The 401(k) Payout Challenge

As we said way back in Chapter 4, one way to think of a defined benefit plan is as an annuity company run by the employer-sponsor exclusively for its own employees. As such, it neatly solves, for the participant, the payout challenge, by providing, on retirement, an income for life.

Defined contribution plans (including 401(k) plans), by contrast, are account-based plans. They are vehicles for accumulating assets. The (overwhelmingly) most common payout form is a lump sum on termination of employment. Leaving the participant with the problem of adequately hedging against the risk that he will outlive his retirement assets.

How big a problem is that? Can it be solved? Why hasn’t it already been solved?

Putting the 401(k) Account to Work in Retirement

The typical individual who retires at, say, age 65 from a 401(k) plan begins this new phase of life with a portfolio of assets and a “liability.” That liability is the need to provide an income for the rest of life.

Let’s unpack that “need” a little. As we’ve discussed at length, the need for income in retirement is complex—it’s not a simple number, e.g., 77% of pre-retirement income. Individuals have some flexibility both on the supply side—in a pinch they may be able to, e.g., go back to work or at least engage in some sort of income producing activity. Indeed that may even be a positive thing. Not everyone simply wants to stop working.

Individuals also have some flexibility on the demand side. They may choose, for perfectly valid reasons—personal economic preferences—to live more modestly in retirement.

Moreover, individuals’ needs in retirement are not just a function of income, they may also be a function of risk. An obvious example of this is unanticipated health care costs. And those risks may be most appropriately addressed through an insurance product, e.g., health insurance, rather than by an income policy.

The Calamity of Long Life

When we ask, “Will my assets last the rest of my life?” we implicate two separate risks/uncertainties:

Risk 1: That we will live longer than we expect to. We call this “longevity” risk.

Risk 2: That our asset portfolio will return less than we expect it to. We call this “asset performance” risk.

The significance of these two risks cannot be underestimated. Assuming the participant has saved “enough,” then if he addresses these two risks adequately he is likely to have a “successful” retirement. If he doesn’t address them, then there’s a good chance that he won’t.

Thus, in most of what follows we will simply be considering different ways of addressing these two risks.

Longevity risk is relatively intuitive. The average life expectancy of a 65-year old female is, according to the Society of Actuaries’ latest data, 87.6 years. It’s 85.6 for a 65-year old male.40 These are averages. We all know that most (nearly all) real life individuals will live longer or shorter lives. And the human condition is such that very few of us know which—know whether we are going to live a longer or shorter life than the average.

Asset performance risk is also relatively intuitive—we’ve been discussing it in different contexts throughout this book. It’s possible to “buy” certainty about asset performance, by, e.g., investing in US government securities. But it’s expensive. To “buy” better performance, the investor has to accept more risk, and consequently more uncertainty about the ultimate outcome.

If you knew exactly how long you were going to live, and you knew exactly what your asset portfolio would earn, the challenge presented by the fact that, at retirement, 401(k) plans provide a portfolio of assets, rather than a lifetime income, would not be a problem. You would simply calculate the payout level you would need to zero out your account on the day of your death.

And—obviously—because, when retiring and receiving a distribution of a 401(k) plan account balance as a lump sum, the participant does not know how long she is going to live and what her portfolio will earn, she risks outliving her assets. That is, she risks old-age poverty.

The Annuity Solution

There is a way to hedge both of these risks: an annuity provided by an insurance carrier guarantees income for life. So, why doesn’t this make the payout problem go away? The retiree who receives a lump sum payout from a 401(k) plan can simply use it to buy an annuity from a commercial carrier.

401(k) plan participants have been extraordinarily resistant to buying annuities. There are several reasons for this. One of the most obvious is cost—several factors make annuities un-attractively expensive.

To start with, average life expectancy is increasing.41

Add to that the fact that annuity carriers assume that annuity buyers are going to live longer than average. That individuals, e.g., in bad health or with other reasons to expect not to live long lives won’t buy annuities, and that individuals who (with good reason) do expect to live long lives will buy annuities. This, by the way, is a problem (adverse selection) that the sponsor of a “classic” DB plan (without a lump sum option) does not have. In those plans everyone has to take an annuity.

And, to repeat what we’ve said elsewhere, as interest rates have gone down, the cost of retirement income has gone up. A lot.

All of these factors have driven up the price of an annuity.

What’s an annuity cost today? $100,000 buys a 65-year old female a monthly income of $524. It buys a male a monthly income of $559. That is not a lot of money. Put another way, $100,000 seems like lot to pay for $524-a-month worth of certainty.

