(MoneyWatch) Listen up! You can own a $500,000 home with a monthly payment of just $1,200! As we now know, too many Americans fell for a pitch like this in the recent real estate bubble; they took on mortgages with low, teaser interest rates and balloon payments. As a result, they bought houses that were simply too expensive for them, and when the monthly payment escalated, they couldn't afford the payments. Thousands of houses were dumped on the market, often through foreclosure. These buyers made important financial decisions without looking too hard at the fine print, and their decisions weren't realistic given their income and personal balance sheet.
As I mentioned in
In themy wife had received a retirement income statement from her 401(k) plan that stated her $200,000 balance could generate an estimated monthly retirement income of $1,083 if she retired at age 65. This represents a payout ratio of 6.5 percent (the income as a percentage of the account balance). By the way, I changed the numbers for confidentiality purposes but kept the payout rate the same.
When I looked at the fine print that came several pages after the estimate, I learned that the institution assumed that my wife would use her 401(k) balance to buy a fixed immediate annuity, even though very few people actually buy such annuities upon retirement. To estimate her annuity income, her 401(k) institution used actuarial assumptions promulgated by the IRS for employers to value their defined benefit plans, not actuarial assumptions that are used to price individual annuities in the insurance marketplace.
What's the difference? Assuming my wife actually buys an annuity with her $200,000 balance, my recent Hueler's annuity bidding service. If I had used the worst annuity price from these five companies, her monthly income would have been $950. This shows that if you don't know the best way to shop for annuities, $200,000 would buy an annuity that generated a monthly income that was well under $1,000.shows that her monthly income would be $1,033, not $1,083. While that might seem like a small difference, my retirement income scorecard used the best price from five different insurance companies, using
In reality, there are many ways to generate a monthly retirement income from savings. Among these various methods, a fixed annuity generates the highest amount of initial retirement income. Other methods are reasonable and produce lower income amounts. For example:
- If my wife worked with a financial advisor who used the often-used "four percent rule" to generate retirement income, $200,000 would generate a monthly income of $667. Suppose the advisor was cautious, however, and recommends a 3.5 percent instead of 4 percent payout rate due to the current low interest environment (a reasonable approach that's suggested by some prominent retirement analysts such as Dr. Wade Pfau). Now her monthly income would be just $583.
- If my wife purchased a popular guaranteed lifetime withdrawal benefit (GLWB) annuity, her monthly income would be $833.
Now let's play this out. Suppose someone you trusted told you that your $200,000 account balance would generate an estimated monthly retirement income of $1,083, but upon investigation, you found out that there's no way you could actually earn this amount of income. Instead, the highest monthly income you could receive would be $1,033, not $1,083, but if you picked other reasonable methods of generating retirement income, each with different advantages and disadvantages, your monthly paycheck could be $583, $667, $833, or $950. Now suppose you go back to the financial institution and point this out, and they harrumph that it's just an estimate, after all, and didn't you read the fine print? Wouldn't you have lost a lot of faith in that institution?
You could take the point of view that in the real world, it's "buyer beware." During the recent real estate bubble, people shouldn't have taken on sub-prime mortgages and they deserved whatever happened to them. Likewise, you could take the point of view that anybody who relies exclusively on their 401(k) retirement income statement for retirement guidance isn't doing a very good job of planning their retirement and they deserve whatever fate they experience. That could mean running out of money before they die.
But just as with with the real estate bubble, financial institutions have some responsibility, too. Mortgage lenders and banks shouldn't have been offering sub-prime mortgages to just about anybody who walked through the door. Similarly, if financial institutions and employers that sponsor 401(k) plans want to be trusted, they need to do a better job of educating their customers and employees about the various methods of generating retirement income.
A much better approach for a retirement income statement would be to show a range of possible retirement income amounts and state that your income amount will depend in part on the retirement income generator that you select. In my wife's case, it would have been better if the financial institution had told her that her $200,000 could generate a monthly paycheck ranging from $583 to $1,033; at least then she would have been alerted that some additional investigation was needed on her part.
As I said in my last post, the 401(k) retirement income statements are definitely a step in the right direction. They will help people start to understand the
Meanwhile, my advice for consumers is to remember that the real world is indeed buyer beware.