How Retirees Can 'Pensionize' Their 401(k)s and IRAs

In a world of defined contributions, American workers have three challenges — inadequate savings, leakage (or loans/early withdrawals) tied to their retirement accounts and the need for retirement income. Plus, just half of all DC plans offer a way for investors to transform balances into periodic retirement income, with only one in five offering guaranteed lifetime payouts.

This situation prompted Steve Vernon of the Stanford Center on Longevity, Wade Pfau of The American College of Financial Services and researcher Joe Tomlinson to explore and devise solutions to “pensionize” retirement plans. Their work, first published last year and then updated this year, finds that only one-third of workers contact financial advisors, and most lack the necessary skills to convert savings into retirement income and typically have short planning horizons.

But research from the Stanford Center on Longevity (SCL) and Society of Actuaries (SOA) has found a “straightforward retirement strategy,” according to the three authors. “Choosing a specific solution that will help workers generate retirement income requires them to make informed tradeoffs between potentially competing goals,” they explain, such as “maximizing lifetime income; providing access to savings (liquidity); planning for bequests; minimizing implementation complexity and costs; minimizing income taxes; protecting against common risks, like longevity, inflation, death of their spouse, cognitive decline, fraud and political/regulatory issues.”

For advisors and investors, the team of researchers developed eight metrics for comparing retirement income solutions:

• Average annual real retirement income expected in retirement,
• An increase or decrease in anticipated real income (inflation protection),
• Average accessible wealth expected throughout retirement (liquidity),
• The rate that wealth is spent down, the average bequest expected upon death,
• Downside volatility (the estimated magnitude of potential future reductions in income),
• The probability of shortfall relative to a specified minimum threshold of income, and
• The magnitude of shortfall.

Investors should maximize the value of Social Security and also work with advisors and/or available software to optimize this income stream. “Our analyses show that for many middle-income retirees, Social Security benefits will represent one-half to two-thirds of total retirement income if workers start Social Security at age 65, and from three-fourths to more than 85% of total retirement income if they optimize Social Security by delaying until age 70,” the report states.

The Social Security/RMD Option The key strategy highlighted by the team is based on Social Security payments starting at age 70 and required minimum distributions (RMD). For older Americans who find it tough to work longer, it may be advisable to use some savings to delay taking Social Security benefits. The Spend Safely in Retirement Strategy, the report authors point out, may produce “more average total retirement income expected throughout retirement compared to most solutions,” automatically adjust RMD withdrawal amounts to recognize investment gains or losses, provide lifetime income “no matter how long the participant lives,” project total income that increases moderately in real terms, produce “a moderate, compromise level of accessible wealth for flexibility and the ability to make future changes,” provide “a moderate, compromise level of bequests,” produce “low measures of downside volatility,” and give older workers flexibility to transition from full-time to part-time work.

“The Spend Safely in Retirement Strategy has another significant advantage: It can be readily implemented from virtually any IRA or 401(k) plan without purchasing an annuity,” the exports say.

In the years leading up to retirement, an older worker might want some retirement savings to build a “retirement transition bucket” for delaying Social Security, based on the amount of benefits the retiree would forgo during the delay period. The transition bucket also would act as a buffer if the older worker is uncertain about the timing of his or her retirement and might protect the worker against large stock market declines during the pre-retirement period.

The bucket might include investments in a liquid fund with minimum volatility in principal, like a money market fund, short-term bond fund or stable value fund.

“Our analyses support investing the RMD portion significantly in stocks — up to 100% — if the retiree can tolerate the volatility,” the report explains, noting that volatility in the full retirement income portfolio is reduced by income from Social Security, “which doesn’t drop if the stock market drops.”

The analyses forecast “reasonable results” with target date funds (many with a 50% stock allocation) or balanced funds (60% stock allocation), which are available on most IRA and 401(k) platforms. “These lower stock allocations could reduce expected income but would also produce lower downside volatility, compared to a 100% stock allocation,” the report says. Low-cost balanced, target date or stock index funds have a critical role to play, they add.

Refinements The authors recommend that retirees have an emergency fund to cover onetime purchases or unforeseen expenses. Some retirees also need money for active travel or other expenses they wish to pursue early on in retirement.

For those who want more guaranteed income than produced by the Spend Safely in Retirement Strategy, a portion of savings could be used to buy a low-cost single premium immediate annuity (SPIA), guaranteed lifetime withdrawal benefit (GLWB) or fixed income annuity (FIA).

For retirees with home equity, these resources could be tapped for a reverse mortgage to generate additional monthly income or a reverse mortgage line of credit to help cover living expenses.