Moreover, with a simple annuity, when the annuitant dies there’s nothing left over for a legacy (e.g., for the annuitant’s children). You can add in guarantees, but they are expensive and will (obviously) reduce the annuity payout.

But—what’s the alternative?

Self-Insuring—Living with Uncertainty

The alternative to an annuity is to self-insure, for the retiree to assume those two risks we identified—longevity risk and asset performance risk. If the participant doesn’t buy an annuity, how much can he pay himself without risking old age poverty?

Payout Based on Estimated Age and Life Expectancy

To provide a baseline, let’s begin by considering what sort of payout, in the form of a systematic withdrawal, a participant could make where those two risks, longevity and asset performance, do not operate. Let’s assume that a 65-year old participant receiving a distribution of $100,000 knows that she is going to live for exactly 20 more years and can earn a return of 6% per year.

In these circumstances our example retiree could take out $716 per month and die at 85 with no money left.

This hypothetical is, of course, completely unrealistic.

So, what happens if we make much more conservative assumptions? Let’s increase the participant’s life expectancy to a more realistic outside limit of, say, age 95 and assume a more or less safe return of 3.8%? On those assumptions, this participant could only take out $466.

What about somewhere in between? Let’s assume that the participant will live to age 90. And let’s include some portfolio exposure to equities. The example glide path we looked at in Chapter 18 posited a 30/70 (equity/fixed income) investment at the oldest ages. Such a portfolio would produce a (theoretical) return of around 5%. Assuming the participant will live to age 90, and assuming a 5% rate of return, our example participant could pay herself $585 per month.

But let’s be clear: this last strategy increases both of the risks we are concerned about. And not insignificantly. Remember, the average life expectancy of a female is 87.6 years. And even if a 30/70 portfolio in fact generates an average return over 25 years of 5%, if there are significant losses in early years, the chances that our example retiree’s nest egg will last till she dies may be compromised. That last point cannot be emphasized enough: individuals retiring in 2008 began the second year of their retirement facing a 37% loss on their S&P 500 portfolio.

Drawdown Strategies—the 4% Rule

Because of the risks inherent in basing payout on estimates (aka guesses) about life expectancy and portfolio rate of return, most advisers recommend a more conservative drawdown strategy—withdrawing a fixed percentage of the participant’s account every year. The conventional drawdown strategy is known as the “4% Rule.” Under the 4% Rule, the retiree initially withdraws 4% of retirement assets in the first year of retirement. In subsequent years, the retiree withdraws that same amount, adjusted for inflation.

The 4% Rule has been subject to considerable criticism in recent years. In the seminal paper The 4% Rule is Not Safe in a Low-Yield World,43 the authors suggest that, while the 4% drawdown rate may have been reasonable when originally developed, declines in interest rates/returns in recent years make it unrealistic. Assuming a 30-year life and near zero real interest rates, a 4% drawdown may result in “failure”—the retiree outliving assets—in a majority of cases.

The Hybrid Solution—A Payout + a Deferred Annuity

Recently, annuity providers have developed a hybrid solution to the payout problem: the participant takes care of, e.g., the first 20 years of payments and the annuity provides income for the period after age 85, if the retiree lives that long.44

At current rates, a female retiree could buy an age 85 deferred annuity of $500 a month for around $14,500. She can then pay out the remaining $85,500 of her $100,000 nest egg with no uncertainty about living too long. The uncertainty about how much her $85,500 will earn over the next 20 years of course remains. A conservative (all fixed income) assumption of a 3.8% rate of rate of return would generate a payout of around $509. And, again (and unless the participant is very lucky in the market), this strategy would generally not provide a legacy.

If instead the participant chose a drawdown strategy of 4% per year, she could initially only pull out around $285 per month (based on $85,500 of principle generating an annual drawdown starting at $3,420 per year), with adjustments in future years for inflation.

In each of these cases, the participant can (theoretically) produce greater income by introducing more risk. With a tradeoff of more uncertainty.

* * *

As was the case with automatic enrollment as a solution to increasing savings, the movement (such as it is) to develop innovative 401(k) payout solutions is largely industry led. Among those innovations we would identify work by annuity carriers developing deferred annuities and the development of internet-based annuity shopping platforms that improve the efficiency of the annuity purchase process. 45

There is at this point, however, no magic bullet.

