Costs matter when generating a retirement paycheck

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(MoneyWatch) When you're developing a strategy for generating retirement income from your 401(k) and IRA, investment and insurance costs matter a lot. You might think that charges of a few percentages here and there might not make much of a difference -- but you'd be wrong. You can significantly increase the amount of retirement income you'll receive over your lifetime by getting the best value for your hard-earned savings.

That's one of many helpful conclusions of a new study by the Stanford Center on Longevity (SCL) and the Society of Actuaries (SOA) titled "The Next Evolution in Defined Contribution Retirement Plan Design."

My last three posts on this report showed that the type of retirement income generator you choose has a significant impact on the amount of retirement income you can expect to receive throughout your retirement, as well as the amount of remaining savings at any point during your retirement. These posts examined the various types of generators and how they operate under different economic scenarios.

But even after you've done the hard work to choose the type of retirement income generator or generators that work best for you, you're still not done. Now you need to find the specific financial product or institution that offers you the best deal, which usually means finding the one with the lowest costs.

The SCL/SOA report estimates the amounts of retirement income that a 65 year-old couple with $100,000 might receive over 30 years of retirement with six different retirement income generators. It also offers projections of this couple's remaining wealth at any point in time. You may want to review those posts forbackground, including descriptions of the specific generators that were analyzed.

The SCL/SOA report also compared the retirement paychecks that could be generated from low-cost vs. high-cost retirement income solutions. This analysis demonstrated that you can increase your retirement income by five to 20 percent by finding the most efficient retirement income vehicles. A summary of the report's analysis is discussed below:

Systematic withdrawals

These withdrawals are one way to generate retirement income from defined contribution accounts, like 401(k)s and IRAs. In this case, you invest your savings and choose a method for calculating your retirement paycheck; with this method, you're expected that the paycheck will last the rest of your life, but there's no guarantee of that if you live a very long time or experience poor investment returns.

The SCL/SOA analysis assumed that low-cost funds would charge investment management fees of 0.5 percent per year (50 bps) and that high-cost funds would charge 1.5 percent (150 bps) per year. The report compared the retirement income that could be generated under two different applications of systematic withdrawals.

With the first application, the paycheck amount was fixed at four percent of assets at retirement and then increased for inflation each year (the "four percent rule"). The paycheck would continue until you die or your savings are exhausted, whichever comes first. In this case, the SCL/SOA report projected that the money in savings would last two to three years longer with low-cost funds compared to high-cost funds.

The second application of systematic withdrawals determined the withdrawal amount as four percent of remaining assets at the beginning of each year throughout retirement. Favorable investment returns, net of costs, would increase future retirement income, while unfavorable net returns would decrease income. In this case, the funds should last indefinitely, since the withdrawal amount is a small, fixed percentage of the remaining assets. The SCL/SOA report projected that after 10 years, the income amount would be 10 percent higher with low-cost funds, and after 20 years, it would be 21 percent higher.

You can find low-cost index funds at mutual fund companies such as Fidelity Investments, Schwab, and Vanguard. Also check your 401(k) plan -- many large plans offer costs that are lower than typical retail funds.

Immediate annuities

Immediate annuities guarantee that retirement income is paid for life, no matter how long you live and no matter what happens in the capital markets. Payments are typically fixed in dollar amount, although it's possible to buy annuities that increase at a fixed rate or for inflation.

One of the most cost-effective methods of buying an annuity is through an annuity bidding service that finds the most competitive annuity purchase rate among reputable insurance companies at the time of retirement, and by reducing transaction charges. The SCL/SOA report states that competitive bidding has the potential to increase your retirement income by 10 to 20 percent, and that reduced transaction charges have the potential to increase your retirement income by 4 to 8 percent.

You can find annuity bidding platforms at Income Solutions or ImmediateAnnuities.com. Some large 401(k) plans are also offering annuity bidding platforms -- check to see if your plan has such a feature.

GMWB annuities

GMWB annuities are hybrid products that attempt to combine the best features of systematic withdrawals with the lifetime guarantees of annuities. GMWB annuities offer you the potential to increase your retirement income if investment returns are favorable, but your income is protected if returns are unfavorable. In addition, it's possible for you to access your funds during retirement, and unused funds at death are available for a legacy. On the downside, in addition to annual investment management fees, insurance companies also assess an annual insurance fee against accounts.

With low-cost GMWB products, the annual insurance and investment management fees can be 200 bps lower than those of high-cost products. In addition, the initial income amount can be 12-1/2 percent higher than with competitive GMWB products. Due to the reduced fees of low-cost GMWB products, the SCL/SOA report projects this gap in income will widen to 16 percent after 10 years and 19 percent after 20 years. Another advantage of this income generator is that the amount of remaining savings is exhausted six years earlier with the high-cost product, although the income would continue due to the insurance guarantee of this product.

Some large 401(k) plans are now offering institutionally priced GMWB products -- check to see if your plan has such an offering.

Shopping for the most cost-effective retirement income generators may seem like a lot of work, particularly after you've made the effort to learn about the various generators and how they operate. Hang in there, though, because you're spending your time wisely as you shop for the income generators that will generate a retirement paycheck for the rest of your life. You'll thank yourself when you reach your 80s and 90s, knowing you've generated the largest retirement paycheck possible from your savings.

  • Steve Vernon On Twitter»

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.

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