How to Get Retirement Income from Your 401(k)

On January 31, Financial Engines, the large investment advisor to 401(k) plan participants, announced a new program called Financial Engines Income +, which their press release claims is "the first retirement income solution designed specifically for 401(k) plans." Several large 401(k) administrators will be offering Income + to their clients, including Aon Hewitt, Mercer, ACS, ING and J.P. Morgan Retirement Services.

Financial Engines' program really isn't the first retirement-income solution for 401(k) plans. Other companies, including Fidelity, Vanguard, Income Solutions and AllianceBernstein, offer such programs. But the majority of 401(k) plans don't offer any payment option that provides a retirement income; 401(k) plan sponsors prefer to pay your accounts in a lump sum when you retire and wish you good luck. It's my opinion that will soon change: Mutual fund companies, insurance companies, and financial advisors all want to address the challenge of generating reliable retirement income from 401(k) balances - and make a profit helping you.

Some providers will likely want to build on the success of their target-date funds, which help you accumulate saving for retirement. With a target-date fund, you only need to make one investment decision - you invest all your retirement savings in the fund that corresponds with your target retirement date, and then all the investing is done for you. Wouldn't it be nice if, when you retire, you could just pick one option for generating retirement income and have the rest of the work taken care of for you?

The trouble is, it's a lot harder to generate retirement income from your 401(k) accounts than it is to accumulate money for retirement. Here are several goals you must juggle when you're selecting a method to generate retirement income:

A lifetime income that never runs out, no matter how long you live
Protection against market declines - so your income never goes down
Inflation adjustments so your retirement income keeps pace with a rising cost of living - and, ideally, rises with favorable market returns as well
The ability to tap into your savings, in case of emergency
The option to leave a legacy to your children or charities

If you think these goals sound a lot like eating your cake and having it too, you're right. Most people can't meet all of the above goals with a single method of generating retirement income, so you'll need to make some tradeoffs. To get inflation protection, for example, you'll likely have to settle for a lower base of monthly income. Or, if you want protection against market declines, you'll likely have to accept limited upside potential if stock market returns are favorable.

If you're offered an option in your 401(k) plan that generates retirement income, don't take the easy way out and select this option just because it appears so simple. First, look under the hood. Before the financial meltdown, many people jumped into target-date funds - and were later surprised when their funds fell significantly in the 2008-2009 crash. If they'd only taken the time to understand what they were buying, they would have seen substantial exposure to equities - it only made sense that these funds would go down if the market crashed.

I'm worried about the same phenomenon happening in the years to come with "simple" retirement income solutions. While you might think you're selecting an option that meets most or all of the above goals, that's not necessarily guaranteed.

So what should you do if you're offered a retirement income solution in your 401(k) plan? First, become familiar with the three different ways to generate retirement income:

Use just interest and dividends.
Take managed payouts, which allow you to draw down principal cautiously.
Buy an immediate lifetime annuity.

Some of the newer retirement income solutions are hybrids that offer a combination of managed payouts with the guarantee of lifetime annuity. Such solutions can appear to be attractive, but you'll need to understand how they operate, what the costs are, and under what circumstances you'll realize increases in your retirement income due to favorable stock market returns. You'll want to compare such an option to simpler solutions, such as an immediate fixed annuity, an immediate variable annuity, an immediate inflation-adjusted annuity, a managed payout mutual fund, or some combination of these solutions.

Don't get me wrong: Such a "one choice" solution is a vast improvement over the method that many people use to generate retirement income: they guess how much they can withdraw each year from their savings and hope their savings will last for the rest of their lives. Unfortunately, with this method, what happens is that they often end up exhausting their retirement savings with many years of life remaining. With a little thought about your own circumstances, and a little careful consideration of the options available to you, you can do much better than that.

Future columns will look under the hood of various retirement income solutions, and will help you learn how to critically evaluate them. If you don't have the time or skills to make this evaluation, it may be smart to hire a professional advisor who doesn't have a stake in your decision - that would be an advisor who you pay on an hourly or retainer basis, such as one from Garrett Planning Network or the Alliance of Cambridge Advisors.
Given the importance - your paycheck for the rest of your life - it will be time and money well spent.

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Steve Vernon

View all articles by Steve Vernon on CBS MoneyWatch»
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 Retirement Game-Changers: Strategies for a Healthy, Financially Secure and Fulfilling Long Life and Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck.

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