In the End it’s about Managing Risk

We’ve thrown a lot of numbers around here. What really matters, however, are those two risks/uncertainties that we identified at the beginning: (1) How long will the participant live? And (2) how much will the participant’s asset portfolio earn? We began by noting that a life annuity “solves” both of these risks/uncertainties, but at a cost.

We then considered two alternative “self-insured” payout strategies—one that was based on estimated life expectancy and rate of return and one that was based on a drawdown rate.

Finally we considered a hybrid strategy, combining a deferred annuity (beginning at age 85) with a “self-insured” payout strategy for the period age 65–85.

The only purpose the numbers are serving here is to allow us to compare (stylized) results under these alternative strategies.

Bottom Line

At current interest rates, none of these strategies is particularly attractive. And it could be argued that, with respect to payout, for large employers at least, a defined benefit plan may present a more attractive solution. That’s because in some respects a DB annuity is necessarily cheaper than an insurance company annuity. The DB plan does not (unless it allows lump sums) have to deal with adverse selection. It has more portfolio flexibility. And it doesn’t include a profit margin.

Moreover, while the foregoing analysis has focused on the two major risks—longevity and rate of return—there are others.

We discussed inflation in the sidebar. Also consider—what happens under any of these alternatives if the participant experiences a “fiscal shock”—e.g., major health expenses not covered by insurance? In such an event, if the participant is “self-insuring” (that is, hasn’t bought an annuity), then he can “invade the principle,” pull out money and address the emergency need, at the cost of reducing future retirement income.

Participants who have bought annuities generally won’t be able to address such emergencies (e.g., pay the medical costs). But their retirement income will be safe.

Given the massive uncertainties retirees face, you can understand how it is that financial planners earn their pay.

It is tempting to say that the right solution here is just a simple, efficiently priced life annuity. But there are many individual situations in which that won’t be the right answer. To name several: Where the participant’s health is compromised, and the participant does not expect to live long. Where the participant has outside resources and thus has the capacity to accept more risk with respect to, e.g., investments. Where the participant is prepared to tolerate a certain amount of downside risk, and the possibility of having to live in reduced circumstances, in return for the possibility of greater upside return. Or where the participant and the participant’s family value the ability to leave a legacy and view living together and investing the participant’s retirement assets “for the long run” as a better deal than sacrificing return for certainty.

What cannot be ignored by the participant is the reality of these risks. Whatever decision the participant makes should reflect a realistic understanding of them.

* * *

We began this chapter on 401(k) plan payout adequacy by identifying two overarching issues. We’ve just finished surveying the first of these—developing rational and efficient ways of addressing the challenge of translating a 401(k) plan’s account-based benefit (and, typically, lump sum payout) into some sort of retirement income that will last the remainder of the retiree’s life.

We now turn to the second—how, in a voluntary system driven by individual choice, we can get participants to make appropriate payout choices.

Individual Choice vs. the “Right Choice”

This problem is the same one we have encountered at every stage of our consideration of the 401(k) system’s adequacy challenges: individual choice. To repeat what we’ve said repeatedly, individual choice is the theme of the 401(k) system. Participants’ choose how much to save. They choose how to invest their savings. And they choose what sort of payout strategy to use in retirement.

Individual choice, here, as in the rest of the 401(k) system, is a positive feature—it allows participants to design a retirement payout that meets their needs. Retirees who want to “do all the things they couldn’t do while working” (most typically, travel) may want to spend more in the early years of retirement. Other “retirees” may want to delay payout of their retirement savings—for instance if they’ve decided to continue working, either in the same sort of work (e.g., transforming from employee to consultant) or in a different area in which they have an interest.

But individual choice is also a system “bug.” The human propensity for hyperbolic discounting we noted in Chapter 15 may lead many retirees to spend more in the early years of retirement, discounting the very real risk that they will outlive their savings.

Because of the way the ERISA rules about payments from DC plans work (and in this regard, compare the rules applicable to DB plans discussed in Chapter 5—Spousal Rights—the Retirement Equity Act of 1984),46 nearly all DC/401(k) plans other than those sold by annuity carriers provide that the default form of payment is a lump sum. The only other alternative offered, typically, is payment over a term of years.

Talk as the Solution?

Many sponsors provide employees with robust retirement counseling programs that include information about the importance of thinking about using the 401(k) plan lump sum payment to provide a lifetime retirement income. There was a 2013 proposal by the Department of Labor to mandate disclosure of that information—that sponsors be required to provide 401(k) plan participants some sort of explanation of what their 401(k) account balances would be worth as retirement income. That effort seems to have foundered on disagreements over methodology.

