June 28, 2018

The private pension system in the US is in transition. The shift is from defined benefit pension plans wholly controlled by employers to defined contribution 401K plans that are partially controlled by the employees enrolled in them. This is happening largely because 401K plans provide greater flexibility to employers, avoiding the large balance sheet liability generated by the employer’s commitment to provide defined benefits over an indefinite future period.

From a retiree perspective, however, defined contribution plans have two major weaknesses. The weakness that has generated the most attention is that employees have not been saving enough in their 401Ks to assure a comfortable retirement. Some of the reasons for this, along with initiatives aimed at encouraging higher 401K savings rates, were noted in a recent article by Anne Tergesen in the Wall Street Journal. She cites the following measures aimed at raising savings rates, which either have been adopted or are pending in legislative proposals:

• Systems that enroll employees into 401 plans automatically, requiring laggards and procrastinators to opt out.

• Authorization of multiple employer plans for small firms that have no plan of their own.

• More convenient methods that employees who are changing employers can use to transfer their accounts to the new employers, avoiding cash-outs that can result in spending splurges.

• Emergency funds that would co-exist alongside 401K accounts so that employees do not raid their 401Ks to meet emergencies.

• An option for investing 401K funds in an annuity.

The second major weakness of 401K plans, which has not generated much if any attention, is that they do not include any way for the individual retiree to manage mortality risk. Such management is an integral feature of defined benefit plans because the employer delivers pensions for life to a group of employees with markedly different lifespans. In contrast, the employee with a 401K is on his own.

While allowing retirees to purchase annuities might be viewed as a step in that direction, the wisdom of purchasing annuities prior to retirement is highly questionable. In my view, the retiree’s objective during her working years ought to be to accumulate as large a nest egg of financial assets as possible. Annuities do not fit that objective.

After retirement, however, when financial assets begin to be drawn down to meet living expenses, that judgment flips.  If there is any likelihood that the retiree could outlive the assets, some of the assets should be allocated to the purchase of a deferred annuity. But doing this makes sense only within the framework of a financial plan that integrates the annuity with a scheme for drawing down financial assets over time. Further, if the retiree is a homeowner, the plan can also include a reverse mortgage.

Here is an example of an integrated retirement plan. The retiree of 63 has a nest egg of $1 million of common stock and a house worth $400,000 with no mortgage. The plan objective is to maximize the spendable funds available to the retiree that will increase by 2% a year, subject to investment risk that the retiree finds tolerable.

The retiree’s $1 million nest egg is divided into 2 parts. One part for $567,122 remains invested and will be drawn down as a source of spendable funds over 20 years. The remaining $432,878 is used to purchase a monthly annuity deferred 20 years. The allocation of the $1 million between the 2 uses is such that the initial draw amount from the assets plus a HECM term payment, amounting to $6047, growing by 2% a year, after 19 years will be just 2% below the initial annuity payment of $8986 that begins in the following year.

A plan of this type must also be managed in response to deviations between the rate of return assumed in calculating the amounts that could be drawn from month to month, and actual returns. My example assumed a 20-year return of 11.24%, which was the median return on common stock during all 20-year periods between 1926 and 2012. The return that materializes is equally likely to be lower or higher. If the return is larger than assumed, the retiree can draw more, accumulate financial assets, or both.  

If the return is lower than assumed, the retiree must scale down the draw amounts to avoid asset depletion. The size of the adjustment depends on the size of the earnings shortfall. The retiree will be aware of the adjustments that might be required by earnings short falls, and will take account of them in deciding on the amount to draw from assets. For example, if the adjustment that might be required using the median draw is viewed as excessive, the retiree could scale down the initial draw, making a shortfall less likely, and the adjustments associated with a shortfall smaller.