Archive for April 28th, 2012

The stock market crash of October of 2008 devastated nearly everyone’s 401k plans; many have not fully recovered or are back to pre-crash levels only because workers have continued to contribute additional money. How did we get here and how to prevent it from happening again?

Until 1978 when tax code 401(k) was added to the U.S. tax code annuities (defined pensions)were the normal and preferred way of funding worker’s retirements.  Wall Street equity firms successfully lobbied the regulators to implement rules excluding all other types of investments and savings.  Today the vast majority of 401(k)s allow only equity market based funds with one or two fixed cash account options.

All kinds of safe investments which are allowed in IRAs are excluded from 401k plans.  Perhaps if workers had safe money options to choose from in their 401ks they would not be facing underfunded retirements.

The U.S. Treasury Department in 2007 started studying the advantages that would result to workers if annuities were an option inside 401(k)s.  Finally the government appears to be concluding the rules need to be changed. 

Here is an excerpt from a Bloomberg interview with J. Mark Iwry, senior advisor to Treasury Secretary Timothy Geithner. 

Q: You’ve introduced proposals to make it easier to offer annuities and other income products in retirement plans. What problems do these address?  

A: Helping manage longevity risk. Let’s say you’ve reached retirement age. You’ve got your pot of money accumulated in a 401(k) or IRA. For many people, figuring out how to manage that pot of money is an unprecedented challenge. What’s a prudent withdrawal rate, and how do I use it to replace my former paycheck?  

You start with the fundamental uncertainty about what lifespan to plan for. At age 65, a man has about an even chance of living to age 84 and a woman has about an even chance of living to age 86. For a married couple, there’s a good chance that at least one of them will live into their 90s. Given uncertain investment returns and the possibility of outliving your life expectancy, many financial planners explain it’s not prudent to withdraw more than about 4 percent of one’s savings every year. (That assumes you make no adjustments over time in response to changing circumstances.) A typical reaction is, “Gosh, I’ve got a quarter of a million dollars in my account. That feels like a lot of money. But 4 percent of $250,000 is only $10,000 a year to add to Social Security. That’s not enough.”  

 

Q: How are you trying to change the current retirement system to solve that       dilemma?

A: One solution is to provide for a predictable lifetime stream of income, such as an annuity provided under a retirement plan or IRA. By pooling those who live shorter and longer than average, everybody can essentially put away what’s necessary to reach the average life expectancy, and those who live longer than average will be protected. The longevity risk pooling means that an annuity might provide an annual income of more like 6 percent or 7 percent, rather than 4 percent, depending on interest rates and the terms of the annuity. 

 

Q: So if this goes according to plan, our readers are going to see more chances to buy annuities through their 401(k)s.  

A: That’s right; the range of choice in those plans should expand. We’re also focused on defined benefit pension plans, which often offer the choice of an annuity — which will last your whole life — or a lump sum. If framed as an all-or-nothing choice, too often people pick the lump sum. We’re trying to encourage plans to get away from an all-or-nothing “choice architecture.”

Had annuities been utilized as 401k investments no one who chose a fixed annuity option would have lost any of their funds in the 2008 market crash. Nor would they have lost any additional money during the ongoing Global Financial Crisis (GFC) or Great Recession.

Hopefully the rules will be changed sooner rather than later. 

You may ask questions in the comments or contact me privately Tim Barton, ChFC