These “talk” strategies are the same (in our opinion, relatively ineffective) genre of solution deployed to encourage participants to save and to invest appropriately. (See our discussions in Chapters 17 and 18.) Unlike in those areas, with respect to payouts, sponsors have not gone the extra step of defaulting retirees into taking payment in an annuity form. Much less mandating annuity payments.47

Sponsor Reluctance to Do More

There are a lot of reasons why sponsors haven’t acted more aggressively. First, whereas DB plan sponsors can be viewed as somewhat paternalistic, the relationship between many 401(k) plan sponsors and their employee/participants is more transactional. After the employee terminates and receives a (lump sum) benefit, the employer–employee relationship is at an end, and the employer may feel no need to encourage the employee to do anything in particular with the plan distribution.

Second, implementing a default to a life annuity would implicate a set of spousal consent rules for married participants that are perceived by many as cumbersome.

401 (k) Plan Annuities and Fiduciary Risk

Third, and probably most significantly, sponsors are concerned that if they offer an annuity, even as just an alternative form of payment, they may be underwriting, for decades to come, the financial soundness of the annuity carrier. That is, if the plan distributes an annuity contract from an annuity carrier, and then, 20 years later, the carrier becomes insolvent and cannot pay the annuity, the participant may be able to sue the sponsor on the theory that the initial selection of the annuity carrier was imprudent.

This fiduciary risk is widely believed to be the major obstacle preventing 401(k) plan sponsors from including an annuity payout option in their plans. The Department of Labor has provided a “safe harbor” for DC plan annuities, but it is generally regarded as not very safe: It still requires a thorough and prudent selection process, including a judgment about the capacity of the annuity carrier to pay future annuity commitments. All of which can provide the basis for a subsequent participant lawsuit.

There is a proposal from the American Council of Life Insurers (ACLI) to solve this problem by, generally, deferring to state insurance regulation on the issue of the financial condition of the annuity carrier. This proposal has been included in some legislative proposals, but as of this writing there are no prospects for its adoption either by Congress or by DOL.

In 2012, the Obama Administration proposed three relatively minor initiatives in support of 401(k) plan retirement income solutions. Probably the most significant of these was a regulation (finalized in 2014) modifying the required minimum distribution rules to permit a limited portion of a participant’s account balance (the lesser of $125,000 or 25% of the participant’s account balance) to be allocated to a deferred annuity. Very few sponsors, however, have implemented a deferred annuity option in their 401(k) plans.

Payout Before Retirement

Let’s conclude the discussion of the 401(k) payout challenge by considering what happens when a participant terminates employment before retirement. It’s a commonplace that American workers change jobs multiple times in their careers. In many respects, the 401(k) system is an adaptation to this, providing a simple and fully portable benefit—a lump sum payment to the terminating participant.

Payout Options for Job-Changers

A participant who terminates employment, but continues working (and doesn’t retire) generally has three options: (1) Leave his account in his “old” employer’s plan. (2) “Rollover” his account to his new employer’s plan (or have it directly transferred to that plan) or to an IRA. Or (3) cashout his benefit.

As a general matter, the Tax Code encourages “leaving money in the system”—participants can avoid (current) taxation by either leaving the account balance in the old employer’s plan or rolling it over to an IRA or a new employer’s plan. And, as discussed above, if the participant is under 59 1/2, taking cash is generally punished by an additional 10% excise tax.

Option 1—Leave the Account in the Old Plan

Generally, if a participant’s benefit is valued at more than $5,000, it cannot be distributed without consent. Thus, participants with larger balances may generally leave their 401(k) account with their old employer. Data indicate that around 30% of participants take this option.48

Option 2—Rollover

Most rollovers go to IRAs. This fact was perhaps the main reason the DOL, in adopting the Fiduciary Rule (which we discussed in Chapter 22), attempted to extend ERISA fiduciary standards to persons advising IRA owners and/or providing advice with respect to rollovers.

The fact is, however, that the mutual fund industry has done a lot to make the IRA rollover process easy and nearly seamless. The very much more complicated and barely workable Tax Code rules for plan-to-plan rollovers have gone unaddressed. While a “money-follows-the-participant” rule may seem an intuitive best option for job changer rollovers, in the US it is nearly non-existent.

