With nearly 70% of employees who fear they do not have enough money for retirement, the challenge for benefit advisers is to provide workers with an educational framework to analyze their individual retirement situations.[i] The problem is particularly acute as employees approach the “Retirement Danger Zone,” which is the period from five to 10 years before and after retirement. Investment mistakes or a market meltdown during this timeframe could have a crippling impact on a 401(k) or similar deferred compensation plans.
The typical 401(k) analysis uses a systematic withdrawal plan over a period of years. With an accumulated lump sum and a simple withdrawal strategy, an employee is supposed to feel secure. However, this approach ignores the realities that face today’s retirees.
First, this strategy looks at 401(k) assets in terms of a lump sum instead of how much income can potentially be generated. Given that most workers no longer have pensions, the real issue is to determine how much income their 401(k) will generate when combined with Social Security benefits to maintain their standard of living.
Second, market performance is not consistent and can be extremely volatile. Market uncertainty can make retirement planning seem more like a game of roulette. Consider the tale of two employees who each invested $100,000 in their company’s 401(k) that tracked against the S&P 500 Index. One employee approached retirement in 2005 and the other in 2017. The table below shows the difference in the market and its impact on their portfolios.
The first employee would have seen the account decline from $100,000 to about $88,000 over the course of four years from 2000-2004. The second would have seen the same $100,000 initial balance increase to about $201,000 over a four year period from 2012-2016 — more than double! Timing is the only difference that affects the outcome between these two plans. Employees feel insecure about retirement due to unpredictable discrepancies that result from market performance.
The third problem with the systematic withdrawal strategy is that it ignores longevity. Today, if you look at a 65-year-old couple, there is a 50% chance one spouse will live to age 92 and a 25% chance that one will live to 97. Trends show that life expectancy will continue to rise and can even experience dramatic changes as demonstrated by the five and a half year global increase between 2000 and 2016. As life expectancy rises, the amount of time spent in retirement also grows. The increase in life expectancies means that employees face the prospect of outliving their assets. This creates uncertainty as to how much money to save based on the number of years which they expect to need funds following retirement and what annual withdrawal percentage is safe during the distribution phase.
Retirement incoming flooring
Given the problems with the systematic withdrawal approach, it makes sense to offer employees an alternative strategy for retirement security. We call it “retirement income flooring.” This strategy provides a “floor” of essential retirement income, which is the amount needed to cover basic expenses. It combines promised-based income assets, such as annuities, with Social Security and, for those lucky few, pensions. The income floor is from guaranteed sources so employees would not have to leave their retirement to chance. Let’s consider how flooring solves the problems associated with systemic withdrawal.
At the most fundamental level, the flooring strategy involves consideration of income generated rather than simply a lump sum in an account. Employees would know exactly how much they would need to invest and how much monthly income would result. This simplifies “income gap” planning and eliminates the uncertainty and guesswork.
Furthermore, employees would not have to worry about the whims of the financial markets, particularly as they approach the retirement danger zone. The key to this approach is for employees to start to transition a portion of their retirement nest egg into promised-based income assets five to 10 years before they retire. The income payments can be deferred until after they retire and their principal would be protected from market fluctuations during this critical time period.
If you can help employees plan early and rebalance their portfolios towards promised-based income assets, they can invest a smaller percentage now to generate the floor income when it is needed. These assets produce higher payout rates to retirees due to mortality credits and payments based in part on life expectancy, which distinguishes them from other income producing assets such as bonds. It enables employees to cover the “income gap” with a smaller percentage of their portfolio, so they have more assets remaining to utilize for liquidity, growth and legacy objectives.
Finally, income flooring eliminates the risk of employees outliving their retirement savings. Unlike traditional investments, promised-based income assets provide payments for life. In fact, the longer someone lives, the more money they will collect. These assets have options such as life or joint-life payouts and a cash refund feature to protect against premature death. Employees can be reassured and know that their retirement well will never run dry.
If employee benefit advisers can provide employees with an alternative framework to analyze and address their retirement income needs, we can eliminate many of the risks and uncertainties hanging over today’s workforce. With fewer retirement concerns, employees can be more productive and less inclined to feel they have to work beyond what they expected. A “flooring” strategy can help employees achieve their most fundamental retirement goal: a stable lifetime income.
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