You know better than anyone how retirement benefits have changed. Traditional pension plans have given way to cash balance and defined contribution plans that are better tailored to today´s transient workforce. But these plans are aimed at helping people save for retirement with little or no emphasis on what happens after someone retires. Many defined contribution plans do not even offer lifetime guaranteed income as a distribution option. And even employees who still have a traditional defined benefit plan, whose sole purpose was to replace income in retirement, are cashing out at alarming rates when given the opportunity. The result is a population with little or no guaranteed lifetime income, except for Social Security.
What they do have is a nest egg. But whether or not these individually managed nest eggs can generate sufficient streams of lifetime income, or whether they will even be contemplated for such purpose, is at the heart of the potential retirement crisis facing our nation. How do people figure out how much they will need? The truth is, they don´t. The 2003 Retirement Confidence Survey published by the Employee Benefit Research Institute found that "fewer than four in ten workers have tried to figure out how much money they will need to have saved by the time they retire so that you can live comfortably in retirement." Little thought is ever given to how much income will need to be replaced in retirement or the level of funding it will take over time to achieve that goal.
The study goes on to explain that "three in 10 workers continue to say they have not saved enough for retirement (29 percent)." In other words, they save whatever and whenever they can afford to, trying always to maximize the benefits of tax deferral and the company match in their 401(k) plan.
Compare this scenario with what you, as a plan sponsor, do to create a traditional pension plan. You work with teams of investment professionals, pension consultants, actuaries, lawyers etc. to create the proper funding, investments, asset allocation and monitoring systems to ensure that retirees will receive their monthly incomes every month, on time, for as long as they live. Today, employees are often completely on their own to replicate this benefit...and the task is daunting, if not impossible, for most.
Risks in Retirement
The ability to understand and execute what is involved in a successful retirement plan is only the tip of the iceberg. There are many other risks retirees face, including inflation, market volatility and timing, and interest rate swings.
Market Risk
We are all painfully aware of the devastating effect market downturns can have on our retirement savings. But what happens if you are already retired? First, the time horizon for recovery is shorter, and if the downturn is severe enough or lasts many months, it may cause a retiree to withdraw additional principal, again lessening the ability of the portfolio to recover when the market returns to normal. Additionally, the timing of the downturn is an equally important risk to consider. If the market decline occurs early in retirement, it can substantially lessen how long a retiree´s savings will last as is illustrated by the following charts. In the first example, a pre-retiree is trying to figure out how long his savings of $150,000 will last. He desires to withdraw $1,000 per month and increase that amount by 3 ½ percent per year to keep pace with inflation. He uses an average rate of return of 12% (the average rate of return of the S&P 500 from 1968 to 1998). He is satisfied that his savings are estimated to last approximately 28 years based on these assumptions.
However, if this retiree had actually invested in the market and withdrawn $1,000 per month adjusting for inflation, his portfolio would have been exhausted in 13 years since market returns are not constant and do not return the average rate each and every year.
*Past performance is no guarantee of future results. Longevity Risk
But by far the biggest risk retirees face is one that we barely discuss, let alone have a complete understanding of -- longevity. It´s no secret that people are living longer and more and more people actually reach 100. But when asked, people today almost always underestimate how long they are likely to live and, more importantly, how great their chances are of outliving their average life expectancy by many years. Most people tend to rely on their family history, estimating that they will live approximately as long as their parents or grandparents did. This usually results in people underestimating how long they will live because they are comparing themselves to previous generations whose life expectancies were not nearly as long due to medical and technological advances that have occurred during their lifetimes and continue to develop everyday...
How Long Will You Live?
Today, a 65-year-old man has a 50% chance of living beyond the age of 85 and a 25% chance of living beyond 92 and, on average, women are still living longer than men.
What this means for people who are living in retirement is an increasing chance that they will run out of money if they don´t estimate correctly how long they will live. Of course, no one knows how long that will be! In the past, people just didn´t need to think about it because their retirement income was guaranteed by their employers or the government. However today, left to their own devices, there are two common ways in which people compensate for this unknown. Preserve principal and live off the interest, or keep withdrawal rates conservatively low to ensure that the money will last even if they live to 100. People are unaware that many experts now recommend withdrawing no more than 3 ½ percent to 4 percent a year. This concept of lowering withdrawal rates, and by extension the retiree´s standard of living, makes them feel as though they are insuring against the possibility of running out of money.
