Payouts from 401(k) Plans

September 25, 2007

By the end of this lecture, you should be able to:

Explain payout options from 401(k) plansDiscuss the importance of longevity risk in planning retirement withdrawalsExplain how life annuities address this risk

Why might they be valuableWhy might people not buy them

Accumulation: The “First Half” of 401(k) / Retirement Planning

How much money will individuals have at retirement?Key issues:

Savings rates• Own contributions• Employer match

Investment choicesAdministrative expenses

Payout: The “Second Half” of Retirement Planning

How do individuals convert their wealth into a sustainable stream of retirement income?Key Issues:

Longevity riskInflation-protectionSpousal protection

Payout Period is Lengthening

Earlier Longer More Retirement + Life = Years in Age Expectancy Retirement

Individuals are Living Longer

Life expectancy at birth in 1900 was only ___ years for men and ___ for women – it has increased approximately ___ years!Today’s 65-year old man can expect to live to age ___Today’s 65-year old woman can expect to live to age ___

But Uncertainty Remains

Fraction of 65 year olds dying by age 70

Men ____Women ____

Fraction of 65 year olds living to age 90+Men ____

Women ____

Your Mortality% Chance of Living to Age …

Males Females

Age SSA SSA

50 94.3 97.1

65 84.6 90.4

75 68.8 78.7

90 25.1 39.4

100 3.5 8.4

Payout Options

1. Lump sum distribution Rules

2. Systematic withdrawals

3. Life annuities/reversionary annuities

Note: All three are covered by minimum distribution requirements

Minimum Distribution Requirements

What is Congress’ objective?Distributions must begin at retirement or April 1 of year after turn 70 (whichever is later)Acceptable methods

Life annuities that are non-increasing (except for inflation protection)Payments made based on (IRS) life expectancy Anything faster is okayGoogle: Minimum Distribution Tables

Problems with these rules?

Why Does Uncertainty about Length of Life Matter?

Retirement financial planning difficultTrade-off two risks

Longevity Risk• The risk of outliving one’s resources

Under-Consumption Risk• The risk of dying with substantial wealth

that could have been used to finance higher consumption levels while living

How Address this Risk?

Life Annuities Trade a stock of wealth for an income stream that cannot be outlivedSolve the consumer’s retirement wealth allocation problemSave early & Often: Rich Dad’s

Cash Flow Quadrant

Annuity Provider’s Perspective

Companies can pool and share longevity risk across a large number of individualsIn the United States, the primary provider of annuities is the Social Security system, which pools longevity risk across nearly the entire population

Why Are Annuities Valuable?

Individual PerspectiveEliminates risk of outliving one’s resourcesProvides higher level of sustainable income than is available without annuities “Mortality Premium”: the insurer can pay a higher rate of return while living in exchange for loss of principal upon death

Example

65 year old male in year 2000$100,000 of financial wealthInterest rate = 6%Inflation = 3%Compare income from:

Inflation indexed annuityNominal annuityVarious “self-annuitization” strategies

Inflation Adjusted Income

0

2000

4000

6000

8000

10000

12000

Age

Cons

tant

yea

r 200

0 do

llars

Real Annuity

Nominal Annuity

1/LE

Self-ann.

Amortize

What is the cost?

What do you give up when you annuitize????Compare & Contrast to an SPDACompare & Contrast to a Variable Annuitywww.immediate annuities.comTax implications of Annuities

Economic Theory

Economic “life-cycle” theory of savings and consumption indicate that annuities ought to be extremely valuableSimulations indicate that the ability to access annuities is equivalent to a substantial increase in wealth

Few 401(k) Plans Offer Annuities

In late 1990s, only about ¼ of plans offered life annuities even smaller todayWhy?

Demand side: workers do not ask for themSupply side: some fiduciary responsibility for choice of insurer, OR, company carries the longevity risk itself (if set up as trust)

Consumer View of Annuities

Lack of consumer understandingIndividuals view annuities as a gamble – what if I die the next day?They are used to insuring against “bad” events, and living a long time is “good”

Already annuitized by Social SecurityWant liquidity for unexpected expensesWant to leave money to kidsOther?