Focus on Monthly Income When Saving for Retirement
One simple number could drastically improve 401(k) participants' retirement prospects -- if only employers, lawmakers, regulators and plan service providers would agree to include it on workers' account statements.
That number is the monthly income you can expect in retirement, based on your 401(k) account balance. A bill introduced in Congress in February would require 401(k) plans to give participants this information every year. And a slew of academic research suggests that it would help workers make smarter retirement-saving decisions.
Given the rapid disappearance of defined-benefit pension plans and questionable health of Social Security, retirement savers need all the guidance they can get. In a recent survey, more than 40% of workers said they determined their retirement savings needs by guessing, according to the Employee Benefit Research Institute. And more than one-fourth said they were not at all confident they'd have enough money for retirement, the highest level in the survey's 21-year history.
While slapping a retirement-income projection on a 401(k) statement sounds fairly straightforward, it would require many 401(k) plan providers to learn a whole new language. For decades, these plans have focused on workers' lump-sum account balances -- and they won't change overnight. Some employers are worried about potential liability if they give workers a retirement-income projection that may turn out to be inaccurate, says Lori Lucas, defined contribution practice leader at Callan Associates, an investment consulting firm based in San Francisco.
Workers who only get a lump-sum account balance are left with a host of "very complicated decisions," says Alessandro Previtero, assistant finance professor at University of Western Ontario's Ivey Business School. Whether your account balance is $100,000 or $1 million, deciding how much more to save, when to retire, and how much to spend in retirement won't be easy. But those questions will be much easier to answer if you have a rough idea of the monthly income your nest egg will generate during retirement.
There's already evidence that greater focus on lifetime income can spark big changes in 401(k) participants' behavior. Putnam Investments early last year introduced a tool that helps 401(k) participants project the monthly income their savings might generate in retirement. At the end of last year, more than one-third of participants who used the tool had made changes to their savings rate, and 80% of those changes represented increased contributions, according to Putnam.
Changing the language of 401(k) plan communications can also change the way workers think about drawing down their savings, researchers have found. Economic models suggest that annuities should have great value to workers, given the risk of outliving retirement savings. But participants who are offered annuities in 401(k) plans rarely make use of these products. Much ivory-tower ink has been spilled in attempts to solve this "annuity puzzle."
One recent study highlights how small variations in vocabulary can influence lifetime-income decisions. Researchers from the University of Illinois, Harvard University and the Brookings Institution asked over 1,300 people age 50 and older whether they preferred a life annuity or a savings account. Some people in the group were given information focused on consumption, showing how much they'd be able to spend over time but not mentioning lump-sum account values. Others were given information focused on investment, including lump-sum account values and risk and return features of each option, but not the resulting level of spending. More than 70% of people given the consumption-focused information preferred the annuity, versus only 21% of people whose information was focused on investment.
"There were small changes in the language we used, and it was enough to trigger people to have a different mindset," says Jeffrey R. Brown, finance professor at University of Illinois at Urbana-Champaign College of Business and co-author of the study. The 401(k) plan's message "has to be about income security in retirement," he says. "That's the point of a retirement plan."
If workers wait around for 401(k) plans to start sending that message and providing reasonable, low-cost lifetime income options, they could be waiting a long time. Callan Associates recently surveyed employers about what they offer or plan to offer in terms of income-for-life products, be they annuities, online services that help workers develop a draw-down plan, or other products. About 75% of employers said they don't offer any such products, and nearly 60% said they very likely wouldn't offer any in the next year, either. Fearing potential liability and flummoxed by 401(k) red tape, employers "lack a clear path as to what they can do and how they can help participants," says Callan's Lucas.
Fortunately, 401(k) participants can help themselves. If your plan doesn't offer income projections, consider online tools that will help you estimate the monthly retirement income you can expect your savings to generate. Simple, free retirement-income calculators include Vanguard Group's tool at retirementplans.vanguard.com, and T. Rowe Price's version at troweprice.com/ric.
Such tools, of course, are just a starting point. But once you begin talking about your projected monthly lifetime income, you're at least speaking the right language for retirement security.