In the retirement plan industry, accumulation of assets is the main focus and retirement readiness is the Holy Grail. However, there has not been as much thought about what comes next for the participant when they retire. New retirees may receive a lump-sum distribution of their plan assets with little guidance on what to do with this distribution after retirement.
A Common Feeling After Retirement – I’m Rich!
A newly-retired employee receiving a large lump-sum payment may now feel “rich.” This can lead to spending down assets too quickly before the realization sets in that they are about to run out of money. In addition, people continue to live longer, which also increases the probability of outliving assets. Unfortunately, there are no “do overs” in retirement savings, so it may be better to avoid the previous scenario by educating employees about retirement income products. This could involve inhouse education and in-plan products, but it could also be outsourced to a third party. While some plan sponsors may feel that retirement income solutions are beyond the scope of their responsibility to employees, others would like to offer products and guidance but are all too aware of fiduciary liability.
Retirement Income Distribution Is Custom and Complex
The reality is that the “decumulation” or retirement income distribution process can often be more complicated than the accumulation process because it is vastly different for everyone. Advice needs to be customized to each participant based on how much money they have saved, where that money is invested, potential life expectancy, when they will start drawing Social Security benefits and the amount of assets a spouse has, among other variables.
An early step in the education process is to establish how prepared an employee is for retirement. Participants need to be able to picture what they will need as monthly income in order to begin the planning process.
This will determine whether they need to keep working or if they can retire early. Interestingly, according to a “Wells Fargo Middle-Class Retirement” study in 2014, half of middle-class Americans in their 50s say they will not be able to retire until they are at least 80.
Asset Retention — Pros and Cons
Retaining assets of former employees in a retirement plan is also a complex issue on which plan sponsors have varying opinions. Some view the retention of these assets in the retirement plan as a positive, raising the average participant balance and reducing administrative costs for all participants. Others view administering the assets as requiring too much time and expense, feeling the retiree would be better off seeking advice from a financial planner.
In addition, most employees do not have the financial background to fully understand the tax implications or the many risks involved with retirement income products that is required to plan the distribution process by themselves. While a financial advisor is the ideal channel for planning the decumulation phase given its highly-individualized nature, only 19% of those employed and 25% of retirees say they have ever sought professional financial advice, according to the “Wells Fargo Middle-Class Retirement” study. Since they may be unlikely to seek the help of a financial planner, this creates an opportunity for plan sponsors to help bring the retirement savings process to the next level.
Exploring Retirement Income Distribution Options
There are a variety of options for retirement plan participants when it comes to retirement income distribution.
For example, the participant can chose to:
- Take regular distributions from their 401(k)
- Manage distributions from a rollover IRA
- Create an income stream from an annuity
- Invest in managed payout funds or managed accounts for retirement income
An investor’s retirement income goals, risk tolerance and potential longevity will help to determine which solution makes sense for them. In addition, there are advantages and disadvantages to each solution that should be considered. Providing education around options such as these can be helpful to retiring participants as they evaluate their many choices and transition to the next stage of their lives.
Taking Regular Distributions From A 401(k)
A participant can simply leave their 401(k) assets in their former employer’s plan and take distributions during retirement. Depending on the plan, they may be able to enroll in a regularly scheduled distribution program, or they may need to manually request each distribution. This may make sense if they are comfortable with the investments they have in their 401(k) plan and see no reason to move their assets. However, they may need to adjust the asset allocation of their account so that they are more conservatively invested for income but with the opportunity for continued growth to fund future withdrawals.
The advantages of this solution include the fact that the assets in their 401(k) account will continue to grow tax-deferred. In addition, if institutional class shares are used for the mutual funds in the 401(k) plan, the participant can continue to enjoy the typically lower-cost fees of institutional class shares as compared with more expensive retail class shares.
The disadvantages arise if there is more limited investment choice in their current 401(k) plan than the participant requires to meet their retirement income distribution needs. Also there is no opportunity to consolidate assets from other 401(k) plans they may have from former employees into one retirement income distribution account. As a result, they may be left with the headache of piecing together an income distribution strategy from multiple accounts.
