highly rated company and check your state’s guarantees in the worse case. I’m getting an annuity and I’m telling my peers to do likewise.
EvilDave, there’s no fire here. No matter what Newt Gingrich says, the government is not going to confiscate your 401(k). It sounds like he read the title of the RFI and wrote a whole column based on it. It’s actually mild stuff.
Mark, we can get deeper into the math if you want, but at 5 percent drawdowns, a significant proportion of retirees outlive their savings. (That’s actually true at 4 percent, also, depending on what you consider “significant.”) You’re taking inflation into account, right?
More details: http://money.cnn.com/2002/06/28/retirement/q_drawdown/index.htm
Annuities pay more than you can safely draw down. They do this through “mortality credits”: annuitants who die young subsidize those who live to 100. In effect, you’re making a bet that you’ll beat your life expectancy. I’d be happy to make that bet. If you want to leave a bequest, easy: annuitize only part of your nest egg.
I like how you said Dave that the idea behind retirement savings is for the government to take your savings in return for a promise to pay you some monthly benefit in your retirement years. But I dont think it is so bad as we all want some retirement security and who better to trust than our own elected government. After all it is through democratic means that they are there and hopfully thinking for our benefits.
No thank you! The government needs to get out of our business.
Mike, I was trying to be pro-annuity!
Shopping rates is an excellent idea, but my feeling about annuities is that the further you step away from the Single Premium Immediate Annuity, the worse they pencil out. Basically, I would say:
Basic SPIA: Good
Inflation-adjusted annuity: Good
Spousal/domestic partner survivorship option: Good
Anything else: proceed with caution
The great thing about the SPIA is that you’re paying for something you would probably do poorly yourself (and in the case of mortality credits, something that would be illegal to do yourself). The other options, like the guaranteed payout period or bequest, have you paying for something that would be easy and more cost-effective to do yourself. I think they’re a poor choice in most–but not all–cases.
I’d actually be interested in the deeper math. I read the article you linked, and honestly it sounds like particularly crazy advice, particularly keeping such a heavy amount of money in equities during retirement.
I’d really like to be pro annuity here, but I’m still not seeing the benefit. Those who die young subsidize those who die old – that part is easy to understand. But this isnt a zero sum game. There’s an insurance company here, that has to pay for it’s overhead as well as make a profit. The numbers *have* to be tipped in favor of the insurance company, or else they couldnt exist. This seems to me nothing more than gambling based on your life expectancy, and if there’s any one truism about gambling it’s that the house ALWAYS wins. Inflation is irrlevant – the actuaries take care of that for the insurance company…the house will still win.
The only way I can see this being of any use is if you or someone else knows you simply cant be trusted with your own money, ie spending too much, having all your money in equities or cash, etc. As long as you remain in control of your money, you and your heirs see all the profit. The state of the market should have little effect on your portfolio if you’re conservatively invested. And you still retain control over your lifestyle – if your savings are dwindling, you adjust your expectations and spending accordingly. You’ve always got some base of income from social security – and say what you want about SS, but I have far more faith in SS staying solvent than trusting my money to an insurance company which could potentially go out of business.
It’s not that I dont think a basic annuity is a legitimate financial instrument, it just seems particularly crazy to me. I can certainly think of people in my life who would benefit from having their financial security taken out of their hands. But I believe that if you know and follow the most basic advice about personal finance in retirement, and you have the self control to not overspend, an annuity simply cannot be in your favor unless you’re borderline immortal.