Could a defined-contribution retirement savings plan launched in 1918 provide insight into one of the trickiest questions in personal finance with 401(k)s?
The quick answer is yes. The retirement savings plan is TIAA, which attracts participants from colleges, universities, and other nonprofit organizations.
The difficult question of personal finance is how employees with 401(k) accounts can turn their accumulated savings into income they can count on in retirement.
The basic conundrum: spend too much too soon, and retirees may have to drastically reduce their standard of living later in life. Retirees who are too careful with their savings could die alive and wracked with regrets about unlived experiences. The complexity is compounded by uncertainty about life expectancy. Will retirees have to count on their retirement savings for five years or 25 years?
If that wasn’t harsh enough, the 401(k), which is about four decades old, was not designed with the distribution phase of retirement in mind. “I would argue that the 401(k) is not a retirement plan,” says David Richardson, managing director of research at the TIAA Institute, the company’s think tank. “They are intended to allow people to save for their retirement. Not much thought about how people take their distributions.
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In other words, 401(k) near-retirees are largely on their own to figure out what to do. A wealth of literature has developed to help them decide how much they can safely withdraw from their savings. The best-known guideline is the 4% rule: withdraw 4% in the first year and each year thereafter an additional 4% plus an adjustment for inflation.
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Many economists would prefer that 401(k) participants turn their savings into life annuities. The basic idea is that in exchange for an investment in an annuity with an insurance company, the retiree secures an income for life. A small group of companies with 401(k) plans offered their participants the opportunity to make their savings profitable. The 2019 pension legislation – the so-called Secure Act – made several changes intended to encourage more employers to offer an annuity option. A similar intent informs the current bipartisan bill known as Secure Act 2.0 which passed the House and is now in the Senate.
In many ways, the TIAA is very similar to a 401(k), the main employer-sponsored retirement plan for private sector workers. But, unlike the typical 401(k), TIAA offers several distinct withdrawal options.
In “Trends in Retirement and Retirement Income Choices by TIAA Participants,” economists Jeffrey Brown (Gies College of Business, University of Illinois at Urbana-Champaign), James Poerba (Harvard), and David Richardson explore retirement income choices to learn more about retiree choices. to favor. The results based on the data are illuminating, in particular two trends.
First, economists may like annuities, but not savers. Specifically, while 61% chose the lifetime payout stream in 2000, only 18% did so in 2018. The change is dramatic, given that TIAA participants had to pay for themselves until 1989. A A number of factors are likely at play, including the market environment of high stock returns and low interest rates during the period studied, which may have encouraged fewer people to break even.
Nevertheless, annuities are also not popular with the average retiree. Annuities are complex contracts. Annuities are inflexible when the household situation changes. “So what do people want?” asks Meir Statman, author of “Finance for Normal People” and professor of finance at Santa Clara University “They don’t want annuities. How many times do people have to say that?”
Second, many other participants are delaying access to their TIAA retirement accounts until their required minimum distribution date. The RMD is the percentage of assets that individuals are required to withdraw from a given age. Among TIAA participants, the number of waits until their RMD rose from 10% in 2000 to 52% in 2018. The age of RMD was 70½ years during the study period. But at the end of 2019, the Secure Act raised it from 72 years and, if the Secure Act 2.0 becomes law, the age of the RMD will finally increase to 75 years.
“RMD is fiscal policy,” says Richardson. “It’s not designed as an exit strategy.”
He is right, of course. But research shows that the IRS’ RMD chart is a more effective strategy than other more well-known rules of thumb such as the 4% guideline. “RMD is a really good rule,” says Statman. “RMD is a very useful guide to how much you can spend.”
Here is my takeaway. Retirees appreciate flexibility. Yes, annuities protect against the risk of living longer than expected, but there are other risks retirees face, including health risks and unexpected expenses. Retirees may want accumulated savings in case a spouse suddenly receives medical aid or an adult child returns home with grandchildren after the divorce. The RMD option is a reasonable choice for those who have enough assets to wait.
There are other ways to reduce longevity risk than buying a private annuity. On the one hand, inflation-adjusted spending declines throughout retirement (with a health care-induced increase later in life). Retirees consume more early in retirement when they are in better health and reduce spending on travel and other leisure activities later with an “I’ve been there before” attitude, three Rand Corp economists conclude. in “Explanations for the Decline in Spending at Older Ages”.
On the other hand, working in the traditional retirement years makes it possible to delay the filing of the application for social security, an annuity adjusted to inflation. The benefit is about 76% higher if you file at age 70 (the last you can file) rather than at age 62 (the earliest).
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It is perhaps no coincidence that the average retirement age among TIAA participants has risen as the RMD option has grown in popularity. Specifically, among participants, the retirement age increased by about 1.3 years for women and 2 years for men.
From a public policy perspective, legislators are right to encourage companies to offer their future retirees an annuity option. Few retirees can accept the offer unless the product itself is significantly improved. Data from the TIAA suggests that retirees prefer to keep control of their nest egg, just in case.