Option 3—Cashouts

Participants taking out cash, or in some cases being forced to take out cash, on termination of employment is, broadly, the most problematic “option” for retirement policy. These are usually small balances, usually for younger employees. The problem is that, to hit 401(k) adequate-benefit targets, saving early in your career is critical. Money that leaks out of the system during frequent job changes by younger employees may lead to retirement “failure” decades later.49

Missing Participants and Missing Benefits

Finally, there is a persistent problem both in the 401(k) system and in the legacy DB system of “missing participants,” although from the participants’ point of view this might more accurately be described as a problem of “missing benefits.”

Plan administrators and trustees find themselves holding typically very small balances for participants that cannot be found. And the search procedures required by applicable regulations are cumbersome, ineffective and distressingly ad hoc.

Most commonly, these amounts get distributed “somewhere” and then are eaten up by fees.

A Clearinghouse, Please

These very significant problems—the absence of a viable money-follows-the-participant process, younger employees with smaller balances routinely cashing out and plans not being able to find participants to pay out small balances to—cry out for some sort of master, software-based solution. Like, a clearinghouse that can (1) simplify the transfer of benefits from employer to employer, (2) match missing participants with their lost benefits (one wonders why the participant’s Social Security Number does not suffice for this) and (3) warehouse benefits that go un-matched (with participants) at no (or a very low) cost.

“Liquidity” versus “Leakage”

Generally, 401(k) contributions can’t be withdrawn until the employee terminates employment. Policymakers have, however, from the beginning, recognized that some employees, because of concerns about “cash flow problems,” may not want to make 401(k) contributions because they are reluctant to “tie their money up” this way.

To address these concerns, the 401(k) rules allow participants to withdraw their contributions when they have a “hardship” and also allow participants to take a loan of a portion of their account.

In this regard, we note that EBRI’s Jack VanDerhei testified before the ERISA Advisory Council that research has found “that participants in plans with a loan option have higher contribution rates than those without such access… It is likely that a similar relationship exists with respect to the availability of hardship withdrawals.”

This desire to encourage contributions by providing cash-strapped employees with liquidity is in tension with another policymaker concern, “leakage”—that when employees take savings out of 401(k) plans they reduce their chances of a “successful retirement.” There is also a concern that hardship distributions and loans compromise tax policy—an (often low-paid) participant might conceivably make a 401(k) contribution simply to “buy” the employer match, then turn around and withdraw that contribution to meet ongoing financial needs. That’s not really retirement savings.

To address these leakage and tax policy concerns, the Tax Code imposes a 10% “early distribution” tax on distributions from tax-qualified plans included in income before age 59 1/2 (with exceptions for, for instance, distributions on death, disability, or on termination of employment after age 55).50

There’s not a lot of data on just how significant this tax is, but a 2009 GAO report (401(k) PLANS: Policy Changes Could Reduce the Long-term Effects of Leakage on Workers’ Retirement Savings), quoted IRS as saying that “5 million tax filers paid $4.6 billion in early withdrawal penalties in tax year 2006.” That is a pretty big number. One wonders how much bigger it was in 2009, during the financial crisis.

Consider that this tax may be being paid by some individuals who, because their income is so low, pay no other income taxes. Is that good retirement savings policy, to make the most cash poor 401(k) participants pay a tax on their savings if they have to withdraw them for an emergency?

Finally, note that EBRI found that “cashouts at job change have a much more serious impact on 401(k) accumulation than either plan loan defaults or hardship withdrawals.”

* * *

This discussion of the 401(k) payout challenge concludes our discussion of the current 401(k)-based system.

Bottom line: the 401(k) system’s emphasis on transparency and individual choice makes it especially adaptive to our current world and world economy. But these features are also “bugs.” With respect to the three adequacy challenges we have identified—savings, investment, and payout—choice, specifically the risk that the participant will make the wrong choice, is a persistent problem. Defaults have gone a long way toward solving part of this problem.

In the end, we may simply have to live with the fact that in this system some participants will fail: to save enough or to invest appropriately or to adopt a reasonable payout strategy. That may be the tradeoff for a system that because of this flexibility is nearly three times as “popular”—covers three times as many American workers—as the DB system.

And there is another problem with the 401(k) system: because all critical decisions are devolved to the individual participant, it is basically a retail system. The economies of scale that are naturally available to a large DB plan, with one big pile of money and one big pile of liabilities, aren’t (naturally) there in a 401(k) plan.

New ways of exploiting scale have had to be developed. And that is an ongoing and imperfect process.

Before we go on to Part III, where we will discuss the “future”—future challenges and possible solutions—let’s consider an obvious question all of this raises: what happens in those cases in which this system does fail? What is Plan B?