Managing Distributions From A Rollover IRA After Retirement
Rolling over a 401(k) to a Roth or Traditional IRA that invests in mutual funds is also an option for retiring participants. Their retirement assets can continue to grow on a tax-free (Roth IRA) or tax-deferred (Traditional IRA) basis depending on the type of IRA they choose while they take the distributions they need for current income via a systematic withdrawal plan. Again making sure the appropriate asset allocation is in place is key, with more conservative investments in fixed income funds or high-quality dividend paying stock funds to provide retirement distribution income. This can be complemented by an investment in more aggressive equity mutual funds for growth.
The advantages of this option include the opportunity for consolidating multiple 401(k) balances into one account, thereby streamlining investment planning, simplifying record keeping and potentially reducing expenses as the retiree transfers their assets from multiple providers to one. In addition, the retiree may benefit from choosing a rollover IRA with an investment firm that offers a wider range of investment choices, including options for generating income.
The disadvantage for some retirees over the age of 70 ½, is that the retiree must take an IRS-mandated required minimum distribution every calendar year. This may or may not make sense for a retiree depending on their situation or goals. It is important for them to determine how these minimum required distributions fit into their retirement income plan. There can be IRS penalties for missed or underfunded distributions if this is not managed carefully. However this minimum distribution requirement does not apply to Roth IRAs, so they may provide a viable alternative.
Even if your employees have thought far enough ahead to calculate how much they need to save to retire comfortably, most don’t know what to do with those savings to create the appropriate income stream to last their retirement. This is where annuities may be useful.
- There are many types of annuities available including:
- Deferred annuities that begin payouts at a specified date in the future, age 70 for example
- Lifetime income annuities that begin payouts immediately from the retiree’s lump sum with guaranteed income over the course of the retiree’s lifetime
- Variable annuities that pay a level of income in retirement that is determined by the performance of the underlying investments
The advantage of annuities is that the retiree can set up a regular and guaranteed retirement income stream to meet their income distribution needs. The concept of annuities is appealing to retirees given the universal fear of running out of money. In fact, a June 2012 survey from MetLife found that 68% of those polled would rather have less guaranteed income than the potential for higher, but not guaranteed, returns.
However annuities have been criticized for having high fees, high commissions and low payout rates in the current low interest environment. The investor needs to carefully consider the financial stability of the annuity provider, the potential payout rates and the fees charged among other criteria when considering annuities.
Managed Payout Funds and Managed Accounts
Managed payout funds are mutual funds that are also designed, like annuities, to provide a steady income stream until assets are depleted. In addition, they offer the flexibility to adjust the level of income distributed depending on the performance of the fund. This can be a double-edged sword as if the fund outperforms, the income distribution can increase. However if the fund performs negatively, this can have an adverse impact on the income available for distribution. When managed payout funds are offered in-plan, they usually provide access to lower-cost institutional shares. The problem with managed payout funds is that they are “one-size-fitsall,” which may not meet a participant’s specific needs. Instead, a managed account with a personalized drawdown strategy could be a better option, although potentially a little more expensive for the investor.
Plan Retirement Income Products — A Growing But Uncertain Trend
While the introduction of in-plan retirement income products into retirement plans is growing swiftly, participant election of these products has been anemic even though a TIAA-CREF survey indicated that “guaranteed money every month” was the top priority of nearly half of its polling sample. According to data from LIMRA LOMA Secure Retirement Institute* there were 33,500 retirement plans at the end of 2014 that offered in-plan income-guaranteed products. However, only 2.4% of participants elected to use these products and 80% of the plans that offered these products had no participant election.
However these products may provide an opportunity to generate more assets in the plan in the face of increasing 401(k) outflows. In June 2015, The Wall Street Journal reported that 401(k) net flows first turned negative in 2013 (-$11.3B) as Baby Boomers retired and pulled their money out of their plans. Estimates are for this trend to continue at an accelerated pace, with net outflows peaking in 2019 and not turning positive until after 2030.
Look To ABG For Resources. ABG continues to provide resources to help retirement plan participants develop a strategy around investing for retirement and transitioning to retirement. Find out how ABG Houston can help your prepare your employees for retirement and also what happens after retirement with our Retirement Solutions for Employers.
To learn more, talk with your Houston ABG representative. ■
*The LIMRA LOMA Secure Retirement Institute provides comprehensive, unbiased research and education covering all aspects of the retirement industry.