These practices may have been fine for the current generation of retirees who probably:
- only needed to rely on their nest egg for a small portion of their incomes
- were disciplined in their spending and are used to self sacrifice, and
- whose #1 goal in retirement was not to become dependent upon their children or the government.
According to a recent study conducted by Ibbotson Associates, Inc. and sponsored by the National Association for Variable Annuities,
"There is an important distinction between market volatility risk and longevity risk. Market risk is typically associated with higher potential returns, while longevity risk is not. For example, stocks tend to be more volatile than bonds, and investors are likely to be compensated with higher returns from a stock portfolio over the long run. On the other hand, living a long life means more resources are needed to fund the longer income needs. Rational investors may decide to take on more financial risk hoping to gain a higher return, if they can tolerate the risk. Rational investors would also want to hedge away the longevity risk, since there is no potential reward for this type of risk exposure. In other words, investors should be willing to pay an insurance premium to hedge away the longevity risk. Insurance companies provide this lifelong benefit by pooling a large enough group (of annuitants). This is very similar to the concept of homeowner insurance, which protects against hazard to one´s home. Lifetime payout annuities provide investors with longevity insurance."The challenge that future retirees will face is one that each one of us can relate to as an individual, but we will not be alone - not by a long shot. Twenty-five percent of 401(k) participants will retire in the next twelve years and the number of people over age 65 will double by 2025. These issues will affect more than 60 million Americans and their families putting an enormous strain on our governmental systems. Federal Reserve Chairman, Alan Greenspan, recently warned that, "delays in making necessary changes in Social Security and Medicare to handle the impending retirement of Baby Boomers could mean abrupt and painful adjustments later on."
Birth Rate 1910-2000 How Can We Put the Security Back in Retirement?
The answer may still lie with you. This is easily accomplished by adding an income annuity as a distribution option in your company´s plan or even outside your plan in form of an IRA rollover. Annuities are the only financial vehicles that offer an income guarantee that you cannot outlive and they come with a variety of options. These options allow employees to tailor their income streams to their specific circumstances. Standard options include spousal protection, payment guarantees for a specific number of years, and a choice of payment frequency.
Income Annuities - A New Generation
Recently, insurance companies have been refocusing efforts on their immediate annuity offerings realizing that the tsunami of aging baby boomers are soon going to require new and better methods to "decumulate" their retirement savings. And as previously stated, they are going to live longer, and yet they will likely have less access to other forms of guaranteed income than their parents did. The result is a whole new generation of retirement income products that will provide the necessary lifetime guarantees with a myriad of options designed to provide flexibility and help to overcome the common objections people have to annuitization.
One of the most common additions to these products is a choice of variable funding options designed to allow retirees to continue to diversify their assets and enjoy the benefits of asset allocation that they had when accumulating assets in their 401(k) plan. Conventional wisdom no longer adheres to the idea that retirees should invest conservatively and drastically reduce stock market exposure. On the contrary, if retirement is going to last 20 to 30 years on average, proper diversification will be necessary to combat the ravaging effects inflation can have over such a long time period.
Retirees may also transfer money among the funding options in order to react to changing market conditions, changes in lifestyle and to continue to be able to rebalance their portfolio on a periodic basis.
One new feature that is starting to emerge is the ability to withdraw money from the annuity. Life situations change over any 20 to 30 year period and retirement is no different. Therefore, income plans need to be flexible, so that a retiree can properly react to those changes. Some annuities now allow a participant to change his or her mind and completely undo the contract during a limited, specified period of time.
These new products are offered as employee benefits on a group basis. They generally have lower fees than publicly offered annuities, usually based on the size of the group and options selected. In some circumstances they can also be tailored to complement or utilize the existing 401(k) funding options.
By offering programs that will educate your employees about the real risks they will face while living in retirement and by putting income guarantees back into your company´s retirement plans, including the 401(k) plan, you can help to fulfill the promise of a secure retirement.
Elaine Stevenson is a senior vice president of MetLife Investors responsible for strategic planning. MetLife Investors, a subsidiary of MetLife, focuses on distributing retirement and protection products through third party intermediaries. She has over twenty-five years of experience in the retirement industry focusing on creating products and services that are offered to individuals and through plan sponsors as employee benefits.