With traditional pensions disappearing, securing reliable low-cost lifetime income for retirees has emerged as a top issue among financial planners and policymakers. Finally, a solution is in sight. The federal government has issued new regulations designed to encourage two important changes:
- Allow 401(k) plan participants to easily convert a portion of their assets to an annuity.
- Create an option within 401(k) plans for deferred annuities, also known as longevity insurance, which some see as a silver bullet.
The new rules have been in the works for a while. But it’s hard not to notice that they were announced a day after American Airlines put an exclamation point on the retirement income problem by saying it would shut down four pension plans covering 130,000 workers and retirees. That monstrous failure will strain the government’s ability to backstop pensions in the future. For decades, traditional pensions were an adequate and secure source of monthly income for life for many retirees. Not anymore. You have to create an income stream for yourself.
With the changing pension landscape, about a year ago momentum began to build for some kind of government-supported annuity. Many annuity products charge high fees and offer holders little recourse should the seller become unable to make payments. Over the years they’ve been a tough sell.
In a New York Times op-ed, two prominent professors suggested that the U.S. Treasury begin offering retirees a low-cost reliable inflation-protected lifetime annuity. Such a product would be a win-win, they argued. Retirees would have the confidence to take the plunge in a vetted product and the government would gain a huge new domestic source of buyers for its debt.
So far the Feds have not taken the bait. But they did take the hint to do something—and the new rules have the potential to change the game for everyone. Until recently, the focus has been on ways to make it easier for individuals to amass savings for retirement. The results have been mixed. Still, Americans have managed to put away $11 trillion in retirement accounts. Now the focus is shifting to the distribution side of the equation: How can individuals draw down those accounts and be certain not to run out of money in their lifetime?
A lot of research has focused on what’s called the safe withdrawal rate, widely presumed to be 3% to 4% of assets each year with adjustments for inflation. Another popular approach is known as the bucket strategy, where retirees maintain three investment buckets: safety (bank CDs, short-term bonds), income (long-term bonds, including international and corporate), and growth (stocks). Each bucket is designed to provide 10 years of income and you draw them down one at a time, starting with the safety bucket.
Annuities are widely seen as part of the solution too. But they pose certain problems that are difficult to get past. With some annuities you have to make a big up-front investment. If you die prematurely, that money is gone. You got a lousy return and your heirs got a lousy deal. Meanwhile, with interest rates so low today it takes a lot of money to buy an annuity that will guarantee you sufficient income to cover all your needs.
But fixed annuities make a lot of sense if your goal is to secure just enough income, say, to cover fixed costs like utilities and rent. This is where the new rules help. In most retirement plans you have an all-or-nothing option. You can convert all assets to an annuity or take it all as a lump sum. Under the new rules, you’d be able to split your assets and buy an annuity that makes sense.
The potential silver bullet is the new rule that encourages 401(k) plan sponsors to offer a deferred fixed annuity as one investment option. These annuities are ideal for the second or third bucket in a three-bucket strategy. You make a relatively modest payment now but do not begin collecting the income for 10 or 20 years, by which time the monthly income should be ample and never run out.
The Council of Economic Advisers estimates that a 65-year-old would have to pay $277,500 for a fixed annuity that pays $20,000 a year beginning immediately. That same fixed annuity would cost just $35,200 if you deferred collecting the income for 20 years. Yes, you’d be 85. But that’s not a stretch if you are healthy at 65. Your chief concern would be inflation. So consider buying a deferred fixed annuity with a built-in inflation adjustment.