Misuse 401(k) retirement income statements and risk going broke
(MoneyWatch) If you participate in a 401(k) or similar plan at work, you might soon receive a statement of your account balances that includes estimates of how much retirement income your savings might generate. This is part of a commendable effort by employers and financial institutions to educate the public on how to manage their retirement savings so they can generate income in retirement that lasts for life.
But while this is a step in the right direction, many people could misuse these statements to their detriment. Let me explain my concern by using an example from a statement that my wife recently received from her 401(k) plan.
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Her account statement showed that her 401(k) balance was $200,000 (it was actually a different amount, but I changed the number for confidentiality purposes). Farther down the page was the following statement:
If you were age 65 today and about to retire, it is estimated that your retirement account could generate this amount of income every month in retirement for life: $1,083
This represents an annual income of almost $13,000 per year. If you divide her estimated annual retirement income by her account balance, the result is an annual payout rate of 6.5 percent.
Don't trust too much
My concern is that a lot of people will trust the information they receive from their financial institution without asking very many questions, and will decide that they can afford to retire based on the estimates of their retirement income. Or they may overlook the word "estimate" and assume it's actually the amount of retirement income that the plan will deliver.
I'm also concerned that retirees will simply keep their account balances invested after their retirement and would start withdrawing whatever monthly amount the statement said their account could generate. The trouble is, with such a strategy you'd have a high risk of experiencing "money death" before you actually experienced real death!
When I took the time to look at the fine print of my wife's 401(k) statement, I found that it assumed my wife would buy an annuity with her retirement savings. The fine print also contained some text about the assumptions that only an actuary like me might understand. By the way, the fine print came several pages after the estimate of retirement income.
When we called the toll-free number on the statement to speak to a customer service representative to learn more about how the retirement income statement was prepared, the person we spoke with was totally confused. After putting us on hold for several minutes, he started reading from the IRS website, in an area that I knew to be the wrong place. So not much help was coming from this financial institution.
What happens if you don't buy the annuity?
The fact is, most people don't buy annuities with their retirement savings; the most common waypeople draw down their retirement savings is to simply take out whatever they need to cover their living expenses. Surveys show that most people who use this strategy are withdrawing at a rate that's too high. For example, Wells Fargo recently surveyed people who were approaching retirement and asked for their opinion on a safe payout rate; the median response was an annual rate of 8 percent of savings, a number that puts you at a very high risk of outliving your money. So while withdrawing at a rate of 6.5 percent is certainly better than withdrawing 8 percent, there's still room for improvement.
If my wife simply kept her account invested and withdrew $1,083 per month, she'd have roughly a 50-50 chance of outliving her money. Actually, the odds would be worse. Because she expects to outlive her life expectancy due to her family history and because she takes care of her health, the odds would be greater than 50-50 that she'd outlive her money.
If my wife would instead visit a financial planner who is experienced in generating retirement income, they would most likely use the "4 percent rule" or a variation of it to estimate her retirement income. Four percent of $200,000 would result in an annual retirement income of $8,000 per year. The 4 percent rule is purposefully conservative and takes into account the possibility that people might live beyond their average life expectancy and/or experience poor investment returns. In addition, with the 4 percent rule it's hoped that you can receive increases in your income to address inflation, while the income with an annuity is fixed.
If my wife had decided to retire by relying on the assumption that her annual income would be $13,000 but later learned that it would only be $8,000 per year, she might have delayed her retirement.
What should be done?
Employers and financial institutions should use retirement income statements as the beginning of a broader campaign to educate retiring employees on the various methods to generate a lifetime retirement paycheck. That will enable employees to make better choices about when they can afford to retire.
My advice for individuals? Learn more about the best ways to turn your IRA and 401(k) accounts into a lifetime retirement paycheck, considering both your circumstances and your goals. Then estimate how much retirement income you might actually receive. Don't decide that you can retire by just looking at your retirement income statement.
Stay tuned for my next post, which will analyze whether the annuity estimate on my wife's statement is realistic.
