Milliman FRM Market Commentary: January 2020
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. Two common “life expectancy” approaches are the remaining expectancy strategy and the 4% rule.
Both of these approaches have several advantages, including:
On the other hand, the life expectancy approaches do have disadvantages:
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
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.